The Horizon

Looking back, 2024 was a dynamic year for investors with multiple macroeconomic factors at play. These included a normalizing economy with stronger growth and moderating inflation, a resilient U.S. consumer who continues to spend, a still-solid labor market, broadening corporate earnings growth, multiple Federal Reserve (Fed) interest rate cuts, and ongoing geopolitical risks.

It was another year of Large-cap, tech-focused companies outperforming, with the S&P 500 Index ending the year up 23%, marking the first time of back-to-back 20%+ gains since the late 1990s. We see this as a powerful macro backdrop and position to be in heading into 2025. In this edition of The Horizon, we highlight some of our longer-term views for this year and beyond, the impact of Artificial Intelligence (AI) on equities, and give an update on the Fixed Income space.

Valuations and growth: A different decade ahead

In “Not a Lost Decade, But Just a Different One,”¹ from our Investment Insights series, we examine reasons why valuations should remain high in the coming decade, although not as high as current estimates. Given that equity returns have been notably strong the past decade and, more recently, up significantly from the low points of 2022, it could be expected that prospective returns may normalize. We believe the next decade may have different core drivers than ones of the past.

The “Great 8 Reasons,” which may allow for higher normalized growth and above average valuations.

1. Asset-light economies: The economy and equity markets today are more asset light, with companies facing fewer high fixed costs for machinery, infrastructure and labor. This provides greater flexibility and efficiency in capital investment.
2. Technology-driven companies: Creates increased levels of productivity translating into improved economies of scale. In our opinion, companies can protect and advance margins more effectively through innovation.
3. Market diversification: While there is still high concentration in mega-capitalization stocks driven by the Information Technology sector, markets are still more diversified today, therefore, economic and profit downturns are less frequent and sharp.
4. Growth in private markets: Companies are staying private for longer. Because there are less initial public offerings in the current environment, it has led to a low supply of equities in the public markets relative to demand. This is generating more support for asset prices relative to history.
5. Heavy asset investment: Asset-light companies are investing in infrastructure and power generation, stimulating growth in heavy-asset sectors.
6. Interest rate stability: Transparency of monetary policy has allowed more effective business planning and capital investment, compared to prior decades.
7. Wealth transfer: The production and transfer of wealth in the public and private markets is vast and growing rapidly. Due to wealth transfers and the need for retirement security there should be increased investment demand.
8. Different core inputs: While it may make sense that equity returns could be lower given valuation levels, the next decade may have significantly different core inputs. These factors should support asset prices, suggesting that future, potential equity returns still remain attractive.

AI revolution: Transforming industry

One of the major advancements of this next era is the disruptive innovation caused by the AI revolution that should begin to unfold across a variety of industry groups, which would help to sustain corporate profit margins and increase productivity. There are many ‘green shoots’ of AI implementation across sectors, which we explore within our Equity Spotlight report, “AI in Tailwinds.”²

• Defense sector: Companies are discovering that AI helps in the decision-making process by improving the inclusion of defense contractors’ and technology firms’ software materials, making it a more efficient process to both interpret and secure data.
• Increased productivity: AI augmented and enhanced tasks like content creation, software development, marketing and sales, and customer service is saving time for both knowledge workers and consumers alike.
• Healthcare advancements: AI has the potential to drastically improve the future of drug development, although this will likely take years to influence revenue and earnings. In the near-term, AI could help customers with ‘connected care’ at home; medication delivery, scheduling medical events, providing recommendations, etc.
• Power sector: AI is driving greater demand for electricity, which has directly translated into higher prices in unregulated markets, improving margins for independent power producers.
• Data centers: While the effects on the real economy from AI are still coming into existence, the buildout of energy-intensive AI data centers – the physical infrastructure required to store and process vast volumes of data – is real and happening.

The Chief Investment Office sees AI in early tailwinds that are boosting profit margins, which have already more than doubled in a generation even without the AI developments that will likely feature prominently in the future economy.

Fixed Income: Opportunities amid volatility

In our Fixed Income Spotlight report, “2025 Year Ahead: Clip Those Coupons, Be Ready if Anything Goes On Sale,”³ we emphasize that for investors who exhibit patience throughout any potential volatility, we are constructive on overall Fixed Income returns, especially in a multi-asset class portfolio. First, The Fed has reduced inflation from its 2022 highs of ~9% to below 3%, while unemployment has increased. The Fed is focused on avoiding a recession; they cut rates during the second half of 2024 and remain on guard going into 2025 to ensure inflation remains under control and the labor market is robust. Usually, rate cuts calibrated to the economy act as gravity on longer-term yields, helping to avoid significant rate spikes. Secondly, Treasury valuations are attractive on a nominal and real basis, both absolutely and relative to other opportunities. Furthermore, real rates have afforded compensation at the high end of the historical range and have been significantly more attractive than anywhere else globally. Third, in both a positive and negative development, valuations are extended across risk assets. S&P 500 trailing, forward, and long-term price/earnings multiples are at the high end of historical ranges. Investment-grade recently hit levels not seen since 1997 and High Yield bonds currently offer no additional yield after factoring in credit losses. When almost everything has been expensive, catalysts are more likely to be able to cause larger price disruptions, therefore, an up-in-quality tilt is warranted. Our highest conviction Fixed Income call remains that the yield curve will normalize as short rates move lower. With that in mind, investors should consider extending out their strategic duration target and not be overly reliant on short-dated Fixed Income or cash alternatives.

Balanced Market Outlook for 2025

Ultimately, our base case for 2025 is a balanced market outlook. The U.S. remains our preferred Equity region relative to the rest of the world given a corporate profit cycle that powers on with continued growth, a robust consumer, and positive impacts from the AI revolution. As inflation continues to slowly trend downward, we continue to emphasize diversification across asset and sub-asset classes.

We continue to advocate for an appropriately balanced, diversified portfolio, with exposure to both Equities and Fixed Income (and Alternative Investments, where appropriate). We recommend investors put cash to work and remain fully invested, which we believe will be beneficial for longer-term financial success.