Reset Expectations

For a data-dependent Federal Reserve, timing may be everything. In what was described as a “close call” by Fed Chair Jerome Powell, the Fed cut the policy rate by 25 basis points to 4.25% to 4.50%, as expected. However, it was the changes to the Fed’s forecast that captured investors’ attention and caused anxiety. The quarterly update of the Fed’s Summary of Economic Projections (SEP) revealed a Federal Open Market Committee (FOMC) with growing concerns about the progress on inflation, with the median 2025 inflation forecast rising to 2.5% from the prior forecast of 2.1%. This reflects not only a higher expected inflation rate for next year but also a year-over-year increase — and a stall in progress. At the same time, the 2025 growth and unemployment rate forecasts rose only modestly.

Altogether, the signal from the Fed is that inflation concerns may be back on the front burner, and this view was reinforced in the forecast for monetary policy in 2025. The September SEP forecast of four rate cuts for 2025 was halved to only two. The FOMC meeting took place before the release of the Fed’s preferred inflation data for November — the PCE, which indicated that both headline and core inflation were rising at a slower pace than expected. The month-over-month gain of 0.1% for each and the 2.4% year-over-year headline rate both suggest that, although progress toward the 2% policy target has been uneven, the U.S. economy remains on track. 

Although investors have become quite obsessed with the Fed’s Dot Plot, few realize that it has only been around since 2012. Then-Fed Chair Ben Bernanke introduced it as a way to improve transparency and provide a visualization of the dispersion of opinion across the FOMC with respect to the monetary policy path versus simply — and only — releasing the median forecast. The financial markets have become increasingly focused on these dots — particularly so given the lack of real forward guidance from the Fed and the more recent pattern of policy pivots and reversals.

For us, we don’t find value in trying to predict where the dots will land or where they will move in the future. We avoid over- or mis-interpreting the dots, given that the individual FOMC forecasts are just that — a point-in-time guesstimate that is done prior to the committee meeting and any collective discussion and debate on economic conditions. Fed Chair Powell himself downplayed the importance of the individual dots, noting that “these projections are not a committee plan or decision.” 

Both equities and bonds have sold off following the Fed’s hawkish cut on Wednesday, with particular pain being felt across interest-rate-sensitive equities like small caps, value stocks and real estate REITs. We caution against extrapolating any of the weekly moves into evidence of reliable trends. As we close in on the end of the year, there is always some noise around investors protecting gains, taking tax losses and even window dressing portfolios: Investors should continue to filter out this noise and focus instead on the fundamentals. The economic backdrop in the U.S. continues to be favorable, with growth gliding toward a soft landing and inflation falling to within a more comfortable range. While we may not get the previously expected tailwind of more aggressive Fed rate cuts in 2025, the change in rate expectations is for the right reason — the growth outlook continues to be strong and, as a result, the Fed is able to be more patient. This is good news.

We continue to believe that the market will broaden in 2025 with a recovery in those sectors and strategies that have effectively been left behind in the era of MAG7 (Amazon, Google, Meta, Apple, Tesla, Nvidia and Microsoft) dominance, which has continued in 2024. For context, as of December 18, the MAG7 have been responsible for 56% of the S&P 500 return this year — close to the 63% contribution they made in 2023. There is fundamental support for this contribution, with these stocks providing collective and expected earnings growth of 36% this year while the remaining 493 stocks in the index are forecast to earn only 3%. Next year, MAG7 earnings growth is expected to decelerate to 21% while the rest of the market enjoys an acceleration of earnings growth to 13%. 

We are all data dependent, and this only ensures that investors will react and often overreact to the various economic datapoints that are released. As we have noted in the past, many of these datasets are backward looking and are subject to sometimes dramatic revisions, and often we can get mixed messages from the barrage of information we receive. Without a firm guiding light — i.e., a monetary policy framework that is designed to provide forward guidance — we are all “walking in a dark room full of furniture” (Powell) and proceeding step-by-step, which likely means we will experience bouts of volatility in financial markets as knees and shins are bumped and investors react. We do anticipate that the Fed will move slowly next year: However, the band of uncertainty around both the pace and magnitude of cuts is wide. If inflation continues to fall, we could get more cuts. However, if we backslide or don’t make continued progress, we would expect a longer pause. If the jobs market weakens in an unexpected way, we would anticipate a policy reaction, as this Fed is reluctant to relinquish progress made toward a soft landing.

Our views on the macro backdrop remain unchanged: We expect a soft economic landing accompanied by continued but uneven progress on inflation toward the 2025 targets. Our view remains that the Fed will react and respond to any unanticipated changes in the growth or inflation outlook, but there is an additional unknown in the form of new policies under a Trump administration that may bend the growth and inflation curves in unpredictable ways, leading to a more cautious Fed. 

Finally, a brief note on the prospect of a government shutdown. As of Friday morning, the outlook for a potential U.S. government shutdown remains murky. After Thursday’s defeat of the “plan B” continuing resolution proposed by Republicans — a plan that included over $100 billion in disaster relief and a suspension of the debt ceiling for two years — it is back to the drawing board with a “plan C” now being mapped out. The second GOP proposal garnered almost no Democratic support, and 38 House Republicans were also in opposition. The third-rail issue at this point is the suspension of the debt ceiling, and it is more likely now that this may be excluded from the next proposal, which is risky business given that the debt ceiling’s current suspension expires January 1.

If no deal is stuck, the government shutdown would commence at midnight. While optimists are suggesting that a government shutdown resulting from failure to reach a deal may be very short lived — potentially only for the weekend — investors are becoming more anxious not only about the possible length of a shutdown but also about the difficulty in getting a deal done with some of the Republicans upon whom President-Elect Trump will rely to implement key planks of his policy agenda.