Making Sense: January Market Update

Amy: Hello, everyone. I'm Amy Thomas, a strategist here at First Citizens Bank. Today is Thursday, January 30, 2025. I'm joined by Phil Neuhart, Director of Market and Economic Research, and Brent Ciliano, Chief Investment Officer. I want to welcome you to our Making Sense: Market Update series. Each month, our team brings information regarding current markets and the economy to help you make your financial decisions.

As always, the information you're about to hear are the views and opinions of only the authors at the time of recording and should be considered for educational purposes only. This information should not be considered as tax, legal or investment advice. And Brent, with that we're ready to go, so I'll turn it over to you.

Brent: Great. Thank you, Amy, and good afternoon, everyone. Hope you're well. Phil, I can't believe it, our first Making Sense of 2025. It's great to be back in the seat with you, and let's knock on wood and hope that 2025—at least from a market perspective—is as good as what 2024 was.

Phil: That would be something else.

Brent: So we've got a lot to cover today. So what are we going to go through? We're going to obviously start, give you an economic update. We'll talk a little bit about the growth outlook, Phil. We'll talk about what's going on currently in the labor market and certainly what's on everyone's mind, which is—where's the path of inflation and monetary policy from here—and certainly interest rates.

We'll do what we normally do, which is talk about markets. We'll start with an equity update. We'll recap a little bit about 2024, talk about fixed-income markets and certainly talk about another thing that's on clients minds, which is policy uncertainty and what's, kind of, going on with government. So with that, Phil, why don't you kick us off?

Phil: Yeah, so let's jump right into the economy, Amy. And as you flip ahead, you can see here in the chart just how good growth has been relative to expectations. So let's first start with last year. Looking at the right side of this chart, you can see 12 months ago, the US economy was only expected to grow 1.5% in 2024, which is really subpar growth. Today, that number—expectation is 2.7%. Now, Brent, we got some updated GDP data.

Brent: Literally this morning, hot off the presses—that number is now 2.8%. So, again, the trend that you just highlighted continues to play out.

Phil: And really strong personal consumption in that report, I should mention. So 2025, thinking about the year ahead, what about expectations there? Well, it started a year ago at 1.7%, again, pretty ho-hum growth. And we're up at 2.2% today. That number continues to rise. We wouldn't be all that surprised to see it rise even further. So the real truth here is that the bear case just has not played out in the US economy. And that's found its way into risk assets.

What about the global picture as we flip ahead? Well, one, you'll notice here that the US is the best house on the block.

Brent: By a long shot.

Phil: Yeah. We used to say best house on a bad block, but maybe it's not such a bad block anymore.

Brent: Yeah, it looks pretty good to me.

Phil: And you can see that in some of this data. So when you look at places outside the US—Germany, Japan, the UK, many of these regions, 2025 growth is expected to be higher than 2024. And many of these regions struggled with 2024, Europe and Japan being key in terms of that statement. So if that were to happen and we see growth come in even okay outside of the US, that is certainly good for corporate earnings and for global markets as well.

Brent: Without a doubt. And you would think that especially if we do see an acceleration in developed international markets and also within Canada as we'll get to when we get to cover equity markets for 2024, where international markets were positive, but struggled a little bit relatively. Hopefully that economic growth linkage might play out well for international equity markets.

Phil: It would be great to see participation outside of the US. So what about chances of recession within the US? Not too surprising. You see all these upward revisions in terms of growth. That has really fallen precipitously. So here we're showing consensus economists—so think Wall Street economic types—their percent chance of recession. Of course, it was 100% in 2020. We had a recession. But you can see that rise-up that started in 2022 and persisted through 2023, really greater than 50% chance of recession.

And by the way, there were reasons for that. The Fed was hiking and growth was disappointing. But the truth is that number has come down, that probability of recession, because things like the labor market really have hung in much better than consensus expected. So speaking of the labor market, let's flip ahead, Brent.

Brent: I was just going to say, so one of the main reasons that economists and market prognosticators have lowered their expectations for a recession is because we've had an incredibly robust labor market. And you can kind of see the last 2 months, the 3-month moving average has been above that break-even rate that would keep the unemployment rate from creeping higher.

December was a good print. I mean, we came off a revised number in November of about 212,000 jobs, which was a great number. Expectations for December were for 165,000 jobs. We came in at 256,000. So another significant beat. And when you get underneath the hood, the subsectors that did very, very well—so think education and health care services, think leisure and hospitality tied into services spending. So, again, robust job creation in the subsectors that would really buoy consumer spending and what's going on there. So, again, seeing very strong payrolls growth and something that we basically need to see to kind of keep that probability of recession low and the economy growing like you covered.

Phil: And the unemployment rate's really been consistent with that as we flip ahead, right, Brent?

