The 2025 Farther Market Outlook: A Delicate Equilibrium

Key Takeaways:

• In 2025, we anticipate a delicate equilibrium between the positive and negative forces shaping the economy and financial markets.

• The 2024 U.S. election of President Donald Trump and the Republican Congressional sweep will have major implications for tariffs, regulatory policy, and income taxes in 2025.
• The Federal Reserve lowered interest rates by 1% in 2024, but indicated that it expects to lower rates by only 0.5% in 2025 – due to uncertainty over the effect of tariffs on the economy and inflation.  This slowing pace of rate cuts and concern over inflation could set up a showdown between the Federal Reserve and President Trump, who favors lower rates.
• We expect lower returns in U.S. stocks and bonds over the coming five years, approximately 5% per annum in both asset classes. We recommend that investors remain invested, as the future path of returns is uncertain.
• Political dynamics should not be the sole driver of investment decisions. Historically, staying invested through both Republican and Democratic administrations has proven far more rewarding than limiting investments to one party's tenure.
• Our current recommendation on portfolio positioning includes:
  • We maintain an overweight position in U.S. equities relative to international markets, anticipating a broadening of U.S. market performance in 2025. Our preference lies with high-quality companies that generate strong free cash flow and pay dividends, as well as small- and mid-cap stocks with low leverage.
  • We recommend adopting a defensive approach in fixed income by focusing on short- to intermediate-term Treasury bonds. This strategy provides protection against rising interest rates while offering the flexibility to seize new investment opportunities as they arise.
  • We believe that select investments in private equity, venture capital, and private credit are well-positioned to benefit from an anticipated resurgence in dealmaking activity in 2025.

2024 Year in Review

2024 reminded us of the importance of expecting the unexpected. 

Two of the year’s most notable surprises included:

• U.S. Presidential Election: The 2024 election took an unprecedented turn over the summer. Donald Trump survived an assassination attempt in mid-July, and President Joe Biden withdrew from the race on July 21st. With only two and a half months before the election, Vice President Kamala Harris became the Democratic candidate. Ultimately, Donald Trump secured the presidency, and Republicans gained control of both chambers of Congress.
• U.S. Stock Market: The U.S. stock market, as measured by the S&P 500, delivered over 25% returns for a second consecutive year. These impressive gains were driven by a combination of corporate earnings growth and price multiple expansion.

The U.S. economy delivered expected results:

• Growth and Inflation: The U.S. economy maintained steady growth, with GDP expected within the 2.5%-3% range. Inflation moderated, with the Consumer Price Index (CPI) easing to approximately 2.7%, down from 3.4% in 2023.
• Interest Rates: The Federal Reserve initiated its long-anticipated rate-cutting cycle in September, beginning with a 0.5% reduction, followed by successive 0.25% cuts in November and December.

Geopolitical Tensions Remained Elevated in 2024

• Global Conflicts: The conflicts between Russia and Ukraine, as well as Hamas and Israel, intensified over the year. However, as we enter 2025, faint signs of hope for potential ceasefires in both conflicts are beginning to emerge.
• Relations with China: U.S.-China tensions persisted, characterized by heightened trade restrictions and increased Chinese military activity around Taiwan.

A Unifying Highlight Amidst Challenges

• The 2024 Paris Summer Olympics showcased the power of global unity through peaceful competition. 
• It is estimated that over 5 billion people – more than half the world’s population – tuned in to watch the games.

Financial Markets Review: Another Year of Strong Returns

Financial markets, particularly in the U.S., experienced a second consecutive year of exceptional performance. U.S. equities surged, driven by robust earnings growth and optimism surrounding the Federal Reserve's anticipated interest rate cuts.

