Following a slow first quarter, the U.S. economy showed surprising strength throughout the rest of the year, growing at 3.0% in both the second and third quarters. This economic growth was driven by robust consumer spending, a slowing yet resilient labor market, and significant corporate spending in the technology sector, particularly in areas related to artificial intelligence. As a result of this stronger growth, inflation spiked, prompting the Federal Reserve (Fed) to delay its rate-cutting cycle until September. In 2024, the Fed cut its benchmark rate by 100 basis points, primarily to support a weakening labor market and low-income households struggling with high prices and interest rates. But with inflation remaining persistent and the potential for Trump’s policies to reignite it, we expect the Fed to pause its rate-cutting cycle until further data indicates the need for additional cuts.
With growth exceeding expectations and inflation remaining stubborn, the yield on the 10-Year Treasury note rose by 70 basis points, ending the year at 4.58%. This increase occurred despite the Fed’s 100 basis point rate cut. Most of the Treasury yield curve is now upward sloping and normalized, as the market anticipates an imminent soft landing for the U.S. economy. Rising yields led to a third consecutive year of struggling bond returns, with balanced portfolio returns driven primarily by U.S. stocks. The Standard and Poor’s 500 index delivered a total return of 25% in 2024, marking the best two-year performance in a quarter century. While U.S. small and midcap stocks also delivered strong returns, they underperformed large caps. International stocks, burdened by a strong dollar, underperformed U.S. stocks.
Following a 50-basis points rate cut, the Fed reduced its benchmark rate by another 50 basis points in the fourth quarter, bringing it to 4.25% – 4.5%. Despite this, yields rose across the Treasury yield curve as U.S. economic growth and the labor market proved more resilient, and inflation remained stickier than expected. The yield on the 10-year Treasury note rose 78 basis points, from 3.79% at the beginning of the quarter to 4.57% at the end of the year. The Bloomberg U.S. Aggregate Bond Index fell by 3.1% in the fourth quarter but had a positive return of 1.5% for the full year. Strong income production from bonds helped offset price declines in late 2024. The spread on the 2-to-10-year segment of the Treasury yield curve widened an additional 18 basis points in the fourth quarter, signaling continued expansion of U.S. economic growth.
In the fourth quarter, all major segments of the bond market — corporates, agencies, and mortgages — fell by 3% or more as yields rose across the Treasury curve. High yield was the only sector of the bond market with a positive return in the quarter, as the underlying yields were able to overcome price declines. High-yield bonds returned 0.2% for the quarter and 8.2% for the year. High yield corporates tightened 36 basis points in 2024, delivering excess returns of 5%, with most of the gains occurring before the Fed’s easing began in September. Investment grade corporate bonds were down 3% for the quarter but up 2% for the year. Corporate spreads finished the year at 80 basis points, having tightened by 19 basis points over the year. Corporate spreads tighter than +80 basis points are at levels that have not occurred since 2005. Spread compression was supported by a resilient economy, strong issuer fundamentals, and continued industry inflows into credit funds.
Municipal bonds were down 1.4% for the quarter but up 1% for the year. The fourth quarter rise in rates pulled down full year results. Short-term maturities outperformed longer maturities for both the quarter and the year. The outlook for the municipal market in 2025 is favorable. Income (yield), which is the primary driver of performance, is higher than it was a year ago thanks to the recent rise in yields. The investment backdrop is further enhanced by continued flows into mutual funds and ETFs.
The Standard and Poor’s 500 index of stocks returned 2.4% in the fourth quarter; a relatively modest gain compared to the 25% for all of 2024. U.S. stocks experienced a significant rally in the f irst two months of the quarter, buoyed easing monetary policy from the Fed and Trump’s win in the November presidential election. Trump’s victory not only removed election uncertainty, but also unleashed investor ‘animal spirits’ at the prospect of a business-friendly regulatory and dealmaking environment. However, the market’s enthusiasm in November faded in December due to a stronger dollar and higher interest rates as U.S. labor, economic, and inflation data surprised to the upside. U.S. small caps were up 0.3% in the fourth quarter and returned 11.5% for the year. Like the broader market, small caps rallied following Trump’s win but slumped in December after the Fed signaled fewer rate cuts. Small caps tend to be more sensitive to changes in interest rates because they have more floating-rate debt than their large-cap peers.
Sector leadership changed significantly in the fourth quarter. Consumer discretionary was the top performing sector, propelled by Tesla, which rose more than 50% as markets speculated that the close relationship between its CEO Elon Musk and President elect Trump would benefit the company. The financial sector was the second-best performing sector as markets priced an easier regulatory environment for banks and a better environment for mergers and acquisitions. Interest rate-sensitive industries such as real estate, housing, and utilities declined. Interestingly, healthcare, which was thought to be less tied to election results than in prior cycles, was a significant underperformer due to political headwinds. While enhanced scrutiny on vaccine manufacturers was anticipated, additional subsectors including pharmacy benefit managers (PBM) and managed care organizations (MCO) were caught in the crosshairs of the new administration. Despite expectations for improving economic growth, materials was the worst performing sector, hurt by the same forces as emerging markets: a more hawkish Fed and tariff fears. Lastly, energy was down in the quarter despite oil being the best performer among global asset classes. Energy’s weakness was attributed to higher projected oil supply driven by a more favorable regulatory environment, which pressured future oil pricing.