Brent: Absolutely. And this is something, Phil, you and I have showed this slide for quite a while, going all the way back to 1960 and looking at the unemployment rate. I mean, certainly been volatile over long periods of time. And we covered in the past that when we hit these cycle lows, we saw the unemployment rate rise at least up to the long-term average, and in some cases above. And here we are from November to December, we saw the unemployment rate tick down from 4.2% to 4.1%. But interestingly, Phil, from May of last year to now, we've been range-bound between 4% and 4.2%.

Phil: Yep. That's something we've been highlighting a lot in client meetings, that the assumption is when unemployment starts to rise, it just rises. But I think it's a reminder how unique this cycle is. The 2020 recession is a one-of-one, right? We had a complete shutdown of the global economy, a reopening which drove high inflation, higher rates very quickly relative to past cycles, and maybe the Fed is engineering a soft landing. And I say the Fed—the truth is it's credit to everyone in the economy, not just the Fed.

Brent: It's a team effort.

Phil: But I think it's really interesting that the unemployment rate has flattened out at what is still a very low historical level.

Brent: Yeah, and going forward, you know, the expectations for this year sit a little higher at 4.3%. But it's been variable. But what's interesting is, again, this is far out there, but expectations for 2026 aren't higher than that—they're 4.1%.

Phil: Right.

Brent: So maybe to your point, we really will see for the first time in a long time somewhat of a leveling out, but it's a sort of wait and see.

Phil: It's certainly something that markets have priced, by the way. A lot of the exuberance in markets is reaction to things like this leveling off.

Brent: And speaking about labor market and sort of the tightness that we see on the next slide here, and we've talked about job openings per unemployed worker, and obviously, you know, the all-time highs that we saw back in 2022, you know, two open jobs for every unemployed person was the highest that we'd seen. But you can see now that that's certainly—when we talked about it all last year—that ratio falling.

But the good news, if you kind of look to the right of this slide, we've seen a leveling out at the pre-pandemic average. So, again, we'll see what that looks like. But what it clearly highlights to me is that we still have a very tight labor market and jobs are still available.

Phil: Right. And by the way, this normalization is a good thing. When we had two job openings for every unemployed person, what were we hearing from our clients? They could not find workers. And by the way, that's still the case in a lot of sectors, but we have seen at least some normalization. That's actually a good thing. We needed some loosening in this labor market. So going back to more healthy averages is a real positive.

Brent: Absolutely. And, you know, the most important part of all this, specifically for our economy on this next slide here, Amy, is consumption. We've said this time and time again that the consumer explains, you know, almost 72% of US real GDP, and this part of it, which is services and goods spending is roughly about 68%.

Dark blue dotted line here is spending on services, and the gold line is spending on goods. And you can see for quite a while, Phil, you know, the most significant component of consumption, which is services spending—which is more than two-thirds of all consumption—still running at 6.6% year over year. And while that's ever so slightly down from the 7% that we saw in November year over year, still robust number. But we have seen a pickup in year-over-year spending in goods from 1.6% up to 3% here. So all in all, the consumer spending on either services and goods remains solidly intact.

Phil: Really a positive. And one of the things driving that consumption, which by the way, came in surprisingly good in this morning's GDP data as well, is net worth. So let's look at this in two different ways. We're showing household net worth. This is in sum, right? This is total net worth.

Brent: That's not yours? This is everybody's, okay.

Phil: Yeah, that is true. But you could change that, Brent.

Brent: Yeah.

Phil: The household net worth, as you can see, it tends to trend up, right? You can see some deteriorations at different points. Look at the financial crisis—that 2007, 2008, 2009 period. Look at the tick down during the sell-off of 2022. So it's not that it's always going up, but there is obviously a trend here.

What is driving this higher? One, home prices continue to rise. The biggest asset on many consumers' balance sheet is their home. Two, we have a stock market near all-time highs. When those two things happen, you tend to see net worth rise. Now, one caveat I should make—and something we talked about during our outlook—is this is a total. This is not saying that everyone is doing wonderfully. And we did show in our outlook that lower-income individuals are not seeing the same expansion in terms of spending. So it's not that everyone's doing great, but it does drive the aggregate data like GDP.

We want to look at this a different way, though. When you just have a line that trends up, it doesn't tell us that much. We wanted to look at what's the percent change from 5 years ago, right? So one, you'll see the most recent data of third quarter of last year—percent change was 49% higher than 5 years ago. That's pretty great. So we wondered, how does that look versus history? And the answer is it's high, right? But we've had other points that were even higher. It's pretty interesting.

Look at the end of the stock market boom of the 1990s. Look at the recovery right before the Great Financial Crisis. Look at how destructive the Great Financial Crisis was. By the way, it's easy to forget as we get years away from that, the impact that still is having on us today. And now you see, of course, a really healthy level after a drop down in the 2022 time frame. The answer is net worth continues to grow. This is a positive wealth effect, right? Not to bring economics too much into it, but when people feel wealthier, they tend to spend more—even if the wage story is maybe not working to the same extent for them. If they have increased wealth, the data shows that they tend to spend more.