• The S&P 500 delivered impressive gains for a second consecutive year, returning +25.02%. 
  • While the index's performance was again led by the dominant 'Magnificent Seven' growth stocks, market breadth began to improve in the second half of the year. 
  • This shift was catalyzed by Federal Reserve Chair Jerome Powell's August announcement of forthcoming rate cuts, which commenced in September.
• Value and small-cap stocks rallied on the expectation of lower interest rates. The Russell 1000 Value Index returned +14.37%, while the small-cap Russell 2000 Index gained +11.54%.
• In fixed income markets, volatility persisted, but income from bond coupons remained the primary driver of returns. 
  • The Barclays U.S. Aggregate Index posted a modest gain of +1.25%. 
  • High-yield bonds performed notably well, benefiting from elevated coupon payments and narrowing credit spreads, with the Barclays U.S. Corporate High Yield Index rising +8.19%.

U.S. equities once again outpaced international markets in 2024. 

• The MSCI EAFE Index returned +3.82%, while the MSCI Emerging Markets Index gained +8.05%.
• The above chart highlights the significant impact of currency fluctuations on international investments. Through September, the U.S. dollar remained relatively stable against a basket of global currencies (green line). However, in the fourth quarter, the dollar appreciated by 7%: driven by expectations of higher tariffs under President-elect Trump and stronger relative GDP growth in the U.S.
• This dollar strength created a headwind for international equities, as reflected in the fourth-quarter reversal of the blue and orange lines in the chart, underscoring the challenges posed by currency dynamics for global investors.

• Longer Treasury yields remained volatile throughout 2024. 
  • The year began with higher-than-anticipated CPI inflation and weaker-than-expected Q1 GDP growth, sparking fears of “stagflation.” By May, however, improving economic data helped ease these concerns, and yields began to decline. Federal Reserve Chair Jerome Powell succinctly observed, “I don’t see the ‘stag’ or the ‘flation.’”
  • Treasury yields dropped further in early August following a disappointing July jobs report, prompting worries over slowing economic growth. Simultaneously, an unexpected surge in the Japanese yen triggered a rapid 20% sell-off in the Nikkei, fueling additional flight-to-safety buying of U.S. Treasuries.
  • Speculation around a Federal Reserve rate cut ended in late August at the Jackson Hole symposium, where Chair Powell stated: “The time has come for policy to adjust. The direction of travel is clear.” The Fed followed through with a 0.5% reduction in September, then introduced successive 0.25% cuts in November and December.
  • Although both short- and long-term yields moved in anticipation of these cuts, longer-term yields have trended higher since the first reduction. As of now, 2-year and 10-year Treasury rates stand 0.75% and 0.95% above their respective lows from September.

Looking ahead to 2025, several developments from 2024 raise challenging questions:

• Will U.S. stocks extend their impressive performance – both in absolute terms and relative to other asset classes?
• Can corporate earnings growth sustain lofty valuations without triggering a market correction?
• What does the recent uptick in long-term interest rates signal, especially given it began after the Federal Reserve cut short-term rates?
• Are geopolitical risks and tariffs fully factored in, or are markets overlooking potential headwinds?

Although markets are generally forward-looking, they are not flawless predictors of the future. They may be looking beyond short-term issues toward a brighter outlook, or they could be underestimating significant risks. Only time reveals which perspective was correct: hindsight is 20/20, while the future remains inherently uncertain.

As we often emphasize, successful long-term investing demands humility. We cannot predict the future with precision, so it is unwise to invest in a single economic scenario or market outcome. Instead, investors should prepare for a range of possibilities and build portfolios resilient enough to navigate multiple potential futures.

2025 Economic Outlook and Risks

The U.S. economy is expected to continue growing in 2025, even as inflation remains above the Federal Reserve’s 2% target. The new Trump administration will need to collaborate with Congress to extend the 2017 tax cuts by year-end. Two opposing forces could shape overall growth: a pro-business deregulatory stance on one hand and the possibility of a tariff conflict with key trading partners on the other.

Economy

In 2024, the U.S. economy grew at an annual pace of 2.5% – 3%, with inflation moderating to a 2.7% annual increase. Looking ahead, the Bloomberg consensus projects a 2% expansion in 2025, while inflation is poised to stay above the Fed’s 2% threshold. President Trump’s pro-growth, lower-tax, and deregulatory policies should support GDP growth. However, his proposed tariffs could add upward pressure on prices by making imported goods more expensive.