In the fourth quarter of 2024, international stocks fell by high single digits due to a strong U.S. dollar and concerns among market participants about the impact of Trump’s policies on international economies. International markets also struggled with ongoing economic stagnation, compounded by negative impacts from a stronger dollar and the likelihood of higher U.S. tariffs. Last quarter’s surge in Chinese equities reversed due to a multitude of structural headwinds. Excess housing units and production capacity have led to a significant debt burden and deflation in China. Chinese overcapacity also hurts the European Union’s export-led model. China faces well known demographic challenges impacting economic growth. These demographic woes are exacerbated by a two-tier system that has long made rural workers leave offspring behind in villages, cutting into projected birthrates. Emerging markets were also down in the fourth quarter, hampered by a stronger dollar and the likelihood of higher tariffs, both of which are inversely correlated with commodity prices. While an improved U.S. economy should be positive for commodities in the long term, a more hawkish Fed keeping interest rates higher for longer and increased tariffs are adversely impacting commodities in the near term.
The U.S. dollar wrapped up one of its best quarters and an epic year, rising almost 8% against a basket of currencies. The currency benefited significantly from the American economy growing faster than most large and developed world economies. While most of Europe appears stuck in a rut and China struggles to contain the fallout from its property meltdown., the Fed’s hesitancy to cut interest rates in the face of sticky inflation and the potential impact of policies of the incoming Trump administration added to the dollar’s strength in the fourth quarter. Emerging market currencies struggled the most against the dollar, with the Mexican peso falling 20% and the Brazilian real down 30% in 2024.
We believe the U.S. economy is on the verge of a “soft landing.” Economic growth remains resilient, the labor market is slowing yet still at full employment and inflation is sticky but likely to gradually slide toward the Fed’s target of 2%. We anticipate the Fed to cut its benchmark rate once or twice in 2025, which may result in a normal upward-sloping yield curve – a sign that investors do not anticipate a recession soon. This would mark the culmination of the Fed’s monetary policy, which successfully brought consumer prices from their highs of 9% in 2022 to its target of 2% without causing a recession. However, once the “soft landing” is achieved, the outlook becomes far less certain and will depend on the substance, severity, and sequencing of President Trump’s policies. High tariffs, coupled with an aggressive deportation agenda, would act as significant headwinds to equity and fixed income markets if there are no offsetting efforts. Conversely, policies advancing industry deregulation and scrutinizing overall government spending would have the opposite effect. In short, much will depend on the policy direction the upcoming administration chooses. Depending on their impact, a wide range of potential outcomes – from an uptick in growth and inflation to an economic slowdown or even a recession – are possibilities.
The Fed lowered its benchmark interest rate by 100 bps in 2024. However, the timing and magnitude of future cuts remain uncertain due to sticky inflation and resilient economic growth and labor market. Huge fiscal deficits and the potential impact of Trump’s policies have also caused term premiums to move higher. We anticipate a continued trend toward normalization of the yield curve slope, to a steeper structure through lower short-term rates and more stable but higher long-term yields. We believe government-backed mortgages are attractive and are overweight in this sector. The sector has wider-than-average spreads, no credit risk, and limited issuance given high rates and low refinance activity. Low demand from banks and the Fed, historically two of the largest holders of mortgages, has pushed spreads wider. We believe the spread widening presents an attractive opportunity for investors. Our mortgage overweight is funded by an underweight to the U.S. Treasury sector. We are also overweight in investmentSunil Swami Chief Investment Officer Alerus Financial, N.A. grade and high-yield corporates. Economic growth accompanied by interest rate cuts may offer a favorable tailwind for credit. Combined with attractive yields, investment-grade credit and highyield bonds may benefit income-seeking investors. Spreads are tight, but yields are attractive and may provide investors with reasonable returns. We anticipate the favorable backdrop of the municipal sector to continue in 2025. Several factors are driving the demand for municipals, including attractive yields when viewed on a tax-equivalent basis.
Corporate earnings will take center stage this quarter as companies provide their first full-year guidance for 2025. Market participants will focus intensely on forward-looking commentary, particularly regarding margin preservation, pricing power, and labor cost trends. Investors also remain watchful for any sign of a broadening of equity returns away from the longstanding, but narrow, outperformance of large, well-capitalized technology companies. The incoming administration’s policies are also a key variable. The impact of these policies will not only drive the overall performance of the stock market but also determine which sectors and industries will outperform the broader market. The pursuit of artificial intelligence by those large companies, as they race for a competitive advantage, remains the dominant theme of equity markets. Notably, the high costs to scale of artificial intelligence preclude all but the largest technology companies from competing, underpinning our preference for large, capitalized companies over their smaller counterparts. We continue to favor stocks in the technology and communications sectors, along with financial stocks, which may benefit from a better regulatory and deal-making environment. A strong dollar makes it challenging for U.S. investors to invest in international markets, and we continue to favor domestic equities.