So let's talk about that inflation story and why we've seen a lot of frustration. I hear about this on the road. It's something we certainly saw play out in an election year. People like us like to say things like "the rate of inflation has fallen to 2.5% to 3%," right? And that's the bars here. The problem with that is inflation was 9%. It was 6%, and it compounds. Inflation's not negative. It's still positive.

So what we're showing here is that when you look at compounded inflation since the beginning of 2021, prices are up 21%. Right? That is a lot. Wages, which is the dashed line here, are only up 18%. So when you hear frustration around inflation, the answer is after a period of very low inflation, we are now seeing inflation that's outpaced wages. This is why there has been a lot of heat on the political class and on the Federal Reserve as well.

What about inflation expectations? One thing that the Fed—and we as market participants have to watch is not just the level of inflation, but what are expectations. Here we're looking at breakeven inflation rates. Think of this as just a market measure of what expected inflation is over the next 5 years, right? That's the dark blue line.

We're showing in the dashed 2% line, that's the Fed's target. So just a kind of an anchor point for you all. And then we have the average from 2016 to 2019—which is 1.7%—and the average since 2021. So first, let's take the pre-pandemic period, 2016 to 2019, 1.7%. That is incredibly low by any historical standard and below the Fed's target. For those who were in markets coming out of the Great Financial Crisis, we were worried about deflation.

Brent: Right.

Phil: And certainly there was pretty severe disinflation. Wage inflation was very low as well. We are now back to a more normal world is the truth. We're averaging 2.5% average inflation expectations since 2021. That's really normal.

Brent: Yes, exactly.

Phil: It's just that what do we all suffer from? Recency bias, and running 2.5% to 3% inflation feels very high. But if you look historically, it really isn't. Now, the Fed's target is 2%, right. They decided this week, of course, to hold rates where they are after cutting a hundred basis points. A lot of that has to do with—we are above their target, but we don't necessarily have to be at 2.0%, right. We want to be near the Fed's target. So we are in a new inflation regime. But I would say it's kind of back to the future, right, where we are going back to the previous regime.

Brent: And I think it's a really important—I want to sort of reiterate an important point that you just highlighted again—is that if I were to take this chart all the way back, the long-term average is north of 2.5% where this average since 2021 is. And we've had fully functioning and growing economies. We've had equity and fixed-income markets that have done incredibly well. So a higher long-run rate of inflation—if in fact, that's what we actually get—Fed still has their 2% target. But again, we can operate and be functional and grow in a higher inflation environment.

Phil: From a historical perspective, the period from the Great Financial Crisis—call it the 2008 timeframe—to the pandemic through 2019, that's the exception to the rule. History looks more like where we are today, but it does put a floor under things like interest rates, which we'll talk about in a few minutes.

Speaking about the overnight rate and the Fed, what's going on in the rate market? And we'll talk about the yield curve in a moment, but when you look at the federal funds rate, of course, you can see the severe hiking that the Fed underwent because we had really unhinged inflation, 9% inflation. And then the Fed held for some time at an elevated rate. And then if you remember, the Fed cut 50 basis points. So think of that as two quarter-point cuts in one meeting in September.

If you go to October 1st, the fed funds futures market was expecting eight more quarter-point cuts, a lot more cutting following that first cut in September. Now, futures are only pricing four quarter-point cuts from October—and two of those have already happened.

Brent: That's right.

Phil: So now we're in a place where futures are pricing roughly two cuts further this year. At points, that's more one to two. Right now, it's two. But if you believe futures, the first cut would not come until sometime middle of the year. So we think the Fed's on hold. The market's certainly expected and we expected them to hold this week, and they did. Why is that? Because the labor market has surprised to the upside, and inflation remains above target. And if inflation is going to be in this 2.5% to 3% channel, it's hard for the Fed to continue to cut.

The good news, though, for markets and market participants is they have cut 100 basis points. So if you believed policy was restrictive, it's 100 basis points less restrictive now. That doesn't necessarily mean it beats the yield curve. But we do see less-restrictive policy today.

Brent: Yeah. And certainly the call out here, I mean, the inherent variability here, as far as market participants' expectations of the path that the Fed will take, and we'll cover this in just a second, has significantly played out in rates markets.

Phil: Absolutely.

Brent: And we believe one of the takeaways when we get into the fixed-income section is that we believe that will continue to play out through much of this year. But I would say it's an opportunistic thing, less so than something to really worry about, but we'll get on that in a second.

So speaking of markets, let's shift gears, Phil, away from the economy and talk about markets. And let's jump into the equity markets here, Amy, and take a quick look at 2024. And you can see here real quickly, let's just focus for the moment on the dark blue bar, which is all of last year. Light blue bar is the first half of 2024. The middle-colored blue bar is the second half.

