Global Market Review and Outlook

• Economic growth in 2024 was much better than feared, and while plenty of uncertainty exists about future trajectory following the U.S. elections in November, the base case remains one of further modest deceleration in growth and inflation.
• 2024 marked a second consecutive year of above-average returns in the broad equity market indexes. With valuations already elevated for the larger-cap stocks, market performance will need to be driven more by earnings growth than multiple expansion.
• The Fed feels the economy is in a good place, and the economic outlook is consistent with further rate cuts by the central bank, as it seeks to ease policy restrictiveness without adopting an outright accommodative policy stance.

Sticking With Durable Franchises

Just like the durable franchise companies we like to invest in, we are pleased to note that this January, William Blair celebrates its 90th anniversary. The company was founded by William Blair in 1935—in the midst of the Great Depression and not far off the bottom of the historic market crash of 1929—and it has been investing in growth stocks ever since.

Over these past 90 years, the return for large-cap stocks has been 1,586,709% and smaller-cap stocks 8,933,601%. Conversely, the purchasing power of holding one dollar of cash has continued to decline due to the combined impact of inflation and growth in the money supply (exhibit 1). For example, one can of Coca Cola today costs $0.86; that same amount back in 1935 would have afforded 23 cans. If this doesn’t highlight the power of staying invested, we don’t know what does.

We are proud of our stability, our culture, and our consistent focus on our clients, and are especially grateful at this milestone for the trust you have placed in us over these many years. We look forward to sharing many more such milestones with you in the future.

Purchasing Power of One U.S. Dollar

(Value of 1 U.S. dollar in 2020)

Economic Growth and 2025 Uncertainty

The consensus amongst economists at this time last year was that there was a 55% probability of a recession in 2024, which was better than the 65% predicted in June 2023 but still worryingly high. The yield curve was deeply inverted in January 2024, the manufacturing sector had been in a recession since the previous year, and it was expected that the lagged impact of the significant Fed tightening would start to firmly bite once consumers had polished off the last of their pandemic-related excess savings and most of the pent-up demand for consumer services (the so-called revenge spending) was fully satiated.

Yet, despite the Sahm rule also being triggered (a rule stating that since the 1960s, there has always been a recession when the 3-month average unemployment rate has increased by at least 50 basis points from the low over the previous 12 months) in July 2024, there was still no recession. The economy grew by (a currently estimated) 2.7% within the year, and inflation continued to drift lower, from 3.1% in December 2023 to 2.4% by September 2024 (now back to 2.7%). The disinflation allowed the Fed to start cutting rates in September, with its main policy rate finishing the year 100 basis points lower than at the start.

The year was marked by two major demand shocks. While we are perhaps more accustomed to hearing about negative demand shocks (financial market crashes, bank failures, and pandemics), these two shocks can be seen as positive ones.

The first was a major surge in immigration. Setting aside the political environment around the topic, immigration can and did fuel greater consumption and greater capacity to produce goods. According to data from the Congressional Budget Office, net immigration over the last three years increased by almost 10 million people, slightly more than in the 10 years up to 2019. For example, the CBO estimates that there was an increase of 3.3 million in 2024 (the same as in 2023) and there will be an increase of 2.6 million in 2025, which compares to an annual average increase of 900,000 in the decade to 2019.

The U.S. economy’s speed limit is often dictated by growth in the size of its labor force (which is a function of population growth and other demographic variables), growth in the size of its capital stock (the plant, equipment, and machinery those workers use), and growth in productivity (or how well both capital and labor are combined to reach better synergies). Hence, more immigrants, from a purely economic perspective, increase not only the economy’s ability to produce more but also consumption levels, as there are now more mouths to feed, homes to be filled, and clothes to be worn.

This surge in immigration has also helped plug a major hole in the labor market, which has been structurally tight, leading companies to struggle to find workers, and this, in turn, has helped ease pressure on labor costs and therefore inflation.

The second major demand shock relates to faster productivity growth. This growth helps resolve one of the curious aspects of the economy’s performance over the past year, which was the sharp divergence between the growth in employee hours worked and growth in total consumption (real GDP growth, exhibit 2).

Growth in Real GDP and Aggregate Weekly Hours Worked

% Change on Year Ago

The divergence was similar to that experienced during the late 1990s, or the last time there was a major investment and innovation boom. It is probably a little too early to suggest that much of this is the result of GenAI; rather, this increase in productivity is likely resulting from the lagged effects of the increased capital investment companies were forced to undertake during the pandemic, when the labor supply was heavily constrained. The emergence of GenAI and the probability that there are many more efficiencies to be gained suggest that this innovation wave still has plenty of momentum into 2025.

With this in mind, economists have reassessed their view as to the economy’s underlying strength and are now attaching just a 20% probability to a recession in 2025. This includes an estimated deceleration in growth to 2.1%. Inflation, however, is likely to remain sticky, with an expected deceleration to a still-above-target 2.5% by year-end.

It is also the reality that greater uncertainty is found with economic forecasts following key elections. President-elect Trump’s election mandate included a series of measures, such as tariffs, deportations, tax cuts, deregulation, and government spending reductions, which, if enacted to the extent described, could have some quite radical implications for both growth and inflation—with deportations and tariffs being the most significant. As much as companies might enjoy the potential for greater deregulation, the lack of clarity into the outlook for other policies will also have a dampening impact on economic activity until it is resolved.