Federal Reserve

The Federal Reserve initiated its much-anticipated series of rate cuts in September, beginning with a 0.5% reduction, followed by two 0.25% cuts in November and December. These actions brought the Federal Funds rate into a target range of 4.25% – 4.50%. Throughout 2024, markets frequently revised their expectations for both the timing and scale of these rate cuts, with forecasts oscillating between as many as seven cuts and none at all.

^{Source: Federal Reserve, December 18, 2024, Summary of Economic Projects, page 12.}

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Shifting Federal Reserve Outlook for 2025
At its December FOMC meeting, the Federal Reserve revised its 2025 forecast in two notable ways within its Summary of Economic Projections (SEP). First, it lowered the projected number of future rate cuts from four to two 0.25% reductions. Second, it raised its inflation estimate for 2025 to 2.5%. Notably, when surveyed about inflation risks, 75% of board members deemed the risks “weighted to the upside,” a sharp increase from just 20% in September. This change likely reflects persistently elevated inflation relative to the Fed’s 2% target in 2024, as well as the potential for a one-time inflationary bump if President Trump implements new tariff plans.

Potential Conflict Between President Trump and Chair Powell
A distinctive risk in the upcoming administration stems from President Trump’s tense relationship with Jerome Powell, whose term as Federal Reserve Chair concludes in May 2026. Although President Trump indicated in a December interview with NBC News that he has no immediate intention of replacing Powell, he also appeared to leave the door open, stating: “If I asked him to [resign], he probably wouldn’t. But if I told him to, he would.”

Trump previously considered demoting Powell in 2019, and incoming Treasury Secretary nominee Scott Bessent has floated the idea of appointing a “shadow Fed Chair” early in the administration to influence policy before assuming the official role in May 2026. Chairman Powell, for his part, responded tersely in November when asked if he would step down at the President’s request: “No.”

Whether this friction escalates in 2025 remains to be seen. President Trump has traditionally favored lower interest rates, which may clash with the Federal Reserve’s decision to slow the pace of rate cuts. Should the President opt to force a change at the Fed, financial markets may experience considerable volatility.

Election Results & Implications: Republicans Face a Broad Agenda

The Republican sweep offers President Trump a stronger mandate to pursue his campaign pledges than would have been feasible under a divided Congress. Although Republicans now hold a 53-seat majority in the Senate, they narrowly control the House at 219 – 215. Historically, even Presidents backed by a unified government have struggled to realize all their goals, suggesting Republicans will advance many – but not all – of their priorities before the 2026 elections.

Pro-Growth, Lower-Tax, and Deregulatory Agenda

President Trump’s economic platform generally seeks to stimulate growth through tax reductions and deregulation, though certain initiatives fall outside this framework. Some can be implemented via executive action, while others require legislation.

Areas Under Executive Discretion

• Tariffs: The President has proposed raising tariffs by 10% on all imports and 60% on Chinese goods, and more recently floated a 25% tariff on goods from Mexico and Canada – countries that, combined, account for 28.5% of U.S. imports. China represents an additional 13%, according to The Wall Street Journal.
• Regulatory Policy: With oversight of the Federal Trade Commission (FTC) and the Department of Justice, the administration can adopt a more lenient stance toward mergers than the previous administration did. However, neither President Trump nor Vice President Vance appears sympathetic to “Big Tech.”
• Energy Policy: Through executive orders, the administration may bolster domestic energy production by relaxing or reversing prior restrictions.

Areas Requiring Congressional Approval

• Income Taxes: Key provisions of the 2017 Tax Cuts and Jobs Act (TCJA) expire at the close of 2025. President Trump has spoken in favor of extending these cuts and removing the State and Local Tax (SALT) deduction, which previously served as a revenue offset.
• Corporate Taxes: The administration has proposed reducing the corporate tax rate on U.S.-manufactured goods to 15%.
• Additional Tax Cuts: Late-campaign promises include eliminating taxes on Social Security benefits, tipped wages, and overtime pay. While popular with voter groups, these ideas may prove less appealing to Congress compared to the broader cuts in the TCJA.