And you can see for US stocks, full year—exceptional year. Twenty-plus percent return. First half, second half we'll take either one of those bars as a full-year number in most normal markets. But again, good year across the board. And you can see a little bit, the second half—whether it's US equities or developed international or fixed income—was a little bit of a deceleration in equity markets, a little bit better in fixed-income markets, so a little bit of a change. But by and large, 2024 was a great year where US markets again dominated the return picture.

So let's go under the hood a little bit, Amy, on the next slide and let's focus on US equity markets here, Phil. We're looking at the S&P 500 and the cumulative return of the S&P 500 from January of 2023. And just, again, certainly not a straight line. And you highlighted some of the variability that we saw in returns, but 63% cumulative return effectively over almost exactly a 2-year period of time—just an incredible run in equity markets.

And right now, we do have positive markets year to date. But again, starting to see some volatility as we expected from a geopolitical perspective and some other noise that's coming into the markets. And we'll touch a little bit on valuations in just a second. But overall, just an incredible run in equity markets.

So let's get a little bit more myopically under the hood, looking at the chart on the left. This is a disaggregation of the sub-asset classes within the US equity market. The left side is 2024. And as we've been talking about for a while and what's been in the financial news media with the Mag Seven, the top ten within the S&P 500, US large-cap growth stocks where the best performers hands down. And look at the dichotomy of performance between best and worst. If you're in small-cap value last year, still great return of 8%. But you had, you know, an incredibly large twenty-plus percent spread between US large-cap growth stocks and small-cap value.

Now, getting into this year, which is on the right hand side, we're starting to see what we talked about in the sort of the second half of last year, more like the last quarter of last year, this breadth. And you're starting to see, you know, other areas of the market. Look at these numbers, mid cap, small cap starting to do better. Look at large-cap value, which was a 20% laggard last year relative to large-cap growth, outperforming large-cap growth, and if we would have taken this slide literally back a couple of days, US growth would have been a zero when everything else was positive. So we've got a little bit of a resurgence in the names, but by and large, it's good to see, and it's good and healthy for equity markets. Breadth starting to play out in other asset classes.

Phil: Yeah, we want to see that broadening. As we dig into that concept, let's flip ahead. We've talked about broadening or narrowness in markets a lot of different ways. The cap-weighted S&P versus equal weighted. We want to show a slightly more technical way here. So here in the dark line, this is just the level of the S&P 500. The dashed light blue line is the percent of members above their 200-day moving average, which basically just means, "is a stock moving above its medium term trend?" right.

And what you'll see is, yes, we had points of broadening last year, but really deteriorated at the end of the year in the December timeframe. Look at that red arrow down. But as broadening has improved, you start to see this move up. This is a good thing and a nice way to kind of look under the hood a little bit at health in the market. Seeing more stocks move above their 200-day moving average is a good thing.

We think there are reasons for broadening, as we flip ahead, and one of them is valuation. So here we're showing price-to-forward earnings for two cohorts. Now, price-to-forward earnings, remember, is what you're willing to pay for a dollar of future earnings. So high here is expensive, low is cheaper. Top ten names, so think those Magnificent Seven and a few others, quite expensive versus their own history. By the way, for me, those names, for good reason, right. Lots of revenue.

Brent: Yeah, incredibly profitable.

Phil: Huge profit margins, et cetera. But when you look outside of those ten names, the other 490, you will notice that price-to-forward earnings is kind of where it's been the last decade. It's not that expensive. So, yes, the market is expensive. You hear that all the time. That is true, but it's a concentrated market, and that expensiveness is concentrated in the top names. We think it's an argument for broadening.

Another argument for broadening is fundamentals. So as we flip ahead, what you'll notice here is 25% of the largest 3,000 US equities have gross margin over 60%.

Brent: It's crazy.

Phil: And look at where that number is, right. It's at 25% now. Look at where it has been in the past. It's risen. So we're talking about a narrow market. But the truth is, there's a lot of good fundamentals and companies underneath the hood, not just in large cap, right? This is the largest 3,000 names. There is value. So, yes, you need the economy to remain on track. Yes, you cannot have a policy error, but there is an argument for broadening, basically just based on there being good companies in the US.

Brent: Yeah. And let's continue on with that profitability theme, and let's talk about corporate earnings and profitability. And again, still early in the Q4 2024 earnings season. So far things are looking good, sitting at about 12.7% above expectations where we were, you know, last quarter, the quarter before. Overall, all-in for fiscal 2024, very stout, robust 9.5%—almost 2% above the long-term average since 1950.

So, again, 2024 is broadly, as of now, meeting the expectations that were kind of put on market pricing that you just talked about. But what I find most interesting, Phil, and you and I have talked about this for months, is how fundamentally resilient expectations are for this year. We've been somewhat range-bound between, let's just say 14% to 15.5%, as far as expectations for this year. And here we are in almost the end of January here, still sitting at 14.8% estimated earnings growth for this year.