Lastly, it is with great sadness that we see yet another round of natural disasters taking place. Following recent devastating hurricanes along the East Coast of the U.S. through the fall, the current fires in California are a deeply tragic event, made all the worse by the fact that they are largely impacting residential areas as opposed to the forest fires that the state is accustomed to and prepared for.

Economically, while devastating, the national implications from California’s fires might not be as great as, for example, hurricanes Katrina and Rita, which in 2005 knocked out approximately 25% of the nation’s productive capacity for oil and gas and caused oil prices to jump by about 15% at the time, then subsequently feeding into headline inflation. California’s fires are mostly residential and will be less impactful on any infrastructure crucial to the nation’s productive capacity, though labor in the services sector will be heavily impacted.

Similarly, any rebuilding should not be viewed as stimulative to growth. As Frederic Bastiat’s broken window fallacy highlights, funds that are being used to repair “broken windows” might stimulate some areas of growth—create more work for the glazier, who can then spend more money at the baker, the butcher, and the shoemaker—it is still the case that the homeowner had to pay the glazier from their savings that could have been more productively spent elsewhere, on something that would have increased the capital stock rather than just repairing something broken to keep the capital stock stable. Or, had they continued to be saved, those savings in the bank could have been used as loans to other entities for greater investment elsewhere.

The inflationary impact could be a trickier one to negotiate for the Fed, as this is just another in a series of what have been “one-off” events causing spikes in inflation. In the past, with regard to events such as Katrina, the Fed chose to “look through” these as temporary supply shocks and not “too much money chasing too few goods.” This might be different today if consumers start to see these as being less-isolated blips and increasingly as inflation simply being permanently higher. If that is the case, the Fed will then need to balance any potential adverse shifts in longer-term inflationary expectations against the adverse impact that higher rates (or fewer cuts) might have on aggregate growth and the rebuilding process that will take years in California, at a time when labor markets are already extremely stretched and housing is in very short supply.

Market Returns Past and Future

U.S. equity market performance in 2024 was once again dominated by just a handful of mega-cap growth stocks—the Magnificent 7 (exhibit 3). These stocks rose by an average of 60.2% in 2024, compared to a still very respectable (but nevertheless much worse) 12.1% for the remaining 493 companies in the S&P 500 index.

S&P 500 vs. Magnificent 7

(Indices Rebased to 100, 28 December 2023)

The aggregate index total return was 25%, which was strikingly similar to the 26.3% in 2023. The last time the market experienced at least two consecutive years of above-20% returns was the 1995-1999 period when all five years were above 20%.

What might we expect to see in 2025? To assess this, we need to break down where returns come from in the first place. For example, 2024’s 25% total return can be described as the sum of the dividend yield in the year (1.3%), inflation (3%), real earnings growth (6%), the change in the P/E ratio or multiple expansion (13%), and the change in the P/E ratio multiplied by the change in earnings, to capture the amplification effect of the P/E, which feeds back onto earnings.  

If we assume a similar dividend yield in 2025 of 1.3% and inflation of 2.5%, we are left with estimates of real earnings growth and multiple expansion or contraction. The current consensus is that earnings will grow by 12.5% in 2025. What we also know is that these estimates tend to deflate over the course of the year by a median of 2.4%, as depicted in exhibit 4. Assuming the same for this year brings us to an EPS growth rate of around 9%-10%.

Progression of S&P 500 2025 EPS Estimates, 2025 vs. Median 2002-2024

(Rebased to Estimate at end of Q4 2024 of $275.05 per share)

What requires a little more guesswork is what happens to the P/E multiple. At a current 21.4x 2025 EPS (24.1x trailing-12-month EPS) and an estimated 20.2x 2026’s earnings, this year’s forward multiple is more than one standard deviation above the historical average of 16.4x. If, using the above assumptions, we assume an unchanged multiple, our return is around 10%-11%. If, however, we assume some compression in the multiple of 1 percentage point, the return slips closer to 5%. This tells us that this year, earnings growth will likely need to do all the heavy lifting in terms of market return, as opposed to the strong contribution from multiple expansion over the previous couple of years.

Two areas we find particularly attractive looking into 2025 are higher-quality small- and midcap segments within the equity market. These are areas of the market that have been widely ignored over the last few years, and where valuation ratios remain historically attractive, having seemingly already priced in plenty of bad news. If we are right, as investors increasingly decide to seek some diversification and take a more active approach to portfolio management in 2025, we could see some strong performance from this area of the market.

The Fed Still Has Room to Lower Rates

The above-mentioned smidcap segments of the market are also likely to be supported by further expected rate cuts from the Federal Reserve. While the market is no longer expecting the Fed to lower rates by as much as it was previously, further cuts are still very likely.

Current pricing is consistent with a terminal fed funds rate of 3.75%, whereas the Fed is currently guiding toward a rate of 3.6%-4.1% in 2025 and a terminal rate of 2.9%-3.6% by 2027. The reality is that the economy is in a relatively good place at the moment. However, if the Fed does nothing, this would be consistent with effectively a further tightening of policy, as real rates would increase (on the back of moderating inflation) and private sector interest rates would also rise as debt contracts mature and ultra-low locked-in contracts roll into new higher-rate agreements, reflecting the prevailing interest rate environment. Thus, further Fed rate cuts would be consistent with moving policy from restrictive territory into still moderately restrictive but not yet accommodative territory (exhibit 5).

Fed Funds Rate Futures Market Expectations & FOMC Projections, %

Total Returns
Sources: FactSet, William Blair Equity Research

We look forward to our meetings and conversations as we move into 2025. As always, thank you for your trust and confidence.

1935 Wealth Management Team