Potential 2025 Developments: Growth vs. Inflation

• Tariffs: Higher tariffs act as a tax on imports, pushing up consumer prices. If imposed gradually or used as leverage to negotiate more favorable trade terms, the inflationary impact may be modest. However, swiftly enacting steep tariffs could trigger a noticeable one-time rise in inflation – or, at worst, spark a retaliatory trade war.
• Tax Changes: Despite Republican majorities in both chambers, extending the TCJA is not straightforward. To avoid a Senate filibuster, Congress must use budget reconciliation – an option available only twice before the end of 2025. According to The Washington Post, Senate Majority Leader John Thune plans to address immigration, energy production, and defense first, leaving TCJA extensions until later in the year. Delays heighten legislative uncertainty, raising the possibility that the tax cuts might expire in 2026, resulting in broad tax increases.
• Federal Budget Deficit: In fiscal year 2024, the federal government ran a $1.8 trillion deficit on a $6.7 trillion budget, with interest on the debt reaching $950 billion – over half the deficit. This significant shortfall could constrain further tax cuts and is likely to keep interest rates higher than their pre-pandemic lows.
• Department of Government Efficiency (DOGE): A notable new initiative is the Department of Government Efficiency (DOGE) advisory committee, led by Elon Musk and Vivek Ramaswamy. Tasked with streamlining government operations, cutting costs, and refining regulations, DOGE’s ability to make a meaningful dent in the deficit remains to be seen.

Geopolitical Risks Remain Elevateed

Despite hopes for resolution in 2025, several regional conflicts continued throughout 2024. The wars between Russia and Ukraine, and between Israel and Hamas, appear closer to ending, while military tensions between China and Taiwan remain a significant concern.

Russia – Ukraine War
Approaching its third anniversary, this conflict intensified with increasingly aggressive missile strikes from both sides. North Korea contributed over 10,000 troops to assist Russia. President Trump has expressed a strong desire to conclude the war, and President Zelensky has signaled a willingness to cede territory for peace and security guarantees – raising the likelihood of a negotiated settlement to its highest point in three years.

Israel – Hamas Conflict
Israel eliminated much of Hamas’s leadership and, in fall 2024, targeted Hezbollah’s military command as well. In response, Iran – Hamas and Hezbollah’s primary military backer – launched two direct missile strikes on Israel, prompting retaliatory strikes that severely damaged Iran’s air defenses. President Trump has demanded the release of Hamas-held hostages before his inauguration, a move that could end the conflict if Hamas complies.

China and Taiwan
China’s ambitions to reunify Taiwan are particularly concerning amid heightened trade tensions with the United States. In December 2024, China conducted military exercises around Taiwan. In an interview with Bloomberg, President Trump signaled a reluctance to defend Taiwan militarily, remarking: “Taiwan should pay us for defense.” Should President Xi interpret this as an opportunity to invade, the potential economic consequences for the U.S. could be severe. While most advanced semiconductor design occurs in the U.S., 92% of semiconductor manufacturing takes place in Taiwan, according to the Semiconductor Industry Association – meaning that any disruption in production would have a profound impact on advanced manufacturing, as witnessed during the COVID-19 pandemic.

Impact on Financial Markets
Although regional wars and major geopolitical events can be devastating for those directly involved, they have historically produced only brief and modest effects on financial markets. According to J.P. Morgan data on 12 significant geopolitical events since the 1970s, the median S&P 500 selloff was -5.6% and lasted only 13 days.

Financial Market Outlook: Anticipating Lower Returns than Recent Years

Investors should brace for a more challenging environment in 2025. Following two consecutive years of 25% gains, U.S. equities now trade at elevated valuations, exceeded only during the dot-com era. Meanwhile, competition from lower-risk assets has increased, as the 10-year U.S. Treasury yield climbed to 4.58% by year-end. With stock earnings yields (the inverse of a 21.5× price-to-earnings ratio) hovering at 4.65%, equities and Treasuries are offering comparable returns.