I don't even really, I'll say it, but I don't even want to talk about 2026 because there's so much to unpack. But the expectation for 2026 is 13.6%. We'll see how long that lasts. But again, it's not 7%. It's not 2%. It's not 5%. It's still double digits. So growth expectations and this earnings and profitability story is continuing this year—and is expected to continue into next year—which I think is actually critically important to keep the equity markets buoyant without seeing any type of multiple contraction.

We need, there's a high bar for earnings and profitability that we're going to have to hit. What does make me feel very confident, or I'd say more confident, is the chart on the right and how resilient forward or next 12-month operating margins are for the S&P 500—still sitting at a very, very lofty 17.4%. Again, forward-looking operating margins, corporations in the United States are doing incredibly well.

Phil: They are, and that margin has expanded greatly after declining during the post-pandemic period in which money was very, very cheap. Nearly free. And there was a lot of fiscal monetary stimulus. This is, to your point on earnings, this is a "show me" year in the stock market, when you have an expensive overall market and a 25% total return last year. Fundamentals need to play out.

And speaking of that, as we flip to our price target, our next 12-month price target is 6,400 on the S&P 500. That's up 5.5% from where we closed on the 28th. Remember, we've had an up year so far, so it's still a decent year. But, you know, top-down consensus is at 6,600. So we are below the top-down. Why is that? Well, we really just had a great year, and we could see a world where, yes, earnings comes through, but maybe the multiple contracts a little bit, and you still have a good price year from an S&P 500 perspective.

So we remain constructive, but we really do expect volatility this year. Something we talked about in our outlook, but we have policy uncertainty. We talked about this in our written work as well. Policy uncertainty, whether you think fiscal, trade, we have monetary policy uncertainty. We have a Fed now on hold. We don't really know what they're going to do. Not to mention, as we already mentioned, a fairly expensive market. So it's a market that, you know, looking at last year, our max drawdown was 8.5%. It's a year that certainly, who knows, but our best guess is we have more bumps along the road this year than last year.

Brent: Oh yeah. And you've highlighted this many, many times, Phil, that, you know, the average entry-year drawdown over the last forty-plus years is about 15% on average, even median is 10% or 11%. So again, last year's drawdown was a little bit more than half of the average drawdown that we've seen. So I could absolutely seeing us have some volatility. And I think the fact that we have a multiple that might come down a little bit, I would argue is healthy, right? If that multiple were to contract just a little bit as earnings—let's pretend they come through in 2025 and 2026. When you think about that numerator denominator effect, that's actually healthy to allow breadth and expansion within prices within the S&P 500 versus just seeing this massive multiple expansion without the earnings story coming into play.

Phil: That's really Goldilocks for the US stock market.

Brent: 100%.

Phil: It is earnings come through, multiples able to contract a bit, but you still have nice price gains on the S&P. What about the yield curve?

Brent: Yeah, let's talk fixed income. And, my gosh, what a volatile, you know, 12 to 18 months it's been. So what are we looking at here? The dark blue line is the highs that we saw in the Treasury yield curve back in April of last year. The light blue line are the lows that we saw in the Treasury yield curve right before the Fed's meeting in September. The gold line is where we are now.

And you can see just the incredible variability that we've had in the yield curve. And more specifically, like, look at that 1-year out. And what we've seen happen is we've seen what's called a bear steepener, where in essence short rates fall at a much faster rate, while longer term yields fall, but not nearly at the rate that you see on the short end. And we've actually seen in the last couple of weeks, some variability on the belly of the curve. Let's think 3, 5 years out to 20 and 30 years.

A lot of volatility, but by and large, moving toward a more normalized curve where yields are upward sloping as you go out in maturities. But by and large, yields are now plentiful, right. The yield to worst on the—let's say the US aggregate bond index—is roughly about 4.9%, which, as we've covered in the past, is a pretty good predictor of future total returns over the duration horizon, which is a little bit more than 6 years. So, again, whether you're looking at Treasuries, you know, a default risk-free asset by and large, starting yields are quite attractive relative to the forward expectations.

Phil: And something, you know, it's important that we've talked about during our outlook, but we should continue to emphasize is this is why we talked about balance in portfolios, right? Fixed income is a much more viable asset class when you see yields closer to long-term averages versus where they were a few years ago, which was extremely low.

Brent: Yeah. And one of the questions on the next slide, Phil. This is a new slide, and thank you to Blake Taylor for doing the awesome job that he does. We get a lot of questions on the road about, "Okay, great. Well, but wait—the Fed, Phil, you say is cutting rates, is on a path to normalize monetary policy, yet interest rates are rising. I didn't think it worked that way." So what we wanted to highlight here is the chart on the left looks at periods of time where we had sort of a mid-cycle adjustment, right? We didn't have a recession that occurred. We had a mid-cycle adjustment.

