Initial Conditions

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Many years ago, I worked for the Office of Revenue and Tax Analysis at the State of Michigan and, from time to time, Saul Hymans and his colleagues from the University of Michigan would visit the state government in Lansing to discuss the latest output from their macroeconomic models of the U.S. and Michigan economies.

As they started into their presentation, I was always eager to hear about their forecast. However, I was rather puzzled about how much time they devoted to the current quarter. I mean they had a big macroeconomic forecasting model – couldn’t we just skip the present and move on to the future?

Over the years, however, I came to appreciate their process. Forecasting is extremely difficult and projections can fall off the rails pretty quickly. That being the case, you should, at a minimum, be pretty clear on initial conditions.

This seems particularly relevant today. At first glance, the economy appears to be on a stable, non-inflationary growth path. However, many financial assets have vaulted off the springboard of that foundation to reach very high valuations. Moreover, the outlook for the economy in 2025 could be significantly impacted by policy changes from the incoming administration, while some longer-term risks are growing. Meanwhile, many investors have much larger, but less balanced, portfolios than just a few years ago.

All of this suggests that most investors should consider some adjustments entering 2025. But in deciding precisely what to do, it is first important to understand initial conditions, as we exit 2024.

Growth: Starting with economic growth, following annualized gains of 3.0% and 2.8% in the second and third quarters, respectively, real GDP is on track for a roughly 2.5% gain in the fourth. Digging into the details, consumer spending appears to climbing by between 2.5% and 3.0%, led by a surge in light-vehicle sales to their strongest pace in three and half years. The Boeing strike likely depressed business fixed investment after three consecutive quarters of 4%+ real growth. However, with this strike now resolved, aircraft output should rebound in early 2025. Homebuilding remains depressed due to much higher mortgage rates than a few years ago. However, from these depths, housing starts should slowly increase, reflecting very low inventories of homes either to buy or to rent. Government spending remains on a steady upward path, as state and local government employment continues to expand, following a delayed post-pandemic recovery. Meanwhile, both inventory growth and the trade deficit should fall in the fourth quarter, following a third-quarter surge in imports and stockpiling.

Importantly, we estimate that this pace of GDP growth in the fourth quarter, combined with Friday’s employment report, implies a 1.9% year-over-year gain in productivity in the non-farm business sector and a 2.6% year-over-year increase in real GDP per worker. These very solid productivity gains should allow the economy to meet steadily growing aggregate demand with steadily growing supply without generating higher inflation, provided the economy can produce further moderate job gains and avoid major exogenous shocks to prices.

Jobs: On employment, the frustrating highlight of the November jobs report was measurement issues, with the establishment survey reporting a strong 227,000 increase in non-farm jobs in sharp contrast to the household survey, which showed a dismal 355,000 slide in the number of workers. However, as we have argued before, the best way to assess the labor market is by looking at a broad mosaic of data. This includes government surveys of businesses and households, private sector surveys, unemployment claims, demand growth that drives gains in jobs and consumer spending that results from those gains. Looking at these in turn:

• The payroll survey shows average job gains of 171,000 over the past three months and 190,000 over the past year, although initial estimates of re-benchmarking adjustments suggest that this overstates job growth.
• The household survey shows an average decline in the number of workers of 98,000 over the past three months and 62,000 over the past year. However, this is based on an estimate of just a 0.6% increase in the 16 and older, civilian, non-institutional population, which, given the immigration surge, is probably an underestimate.
• Both initial and continuing unemployment claims have stabilized in recent weeks at levels that are below their averages for the five years before the pandemic.
• The Conference Board consumer confidence survey shows twice as many people claiming jobs are “plentiful” as opposed to “hard to get” while the ISM manufacturing and non-manufacturing surveys suggest roughly stable job growth in November. The National Federation of Independent Business monthly job survey shows still elevated job openings relative to history, mirroring government data. In all cases, these data suggest less labor market tightness than in the super-hot market of 2022. However, they all also suggest recent stabilization in the job market at strong levels.
• Finally, steady real GDP gains of between 2.5% and 3.0% over the past 9 months suggest solid job growth into 2025 while early indications on fourth-quarter consumer spending provide circumstantial evidence that the labor market is still improving.