In this context, a well-diversified portfolio may prove more essential than ever. The classic adage “buy low, sell high” takes on renewed importance when bonds appear inexpensive and stocks appear expensive. We believe investors will need to pay closer attention to relative valuations – both across asset classes and within them – to uncover worthwhile opportunities.

^{Source: Compustat, FactSet, Federal Reserve, Refinitiv Datastream, Standard & Poor’s, J.P. Morgan Asset Management.}

^{Dividend yield is calculated as consensus estimates of dividends for the next 12 months, divided by most recent price, as provided by Compustat. Forward price-to-earnings ratio is a bottom-up calculation based on IBES estimates and FactSet estimates since January 2022. Returns are cumulative and based on S&P 500 Index price movement only, and do not include the reinvestment of dividends. Past performance is not indicative of future returns.  Guide to the Markets – U.S. Data are as of December 31, 2024.}

U.S. Equities: Opportunities Within a Broadening Market‍

U.S. equities have delivered impressive gains over the last 15 years, and we continue to view them as a core component of our clients’ strategic allocations. While we anticipate more modest returns overall in the coming years, we also see attractive opportunities emerging in select market sectors.

Over the past decade and a half, the United States has often been the “best house on the block” among global equity markets, propelled by a host of structural advantages – ranging from a robust rule of law and technological leadership to energy independence, a strong military, and the benefit of friendly neighbors separated by two oceans. These factors helped drive a substantial expansion in price-to-earnings multiples, which we do not expect to repeat at the same pace in the near future.

^{Source: FactSet, Refinitiv Datastream, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management. Returns are 12-month and 60-month annualized total returns, measured monthly, beginning 12/31/1999. R² represents the percent of total variation in total returns that can be explained by forward price-to-earnings ratios. Price-to-earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since May 1999 and by FactSet since January 2022.Guide to the Markets – U.S. Data are as of December 31, 2024.}

A Broader Perspective Beyond Short-Term Forecasts

Much of Wall Street’s attention centers on near-term predictions. For instance, according to a CNBC survey, the consensus target for the S&P 500 by year-end 2025 is 6,630. Yet at current valuation levels, the next 12 months could unfold in almost any direction, as the above left-hand chart shows how yearly returns can appear nearly random. Looking further ahead, the above right-hand chart suggests more subdued five-year returns in the 3 – 5% range for the S&P 500.

We are not in the business of forecasting the market’s short-term twists and turns. The greatest threat would be a recession – or even the fear of one, as was the case in 2022 – which could significantly alter the market’s momentum. Nonetheless, we believe a long-term commitment to equities remains an excellent strategy for compounding wealth and hedging against inflation – particularly for taxable investors. It is also important to remember that the equity market is not a single, uniform entity; opportunities can arise whether valuations are high or low.

Market Sector Opportunities

Valuations for the largest 10 stocks in the S&P 500 are near historical extremes compared to the rest of the index, yet such imbalances do not typically last forever. Over the past decade, mega-cap technology companies have fueled market gains (shown in the below chart), and their growing share of the S&P 500’s market cap reflects the substantial free cash flow and operating income they generate. In addition, their high research and development spending suggests that their competitive advantages may endure for some time.

^{Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management. The top 10 S&P 500 companies are based on the 10 largest index constituents at the beginning of each quarter. As of 12/31/2024, the top 10 companies in the index were AAPL (7.6%), NVDA (6.6%), MSFT (6.3%), AMZN (4.1%), GOOGL/GOOG (4.0%), META (2.6%), TSLA (2.3%), AVGO (2.2%), BRK.B (1.7%) and JPM (1.4%). The remaining stocks represent the rest of the 492 companies in the S&P 500.Guide to the Markets – U.S. Data are as of December 31, 2024.}

Despite the dominance of large-cap tech in driving free cash flow growth over recent years, we anticipate that future free cash flow gains will expand beyond these top names. This inflection point creates a broader range of opportunities across the market. In our view, companies of any size that demonstrate robust free cash flow growth are poised to perform well.

