Strong growth and lower—but persistent—inflation are keeping interest rates high, which may keep a lid on stock prices.
2024 saw significant gains in global stock markets, driven primarily by robust economic growth and impressive corporate profits. At the same time, bond markets faced challenges due to persistent inflation and rising long-term interest rates.
This push-pull is likely to continue in 2025 as strong economic growth and low unemployment keep inflation and interest rates elevated. Consequently, stock prices may have a difficult time repeating the gains of the last two years.
Indeed, strong economic growth and low unemployment may mean the fight against inflation is not quite over. And, more importantly for stock prices, the path to lower interest rates may be longer than previously thought.
In fact, the recent downturn in stock prices was likely due to rising bond yields, which have been increasing despite the Federal Reserve’s cuts in short-term interest rates. The bond market’s assessment of the economy — and of the inflation risks posed by the incoming administration’s policies — is less sanguine than the Fed’s.
Economic growth accelerated throughout 2024, rising from a 1.6% rate in the first quarter to a revised 3.1% rate in the most recent third quarter measure. Corporate profits grew consistently in 2024 and are expected to grow at 9% for the year. Current consensus estimates for 2025 show further acceleration up to 14%. More importantly, the sources of earnings growth are broadening to include companies from every industry and not just the largest tech companies.
Inflation Remains Above the Fed’s Target
The Labor Department reported in mid-January that the Consumer Price Index rose 0.4 percent from November, and was up 2.9 percent from a year earlier. It was the fastest one-month increase in overall prices since February, driven in part by another sharp rise in the price of eggs and other groceries.
While inflation has cooled substantially since the middle of 2022, when it hit a four-decade high of more than 9 percent, the more recent reports show that progress has slowed, or even stopped outright: By some measures, inflation hardly improved in 2024.
“When you step back and look at the overall state of inflation, we’re not really going anywhere,” said Sarah House, senior economist at Wells Fargo. “While there has been progress, the pace has been really disappointing.”
Prices continued to rise in some of the categories that matter most to consumers. Grocery prices, which were relatively flat in late 2023 and early 2024, are rising again, led by the price of eggs, which is up by more than a third over the past year. Gas prices jumped 4.4 percent in December, although they were lower than a year ago.
And with inflation proving more stubborn than policymakers had hoped, Americans will likely need to wait longer to see lower interest rates on their mortgages, car loans and credit card balances.
Officials at the Fed have voiced increasing concern about the slow progress on inflation, and while some of the details in Wednesday’s report were encouraging, the data is unlikely to do much to ease those concerns.
As a result, investors widely expect the central bank to hold interest rates steady at its meeting later this month. That would break a streak of three consecutive rate cuts, and some forecasters now say that policymakers may not lower rates at all this year. This is a sharp departure from previous expectations of several Fed rate cuts in 2025.
Tech: A Historical Reminder
The outsized gains on the S&P 500 over the last few years have been driven largely by big-name tech companies. These so-called “Magnificent Seven” stocks include Apple, Google, Microsoft, Meta, Nvidia, Tesla and Amazon. These are great companies on the leading edge of innovation and their stock prices have soared.
Indeed, tech stocks have bolstered returns before. They were the key to outstanding market performance in the 1990s, the dot-com era. From 1995 through 1998, the S&P 500 gained more than 20 percent annually, and came close to 20 percent in 1999, largely on the strength of tech stocks.
But the market rose too high, forming a bubble that burst in March 2000. Starting that year, for three consecutive years, stocks had catastrophic losses. If you invested in stocks for the first time in late 1999, your holdings would have been underwater until well into 2006. Returns for an entire decade were disappointing.
By some metrics, stocks aren’t as extravagantly priced today as they were then, but they are high enough to be concerning. The classic valuation metric of the price-to-earnings ratio (P/E) for the S&P 500 is now roughly 30. While this isn’t as high as it reached during the tech bubble, it is twice the historical median P/E of 15.
This is not to predict that the stock market is going to decline, or that the “Magnificent Seven” stocks are setting up for a crash. However, history suggests a sobering lesson: stocks and sectors go out of fashion. What worked over the last two years may not work in the next one. For this reason, we continue to broadly diversify portfolios and not concentrate only on the big tech stocks that have driven the S&P 500’s performance over the past several years.
The Great Unknown
Current and near-term economic growth, corporate profits, unemployment, inflation and interest rates are all somewhat known quantities. However, what is not known is how the incoming administration may or may not disrupt these economic measures.
The new proposals are dizzying. The incoming president says he wants to deport millions of immigrants; impose tariffs on all countries, especially China; slash taxes; expand the use of cryptocurrency; eliminate wind-powered electric generation; and increase production of fossil fuels.
It’s impossible to know which policies will be carried out or what all the economic and market consequences might be. And with this in mind, it is little wonder that the financial markets have been choppy since the November election.