Inflation: The week ahead will see the usual mid-month crop of inflation data, with consumer prices due out on Wednesday, producer prices released on Thursday and import prices published on Friday. We expect a modest 0.2% month-to-month increase in both consumer and producer prices and an outright decline in import prices. All three of these measures could see higher year-over-year increases than a month ago, which some may point to as a sign that inflation is rising again. However, these stronger year-over-year gains are more of a reflection of cool inflation a year ago than any genuine reheating in price pressures today. Indeed, it is important to acknowledge that there is very little evidence that inflation pressures are building.

• First, there is little reason to worry about imported inflation, with mediocre overseas economic growth, rising non-OPEC oil production and a 7% increase in the trade-weighted dollar since the start of the year.
• Second, we estimate that fourth-quarter year-over-year wage growth will come in at 4.0% which, given an expected 1.9% year-over-year gain in non-farm business productivity, is entirely compatible with the Fed’s 2% inflation goal.
• Shelter costs and auto insurance continue to play an outsize role in CPI inflation, accounting for 86% of the year-over-year increase in October. However, with inflation in new leases running well below the government’s measure of shelter inflation and new vehicle prices down year-over-year, both of these sources of inflation are likely to continue to abate in the months ahead.
• Inflation expectations also appear well anchored, with the spread between nominal 10-year Treasuries and 10-year TIPs running at 2.24% on Friday, right in line with the CPI reading necessary to achieve the Fed’s 2% target for consumption deflator inflation.

In short, while higher tariffs and tighter immigration could result in higher inflation in 2025, this would be because of active policy choices rather than any underlying trend of rising inflation pressures.

Profits: On profits, in the first three quarters of this year, S&P500 earnings were up 5.7% on a pro-forma basis and 8.0% on an operating basis. As the year draws to a close, analysts are, if anything, getting even more optimistic, projecting year-over-year gains of 11.6%, pro-forma, and 13.8%, operating. Moreover, earnings growth appears to be broadening out - 10 out of 11 S&P500 sectors could post year-over-year gains in operating EPS in the fourth quarter of 2024, compared to just 5 a year ago.

Given this backdrop, and without the disruption of fiscal policy changes, the Fed should have been on track to ease slowly, in line with their September summary of economic projections, lowering the federal funds rate to under 3.00% by the summer of 2026.

Policy Risks and Portfolio Balance

However, despite these very benign initial conditions, investors have reason for caution as 2024 draws to a close.

First, the fine balance that the economy has achieved between growth and inflation could be upset by policy moves, with the potential for higher inflation, in 2025, due to tariff increases and reduced immigration and, in 2026, due to fiscal stimulus. Productivity gains from deregulation and fiscal drag from government cost-cutting would likely only partly counter these effects. Moreover, faced with the prospect of inflationary policy measures from the other side of Washington, the Fed could curtail its easing, as the futures market now anticipates. While we still expect the Fed to cut the federal funds rate by 25 basis points next week, in recognition of a benign inflationary starting point, its new summary of economic projections is likely to project less easing going forward.

Second, investors need to take a hard look at valuations. As the S&P500 hit a new all-time high on Friday, its forward P/E ratio climbed to 22.4 times, about 1.7 standard deviations above its 30-year average, with valuations looking even more stretched among large-cap growth stocks. Fixed income also looks expensive. The 10-year Treasury yield at 4.17%, is roughly 1% higher than year-over-year core CPI inflation, compared to an average 2.7% real yield in the 50 years before the Great Financial Crisis, despite massive and growing government borrowing. Meanwhile, credit spreads remain very tight for both high-yield and investment grade corporate bonds.

And, third, because of spectacular investment gains, many investor portfolios are now unbalanced. In particular, assuming no rebalancing and the reinvestment of income, a 60/40 portfolio at the start of 2019 would have more than doubled in value by today. However, that investment would now not be a 60/40 portfolio, but rather a 79/21 portfolio.

While most investors have likely rebalanced to some extent in recent years, many now have portfolios that are riskier than they were a few years ago even as the increase in their wealth could have allowed them to take less risk.

Despite general discontent that was so evident in the recent election, at the end of 2024, economic fundamentals remain very positive, particularly for financial assets. However, it is possible that policy changes or other events will undermine those fundamentals in 2025 – a risk that is amplified in portfolios by high valuations and portfolio drift. Given this, it is important for investors to ask whether the asset allocation that served them so well in 2024, is still right as we enter 2025.

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Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

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