Signs of a more inclusive market have already emerged, with dividend payers, value-oriented stocks, and small caps posting strong results in the latter half of 2024. While it is always wise to be cautious about short-term trends, President-elect Donald Trump’s pro-business agenda – easing regulatory hurdles at the FTC and Justice Department, reducing regulations for banks, energy, and health care, and boosting defense spending – could further support broad-based gains. Over the longer term, developments such as electric vehicle adoption, the onshoring of manufacturing, and the construction of AI data centers will spur additional demand for electricity, also contributing to wider market participation.

Late 2024 discussions often focused on three segments: the “Magnificent Seven” mega-cap stocks (Nvidia, Meta, Tesla, Amazon, Alphabet, Apple, and Microsoft), the “S&P 493” (all other stocks in the S&P 500), and small caps. In 2024, earnings for the Magnificent Seven rose strongly, the S&P 493 was flat, and small-cap stocks (Russell 2000) saw earnings decline – factors behind the notable performance gap between the Magnificent Seven and the rest of the market (as shown in the below chart).

^{Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management. *Magnificent 7 includes AAPL, AMZN, GOOG, GOOGL, META, MSFT, NVDA and TSLA. Earnings estimates for 2024 are forecasts based on consensus analyst expectations. **Share of returns represent how much each group contributed to the overall return. Numbers are always positive despite negative performance in 2022. Guide to the Markets – U.S. Data are as of December 31, 2024.}

Looking to 2025, however, consensus forecasts suggest more balanced growth. The Magnificent Seven are still expected to post solid earnings increases – though at a slower pace, moving from roughly 33% to 20%. The S&P 493 should see growth rise to around 15%, and small-cap earnings are projected to rebound sharply. Given lower valuations for the S&P 493 and small caps, and their narrowing growth gap relative to the Magnificent Seven, we see compelling investment opportunities in these areas.

Small-cap companies, in particular, continue to trade at some of the steepest discounts versus large-cap names in over two decades – a dynamic fueled by higher interest rates and enthusiasm for mega-cap tech. We believe this gap is poised to narrow as small-cap earnings growth recovers and as these firms benefit from the opportunity to refinance debt more favorably in a lower-rate environment.

Where We See Opportunity in U.S. Equities

1. Quality Companies with Free Cash Flow and Dividends: We remain overweight in firms producing strong free cash flow and consistently growing dividends, largely due to their relatively attractive valuations compared to pure growth stocks. We expect free cash flow growth to broaden beyond the Magnificent Seven, and a more accommodative monetary policy could bolster earnings across a wider range of industries.
   
   
2. Small- and Mid-Cap Stocks with Lower Leverage: We also favor small- and mid-cap stocks, given their discounted valuations and prospects for accelerating earnings growth. In particular, we prefer companies with below-average leverage, which stand to benefit from the improving debt-refinancing environment that lower rates would provide.

International Equities‍

In the near term, we favor U.S. equities over international stocks despite their higher valuations. Pro-domestic policies that encourage investment in the United States should serve as a tailwind for U.S. markets, while a strengthening dollar may weigh on international portfolios.

From a valuation standpoint, international stocks currently trade at a near-record 38% price-to-earnings (P/E) discount relative to U.S. equities, according to data from J.P. Morgan Asset Management. This discrepancy largely stems from the premium that investors have assigned to U.S. stocks. In fact, international shares are now trading close to their 20-year average multiple of about 13x earnings. Although we recommend an underweight allocation to international equities, we still see merit in holding them as part of a diversified, strategic asset mix given their relatively cheap valuations.

Over time, we expect the gap in P/E multiples to narrow, allowing international stocks to outperform. However, we do not believe that moment has arrived. We will continue to track both valuations and economic performance to determine when this trend may reverse.

