Vanguard I Quarterly economic and market update - December 2024
Quarter in Review
Equities slowed down over the last quarter of 2024, capping an otherwise positive year for risk assets. U.S. equities were the clear outperformers over the year, gaining 25%, boosted by the resolution of election uncertainty, robust economic activity, and moderating inflation. However, U.S. and global markets pulled back at the end of the quarter after the U.S. Federal Reserve (the Fed) became slightly hawkish in December, scaling back the number of interest rate cuts expected in 2025. Over the quarter, Japanese equities outperformed other regions, gaining 5.4%, to be the second-best performing major equity market after the U.S due to continued optimism about the end of deflation and ongoing corporate reforms (Figure 1).
Global growth stocks, particularly large-cap tech stocks, continued to deliver outsized returns driven by positive Al sentiment and strong earnings, with the "Magnificent 7^" returning nearly 16% for the quarter and over 67% for the year. Emerging markets equities experienced a quarter-end boost from another round of Chinese stimulus efforts and strong performance from India and Taiwan. Australian equities wavered in the final month of the year, ending the quarter down 0.8% but growing 11% over the year. Financials and industrials outperformed over the quarter, while the property sector slid and consumer discretionary took a hit.
Banking benefited from strong earnings from the big four banks and optimism that inflation is now under control with interest rate cuts on the horizon, allaying fears of a significant spike in mortgage defaults. However, the materials sector recorded a decline of over 10% due to concerns over China's economic growth and inflationary pressures.
While developed markets central banks began normalising policy in 2024, resilient growth and stickier inflation meant markets pared back expectations for how quickly rate cuts would be delivered, particularly in the United States. This led to higher yields and curve steepening as long-end Treasury yields rose further than short-term yields, leading to a 1.7% fall in the Global Aggregate Index over the quarter, but a 1.5% gain over the year as higher starting yields cushioned losses (Figure 2).
Australian mid- and long-term bond yields also rose, dampening the Composite Index which was down just over 2.5% but still posted close to a 3% gain over the year, while lower duration assets such as cash were positive over the quarter. High-yield bonds were the top performing sub-sector again, benefiting from a combination of high all-in yields and tightening spreads. European government bonds also outperformed as the weaker economic outlook and political turmoil translated into greater confidence in the downward direction for interest rates.
In currency markets, the USD rallied as markets expected proposed tariff plans to provide medium-term support by narrowing the U.S. trade deficit. Among G10 currencies, the AUD was one of the worst performers, down over 10% against the USD, with iron ore prices falling by 7.5% over the quarter. Broad commodity performance was negative with precious metals, particularly gold, retreating from the all-time highs this year due to rising geopolitical tensions and market uncertainty. Brent crude oil prices strengthened due to production cuts, and energy outperformed.
Global inflation has slowed sharply in the last two years and is now within touching distance of central banks' targets. But the path to disinflation has been uneven across countries, with most developed markets enduring monetary-policy-induced slowdowns to get there. The United States is a notable exception, having experienced accelerating economic growth and full employment with no discernible effect from restrictive monetary policy.
Has the U.S. achieved a soft landing? Or will the impact of high interest rates eventually lead to a hard landing? These questions have dominated the market narrative over the last two years, with the focus on whether the Fed can perfectly time the rate-cutting cycle to achieve painless disinflation.
Yet this emphasis on the "landing" may not fully explain the pairing of exceptionally strong growth and falling inflation that we've witnessed in the U.S. The forces that do explain it suggest a new narrative for the economy and markets.
In our 2025 outlook, we adopt a framework centred on the supply-side forces that have shaped the U.S. economy. These include a surge in both labour productivity and available labour. Supply-side forces offer a more satisfying explanation for the positive growth and inflation dynamic.
Emerging risks-such as those related to immigration policies, geopolitics, or potential tariffs-also fit more naturally into this supply side-aware framework.
Against the backdrop of restrictive monetary policy, the U.S. economy has had the favourable combination of strong real GDP growth, loosening of overly tight labour markets, and falling inflation. With headlines on Fed policy always front and centre, it is tempting to attribute this good fortune to a "soft landing" engineered by the Fed. However, a closer look suggests that this interpretation may be insufficient.
Rather, continued U.S. robustness may owe more to the fortuitous supply-side factors, including higher productivity growth and a surge in available labour (Figure 3). Higher output and lower inflation can generally coexist only when the supply-side forces are in the driver's seat. These dynamics have altered our baseline U.S. economic outlook and point to the primary risks on the horizon.
Vanguard I Quarterly economic and market update - December 2024