And what you can see in the dark blue line on the left is where we are right now. But if you look at three of those other four periods, you saw rates actually rise from—let's say now over the next 8 or so months, right, so looking at that whole 12-month period from the beginning of a Fed easing program to the next 12 months. So, again, what you do see is, number one, those lines don't go in a straight line. There's a lot of variability in rates, but it is not inconsistent, at least historically, to see in a mid-cycle adjustment, which we believe it might be that yields are not only volatile, but rise.

Phil: And before you turn to the right side, I mean, what's interesting about the left side is—think about it, it's a mid-cycle adjustment, and we do pull off no immediate recession, which did not happen, we would have already had it. But certainly we can always have one in the future. But the 2024 recession, 2023 recession expected, then it's pro-growth, right. And rates tend to move up when growth and inflation expectations rise. Well, that's what happens when an economy is doing pretty well.

So it's not too surprising you look in the past that that happens during mid-cycle adjustments. We don't know yet here—you never know until you have the benefit of hindsight—but, certainly it appears that our economy is doing okay, and probably pretty well.

Brent: Yeah. And just to close this slide out when you look at the right. Even in the in the previous four recessionary periods of time from the beginning of the Fed easing program to 12-months forward. Yes, three out of the four times rates basically fell, but it wasn't this gargantuan drop in rates. So to expect the 10-year to go from its, you know, let's call it 4.5, 4.6 handle down to three, that would be a pretty tall task and at least not indicative of the historical pattern that we've seen.

Phil: Yeah, Alan Greenspan refers to this as the great conundrum. The Fed controls the overnight rate. Assuming that what's happening to the overnight rate is what's going to necessarily happen with something like the 10-year Treasury is unwise. They can move in different ways for sure.

So let's flip ahead. Another question that we are getting in every single meeting is tariffs. And certainly we have seen the market move on tariff news—both ways, right? Certainly something that has been market moving. We saw that around the inauguration. So far, the administration has been quite restrained on tariffs relative to some campaign rhetoric. But this is being used certainly as an economic and policy tool—and in many cases a negotiating tool. The one key thing if you think about game theory of negotiations is neither party knows where you land. So there is uncertainty here because the truth is no one knows exactly where we land, including the parties negotiating.

We wanted to show historical tariffs. You can see that really the 20th century has been a pretty low-tariff environment. By the way, that's been an exceptional period for growth in the US. You do not want high barriers to trade. Of course, you can see that 2020 we saw a little bit tick up. That puts in perspective just how minor the 2018 tariffs were.

Now, we're showing here the range of possibilities. I do not want you to think that we are saying that tariffs are going to go to the top end of that. That is north of 20% universal tariffs, 60% on China, et cetera. We don't think that's where we land. And the market, by the way, is not pricing it.

Brent: That's right.

Phil: When you look at stocks, when you look at rates coming down, certainly the market is not pricing that worst case scenario. But we wanted to just put in perspective, historically, if everything that we heard in the campaign came through, that's where you are. We don't think that's the base case. We think that the restraint we've seen so far and using tariffs as a negotiating tactic is really where we settle.

Does not mean that targeted tariffs and tariffs on certain regions don't impact markets. They do, right. We, of course, see an impact on things like inflation and company margins. Markets have to account for that. But so far it's been pretty restrained. I think markets have cheered that.

Brent: Yeah. And again, even if you were to take—first of all, I'm really disappointed you didn't take this back to 1776. 1790 is not far back enough. But even if you were, to your point, look at the midpoint—or even let's say that third quartile, it's still significantly higher than any point really in, sort of, the modern era. And again, to your point, time will tell, but I think it is critically important that, and you say this all the time when you're in front of clients and traveling—it's companies are going to pay this.

Consumers see that in their pass through. So, again, you know, as we think about what might the other side of what could be a potential headwind for corporate earnings and profitability, we'll see. This is one of those things that we're certainly watching very closely, but this is not enough data now.

Phil: Absolutely. And something that is one of the risks on the table when we talk about policy uncertainty.

So let's talk more fiscal because it's just so uplifting. Something we've talked about before, but we certainly get a lot of questions on and wanted to highlight today with the new administration is—what's the state of play in terms of fiscal debt from the US government?

So here first we're showing—this is debt by various sectors, the level of debt in the US as a percentage of GDP. And what you'll notice is before the financial crisis, right before that sort of 2007, 2008 period, household and nonfinancial businesses had a higher debt as a percentage of GDP than the federal government. And then we saw two major ticks up in that federal government line. One, Great Financial Crisis that is quite a tick up. A reminder of just how much stimulus there was and the weight that put on GDP and the economy. And then you see this really sudden move up during the pandemic.