Cash: Focus on Safety and Extending Maturities

We recommend preserving the safety of cash holdings with U.S. Treasury securities and, for investors carrying higher-than-average cash balances, extending maturities into the 1- to 2-year range. This approach helps lock in current short-term yields before further rate cuts drive them lower. 

We continue to favor direct U.S. Treasury investments or money market funds and ETFs holding Treasuries. In addition to offering a high degree of security, Treasury securities provide a tax advantage for taxable investors, as their interest is not subject to state income taxes.

Fixed Income: Position Defensively for Future Opportunities

Historical evidence shows that the starting yield in the bond market is a strong indicator of its performance over the following five years. As illustrated by the upward sloping trend in the below chart (based on data since 1976), current bond yields suggest approximate annual returns of 5.1% for taxable bonds over the next 5 years. We advocate maintaining a defensive posture in fixed income now, positioning investors to capitalize on emerging opportunities as market conditions evolve.

^{Source: Bloomberg, FactSet, J.P. Morgan Asset Management.  Returns are 60-month annualized total returns, measured monthly, beginning 1/31/1976. R² represents the percent of total variation in total returns that can be explained by yields at the start of each period. Guide to the Markets – U.S. Data are as of December 19, 2024.}

Cautionary Lessons from History

‍Two past periods stand out as reminders that bond returns can fall short of expectations when inflation and yields rise sharply. In the late 1970s and again in the early 2020s (seen as the orange and purple dots below the diagonal in the above chart), surging inflation led to negative price returns that eroded much of the bonds’ income. 

Should President Trump’s proposed tariffs and fiscal policies – or the Federal Reserve’s monetary policy – push inflation and interest rates higher, actual bond returns could similarly lag those implied by current bond yields. Nevertheless, today’s higher starting yields should offer better downside protection than was available earlier in the decade.

A Defensive Posture in Bond Portfolios

‍We view the potential for rising rates as a credible risk. Consequently, we advise positioning portfolios more conservatively than the broader Bloomberg U.S. Aggregate Index. To borrow a football analogy, adopting a “defensive crouch” in bond allocations enables investors to preserve flexibility and respond quickly to emerging opportunities if market conditions evolve.

Implementation Strategies in Fixed Income

1. Shorten Portfolio Duration: We recommend reducing exposure to longer-maturity bonds and reinvesting proceeds in short- to intermediate-term bonds. This step lowers sensitivity to potential interest rate increases while preserving a steady income stream.
   
   
2. Leverage the Steepened Yield Curve: Recent yield curve steepening offers an opportunity to construct high-quality Treasury portfolios that capture higher yields without taking on excessive duration risk. We suggest a mix of 2- to 8-year Treasury bonds. For those concerned about inflation, adding 5-year TIPS can provide a degree of protection against rising prices.

Areas of Potential Opportunity

• High Yield Corporate Bonds: Current spreads of 2.9% above Treasuries are well below the historical average of 5.1% (since 2001). Should spreads widen significantly, we would consider increasing our allocation to this sector.
  
  
• Agency Mortgage-Backed Securities (MBS): While the uptick in mortgage rates has made existing MBS more appealing, the 10-year Treasury yield – closely tied to mortgage rates – is more likely to rise than fall. If yields climb further, we would look to overweight MBS positions at more attractive entry points.

Municipal Bonds

For taxable clients, we remain positive on the municipal market entering 2025. Tax-equivalent yields are compelling across the curve, and a slower pace of Federal Reserve rate cuts could sustain these levels. High yield municipal bonds have performed particularly well, and we see momentum continuing given strong credit fundamentals in both the investment-grade and high-yield segments. 

With a new administration taking office, we will closely monitor any legislative developments that could influence municipal bond markets.

Alternative Investments: Opportunities for Diversification and Enhanced Returns‍

We view alternative investments as a vital component of our clients’ portfolios, both for their diversification benefits and their potential to improve overall risk-adjusted performance.

