Financial markets in 2025
Clinical Associate Professor of Financial Management, Kelley School of Business
Associate Professor & Blanche “Peg” Philpott Faculty Fellowship, Kelley School of Business
Assistant Professor of Finance, Kelley School of Business
In our 2024 financial forecast, we discussed several factors that were expected to influence stock and bond market returns, including interest rates, inflation, a series of international conflicts and an impending presidential election. Despite our cautionary stance in last year’s forecast, both stock and bond returns have been positive thus far in 2024.
As the market predicted last year, the Federal Open Market Committee (FOMC) lowered the federal funds target rate in September for the first time since the early days of the COVID-19 pandemic. The last cut, made in March 2020, resulted in a target rate of 0.00% to 0.25%, a level that lasted into 2022. As of November, the target federal funds rate is set at 4.50% to 4.75%, following cuts of 50 basis points at the September meeting and 25 basis points at the November meeting. The derivative markets point to 4.25% to 4.50% by the end of 2024, based on a 25-basis-point cut in December. The derivative market projection for the federal funds rate stands at 3.25% to 3.50% by the end of 2025, which is projected by financial market pricing to be the lowest level achieved during the current round of rate cuts.
Last year, we noted that the tight labor market persisted. The unemployment rate was sitting around 3.8% in October 2023 and has ticked up slightly over the first 10 months of 2024, starting out at 3.7% and reaching 4.3% in July before falling to 4.1% in September (seasonally adjusted). Despite the continuing tight labor market, inflation didn’t increase, and core inflation decreased from 3.9% at the end of 2023 to 3.3% in September 2024. This decrease was partially aided by a lower federal funds rate. We expect the decline in rates to continue, but that could change depending on the election outcome.
Finally, the conflicts around the world that we were concerned about last year continue to rage, and the situation in the Middle East is becoming more volatile with the opening of a “second front” on Israel’s northern border and escalation between Israel and Iran. As Iran is a major oil producer, this could shake up oil prices if its oil infrastructure is damaged. However, relative to 2022 (when Russia invaded Ukraine), the demand for oil has been tepid, and the Energy Information Administration has revised down its global demand forecast for 2025, which could help absorb some disruption in oil production.
Looking back on 2024
Stocks performed better than we expected in 2024 and, as of mid-October, the S&P 500 achieved 45 new closing highs, or about one every four days, with the index up about 23% for the year. Over the same period, the technology-heavy Nasdaq-100 was up around 21.5%, slightly lagging the S&P 500. Finally, the small-cap benchmark, the Russell 2000, lagged the other widely followed indices, rising only 11% as of mid-October.
If current market conditions hold, the Russell 2000 will have underperformed the S&P 500 in eight of the last 10 years. A common belief about small-cap stocks is that they outperform large-cap stocks over the long term. This has not been the case over the past 10 years and the performance gap is narrowing. Either small-cap stocks need to play some catch-up with large caps or the small-cap outperformance thesis needs to be revisited. This coming year may be a pivotal one with respect to this common belief about small-cap investing.
Bond returns have been modestly positive for the first 10 months of 2024. Investment-grade bonds are up nearly 3% year-to-date, while high-yield bonds are up more than 7%. This follows a good year for bonds in 2023, during which prices were up in anticipation of future interest rate cuts, and a dismal 2022, during which rates rose rapidly and sent prices lower. Where bond prices go from here largely depends on the Fed’s stance toward interest rates, and whether cuts continue as expected or slow in response to inflationary pressures.
We now turn to fundamentals that can be positive or negative for the financial markets. Similar to our last forecast, it was more difficult to find positives than negatives heading into 2025.
Positive fundamentals
The positive fundamentals for stock returns in 2025 include:
Lower interest rates: This was also listed as a positive for 2024. “Lower interest rates” may have been better stated as “the anticipation of lower rates,” as the rate cut that the market anticipated to occur in June was not realized until September. Any instance when the financial markets doubted a rate cut would occur in a timely fashion was met with a quick sell-off in stock prices (see early August 2024).
Derivative markets pointing to less volatility in 2025: A common measure of volatility expectations is the Cboe Volatility Index, commonly known as the VIX. Future VIX prices, specifically futures contracts expiring in 2025, anticipate a lower VIX, which often coincides with a bullish stock market.
Consumer resilience: Consumption continues to remain strong, although a bit choppy. Our model expects consumption to grow on a year-over-year basis by more than 2% in 2025 and 2026. This pace is not overly bullish, but our models do not expect a drop in consumer spending, with the consumer representing two-thirds of U.S. economic activity. If our forecast is correct, this may provide a floor for stock prices as valuations catch up with the indices.
Negative fundamentals
The negative fundamentals for stock returns in 2025 include:
An ending rate-cut cycle: We currently project rates to bottom out at 3.00%, slightly lower than current market projections. The timing of rate cuts priced by the markets is similar to our projection, which means the equity market may start to anticipate tightening. However, regardless of the final level for the federal funds rate, stocks may be skittish as the end of the cycle for lower rates approaches in late 2025.
Potential inflation pressures: It remains to be seen what the next presidential administration will do in terms of government spending. Uncontrolled deficit spending could crowd out private investment and weaken confidence in U.S. debt as a risk-free asset. Many economists believe increased government spending contributed to the inflationary pressures of 2022. Hopefully, the incoming administration will avoid a repeat.
Slow economic growth: We have an outlook that matches a soft-landing scenario, projecting real GDP growth in 2025 and 2026 to run at a 2.0% to 2.1% annual rate. This relatively slow growth could translate into a lack of significant corporate earnings growth. With stock prices pushing towards high valuations, a lack of earnings growth will have a dampening impact on stock returns.
Forecast
The S&P 500 and Nasdaq-100 are both higher on the year by more than 20% with 10 weeks to go in 2024. Small-cap stocks again lagged, but have returned a respectable 11% this year. As noted, the relative performance of small caps as represented by the Russell 2000 versus the S&P 500 has been dismal over the past 10 years. It may be that 2025 is the year that small-cap stocks make up some of this underperformance.
The stock market in 2024 was fixated on the Fed. Anytime it appeared the first cut might be pushed out, stocks reacted negatively. Worries about inflation could hamper the Fed’s flexibility to continue to cut rates in 2025 and reach the market’s projection of 3.5% (or our outlook of 3.0%) by the end of 2025. Any doubt will weigh on stocks and making it through the full year without any surprises or disappointments is highly unlikely. With stocks priced for a perfect soft landing and recovery, we believe 2025 may be a year of below-average stock performance.
The 10-year yield stands at 4% as of mid-October, slightly higher than where it stood at the end of 2023 (3.8%), but much lower than the 2024 peak of 4.7%. The two-year yield is at 3.95%, just below the 10-year yield, making the yield curve basically flat. Our current projection is for the 10-year yield to fall within a range of 3.70% to 3.75% over the next couple of years. This projection is dependent on the federal funds rate approaching 3% by the end of 2025. A higher 10-year rate could result if the Fed is unable to cut rates to current market projections.