So we were in a place where, yeah, people have always talked—really since time—but certainly since the 1980s, people have talked about debt in the US. The truth is, though, it wasn't that onerous until the last two major moves up. Now you're in a place where the federal government as a percentage of GDP has a lot more debt than nonfinancial business or households.

This is going to shock everyone on the line. The federal government is not a wonderful allocator of capital, right? You'd rather that be nonfinancial businesses and more efficient allocators of capital. This does cause what we call crowding out and it lowers the potential growth of US investment. Why do we call it crowding out in economics? It's because this debt has to be financed. So you think about Treasury auctions, that means money is flowing into Treasuries that could be going into a more efficient use of that capital.

Brent: And not that we wanted to do that here, but if you were then to overlay yet something else as you look at rates and the underlying cost of that debt. Now, again, remember that you have about a little bit more than 50% matures inside of 3 years, two-thirds matures inside of 5 years. And obviously, as I just highlighted, that part of the curve is certainly coming down. But it's not only the aggregate amount of debt, it's the underlying cost of that. And if we are going to see rates higher for longer, that will also provide another, you know, headwind to our government.

Phil: So, let's, to that point, let's flip ahead. And so how do you address this, and how is this money spent? So this is federal government spending—not the level of debt, the spending as a percentage of GDP based into different categories. So first let's start with the purple bars at the bottom. That's net interest. That's what you're speaking to. Look at how it has risen, and if you look at projections, it continues to rise. Why is that? Rates have gone up. If Treasury yields go up, that means the government is paying more to finance that debt.

As you move to the set of bars above that, that is the second nondiscretionary category, mandatory. Big categories here are things like Social Security and Medicare. That takes a lot of political will, let's say, to change. And then discretionary are the smaller categories, defense and nondefense. Now, today, discretionary is about 28%. If you look out to the end of this period, that goes to 22% in 2034 in these projections, meaning mandatory is rising to 78%.

So when we talk about addressing spending issues in the US government, it's difficult, right. When you're only talking about 22% to 28% are discretionary, mandatory is the vast majority. And this takes acts of Congress. This takes, again, a lot of political will. And with that interest, you just have to pay it, right. So the answer is—there are no easy answers here. And this is much more difficult than what we might hear during campaign season.

Brent: Yeah. And it's obviously a long-term structural issue that has to be addressed. And certainly, we do get a lot of clients that are asking questions, and it does make it more challenging for the current or new administration because of the slim majority in the House. Much of any type of changes that are even proposed would likely have to go through the reconciliation process, which has budget implications as we're highlighting here. So again, it'll be interesting and difficult conversations in the future and something that we're certainly watching.

So, Amy, I see that we do have and we did get a lot of questions in the registration process. Why don't we jump to the Q&A?

Amy: Yeah. First of all, you guys nailed that. The break did you well. Nailed it. Just great job. So, yeah, before we jump into questions, just a reminder to everyone. First of all, if you're joining us for the first time, thank you for being here. We do this every single month. And throughout the month, we have several publications available to our subscribers.

If this is something that you're interested in and would like to get signed up, you can use the QR code on the screen or visit FirstCitizens.com/MarketOutlook to get signed up.

So let's switch gears and go into questions. No surprise—first question right off the bat. How will the new administration's policies impact markets going forward?

Phil: Yeah, this is a question we're getting along the road and some of it we address. So I might sound a little repetitive, but first, I want to step back just for a moment and remind everyone something that we always say during election seasons, which is markets do turn to fundamentals, right. Yes, policy matters. But trust me, if every president had a knob that they turned up the stock market, the stock market would never decline.

Brent: That's right.

Phil: There's not this one-to-one control. In fact, policy is one of literally millions of variables that drive the market. The market eventually goes to things like margins and earnings growth. Some of that can be impacted by policy. A lot of it is not. A lot of it is just things like business cycles, global growth et cetera. So where are we on the policy front? The truth is right now in early days we're just in the uncertain policy side. We mentioned tariffs. We don't know how that turns out. Can't tariffs impact markets? 100%. Do we know where they land? We do not.

When you think about the fiscal side—tax, for example. The budget-reconciliation process is going to come into play because you have such a narrow majority in the House. So what happens with potential tax cut extensions this year? So the short answer is—we don't invest on this, right, we don't trade on potential policy. We have a quantitative approach overlayed with, of course, our subjective overlay. But Brent's team is not saying, "well, the President said this on Tuesday. Let's swing the portfolio on Thursday." We return to fundamentals very quickly.

Brent: Yeah. I mean, I think that makes a ton of sense. And it certainly makes sense, I think that we kind of expected this new administration to come out of the gates, kind of at full steam. My personal opinion is I do believe things will start to settle down and get to a point where we start talking about things. And as you highlighted because there is such a slim majority, 219 to 215 in the House, almost everything of substance is going to have to go through that reconciliation process. There's going to be paid fors and concessions that will have to be given, so it just logically makes sense that you would have more unilateral executive orders to get that out there based on some of the campaign promises and things that were discussed.