• Private Equity & Venture Capital: Lower financing costs and a more favorable regulatory environment are poised to boost M&A activity and dealmaking. This uptick should benefit select private equity and venture capital strategies, particularly those investing in private markets through secondary purchases.
• Private Credit & Direct Lending: A higher volume of mergers in 2025 could also spur opportunities in the $1.5 trillion direct lending market. Despite the prospect of lower interest rates, private credit yields may remain attractive compared to similar opportunities in public credit markets.

Beyond these areas, other alternative strategies can further enhance portfolios:

• Hedge Funds: We favor select long/short hedge funds for their diversification properties.
• Infrastructure: This asset class is appealing from a relative-value perspective.‍
• Publicly Traded REITs: REITs can offer reliable income streams. Although we currently underweight real estate, we continue to recognize its strategic value in portfolio allocations.

^{Source: Burgiss, Morningstar, NCREIF, PivotalPath, J.P. Morgan Asset Management.}

^{Global large cap equities and global bond are based on the world large stock and world bond categories, respectively. *Manager dispersion is based on annual returns over a 10-year period ending 3Q 2024 for Hedge Funds, U.S. Core Real Estate, U.S. Fund Global Equities and U.S. Fund Global Bonds. Non-core Real Estate, Global Private Equity and Global Venture Capital are represented by the 10-year horizon internal rate of return (IRR) ending 2Q 2024. U.S. Fund Global Equities and Bonds are comprised of U.S.-domiciled mutual funds and ETFs Guide to Alternatives– U.S. Data are as of September 30, 2024.}

Manager Selection: A Key Driver of Consistent Performance
Selecting the right manager is crucial to achieving strong, stable returns, and this is especially true in alternative investments. As demonstrated by the above chart, the range of performance in non-core real estate, private equity, venture capital, and hedge funds far exceeds that of the public markets. 

In light of this variability, we devote significant resources to identifying and investing with best-in-class managers on behalf of our clients.

Concluding Thoughts: Maintaining a Long-Term Perspective

We anticipate that 2025 will be defined by a delicate balance between positive and negative forces. On the upside: strong corporate earnings growth, declining short-term interest rates, deregulation, and tax cuts may provide support. Meanwhile, elevated stock valuations, tariff-related inflation risks, rising long-term rates, and the potential for conflict between President Trump and the Federal Reserve introduce uncertainty. How these factors interplay will shape the economic and market landscape in 2025.

It is unrealistic to expect the recent momentum – particularly in U.S. equities – to persist indefinitely. While certain asset classes can remain overvalued for extended periods, timing a reversion in valuations remains challenging. When valuations do normalize, they may do so either through lower prices or stronger earnings growth (the latter being more favorable for investors). Moreover, while valuation is a poor predictor of short-term market moves, it has proven more reliable in forecasting 5-year returns. Current valuations imply 5-year annual returns of roughly 5% for both U.S. stocks and bonds – somewhat lower than recent history, but still above the rate of inflation. Critically, most investors have horizons longer than 5 years, making a steady, long-term outlook essential.

^{Source: Ycharts data from 1950 through 9/30/2024}

Following a contentious 2024 election, we advise against letting political preferences drive investment decisions. Republicans should be wary of becoming overly bullish, while Democrats should resist excessive caution. Historically, market performance has not differed dramatically across different administrations. Indeed, equity returns were comparable during the Obama and Trump presidencies (16%) and only marginally lower during Biden’s term (14%). As the above chart illustrates, remaining invested regardless of the party in power has yielded far better long-term outcomes than switching in and out based on political sentiment.

Ultimately, investors should align their allocations with their time horizons. Those with a longer runway can afford a heavier focus on riskier assets like equities, while those with nearer-term needs should prioritize bonds, especially given today’s higher yields. By matching your portfolio to your time horizon and maintaining appropriate diversification, you can better navigate normal market fluctuations.

In closing, we hope you enjoyed a restful holiday season with friends and family, and we wish you a healthy and successful 2025. Please connect with your Farther advisor for any questions regarding the content presented in this piece.