But again we do believe it'll settle down, but I think you nailed it, Phil. The most important thing from an investing perspective is—please do not make investment decisions that are based on what's going on in the news. Right? That is a very bad way of investing. Stick to fundamentals. Stick to a long-term viewpoint. Stick to financial planning. That will serve you well whether you're an individual or a business over the long term.

Phil: And one thing I should point out, we mentioned trade and taxes and uncertainty there. One thing I think that you can see the market cheering and investors cheering is the likelihood of lower regulation and higher in mergers and acquisition activity. And that's through appointments, right? So people can be policy in that way. So I think that the administration has certainly had a pro-growth tilt, but the details are still somewhat unknown. But certainly if you look at sector specifics, markets like the idea of less regulation and more M&A activity.

Brent: 100%.

Amy: Well, Phil, we've talked about this in a couple of publications already and a little bit today, but there's a lot of questions around why longer-term rates are still going up, even when the Fed is cutting interest rates.

Phil: And Brent dug into this some, but this has been unique. I think there's a few things going on here. One we showed, which is simply since the Fed started cutting, the expectations around the number of Fed cuts has declined. If you think the overnight rate is now going to be higher, say, at the end of 2025 than you thought 4 months ago, well, the yield curve should react to that. Additionally—and sort of one of the underlying reasons for that change of Fed expectations—is growth has been better than expected, right. We continue to see upward revisions on growth. And inflation at best is in a 2.5% to 3% channel sideways. We have not seen dramatic improvement in inflation. So if you're seeing a growthy environment that should put a floor under rates and the yield curve has to express that.

Brent: Yeah. And like, let's take this from an investor's point of view. We covered this in our 2025 outlook. And again, the numbers are ever so slightly stale back in August of last year. And the horizon actuarial study, the 41 larger firms out there that are prognosticating on forward-expected returns for the next decade, averaged all together coming in about 6.5% for US large-cap stocks over the next decade.

We're a little higher than that, but the range of outcomes are, kind of let's say, the wisdom of crowds comes together and 6.5% smells about right. You have a starting yield to worst in fixed income of let's just round it up to about 5%, anywhere between that 4.5% to 5%. So that spread differential between expected return on equities and fixed income is in the fourth quartile of tightest spreads that we've seen post-World War Two versus a decade that ended where you saw large US stocks returning almost 16%, bonds returning about one-and-change percent. That spread differential of almost 14.5% to 15% was in the first quartile of widest spreads that we've seen since World War Two.

So every dollar that you were in stocks versus bonds was incredibly compensated for based on that asset allocation decision. We believe in the future, like we called out in that outlook, that that spread is going to be much narrower. And that's a good thing for investors because you can have some more lower-volatility asset classes in your portfolio and still have a reasonable, real return over and above inflation. So I think it's actually a good thing.

Phil: Yeah. Balance in portfolios is a great thing to be able to have.

Amy: Brent, we've already seen a fair amount of volatility this January. What are you saying to clients that are concerned about jumps in the market and keeping stability within their portfolio?

Brent: Yeah, I think, look, we're all human beings. And because of technology, we can watch our wealth go up and down every second of the day by looking at our smartphone. So certainly the behavioral side can be challenging, but certainly investors have reaped the benefit. We talked about where the equity markets have been. So that wealth creation in equity markets has been robust.

I think the most important thing to keep one tied to the mast and not make behavioral mistakes at this part of the cycle is to have a comprehensive financial plan. If you can sit down with our wealth professionals and systematically go through what's important to you or business planning or whatever it might be—depending on what type of investor you are—the underlying confidence and conviction that will give you and allow you to sleep better at night and allow us to focus on making those structural decisions in the market. Tie yourself to the mast, stick to those long term goals and objectives. We believe that that will pay off for you in the long term.

Amy: Brent, we got a last minute question here that I think is directed to you. Why are the Philadelphia Eagles the best football team?

Brent: Yes, that is closer to a fact than a prognostication. And look, I'm—it's going to be a great game on the ninth. I'm super excited. You can't really see, but I'm already painted green under this suit. So I'm quite excited for my Philadelphia Eagles, and may the best team win.

Amy: Well, Brent, thank you for that. And thank you both for taking a deep dive into markets and the economy. I want to thank our listeners for trusting us to bring you this information. We'll be back with you again next month.

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Authors

Brent Ciliano CFA | SVP, Chief Investment Officer

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Brent.Ciliano@FirstCitizens.com | 919-716-2650

Phillip Neuhart | SVP, Director of Market & Economic Research

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Phillip.Neuhart@FirstCitizens.com | 919-716-2403

Blake Taylor | VP, Market & Economic Research Analyst

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Blake.Taylor@FirstCitizens.com | 919-716-7964

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