February 2025 Market Commentary

January Jitters

Market breadth improved in January following a tough two-year trend of a limited number of stocks outperforming benchmarks. The AI paradigm was tested by the arrival of a low-cost solution from China, momentarily upsetting the upward path of the technology titans' stock prices. Economic data showed signs of weakening, but the Fed hit the pause button on rate cuts to start the year. The Trump Tariffs are dominating headlines, but it is too soon to determine the economic impact.

Equity and bond markets bounced back from a tough December, with all our tracked major indices posting positive returns in January. Non-U.S. markets outpaced the S&P 500 Index for the second consecutive month. Ten of the 11 S&P 500 Index sectors generated positive monthly results in January, with Technology the lone decliner (down 2.9%). Communications Services led the charge with a 9.1% gain while Health Care, Financials, Materials, and Industrials each delivered at least a 5% return in January.

"Prices change when events are different from what the market has expected them to be."

-Peter Bernstein

A Five-Year Market Run with Limited Leadership

Stock market breadth is one measure of the overall health of the stock market, indicating the extent to which stocks are participating in a market trend. It looks at the number of stocks advancing versus those declining to provide insights into the market's strength or weakness. Strong market breadth, where many stocks are rising, suggests a healthy and sustainable market trend. Conversely, weak breadth, where only a few stocks are driving the market, may indicate potential instability or an impending reversal.

Last month, we observed that market breadth remained weak for the second year in a row, with just 31% of S&P 500 Index stocks outperforming the index. Since the turn of the century, market breadth fell below 35% just three times, in 2020, 2023, and 2024. Most years, about 50% of the S&P 500 Index stocks outperform the index. Weak market breadth is generally bad news for stock investors, but that was not the case over the past five years.

The S&P 500 Index generated a 14.5% annualized return over a five-year period ending December 31, 2024. It was an impressive achievement, especially considering the limited market breadth and numerous challenges, such as the highest inflation rate in 40 years, the COVID-19 pandemic, and the Federal Reserve Bank's aggressive interest rate hikes. The 14.5% annualized return crushed the preceding 20-year and 50-year annualized returns of 6.1% and 10.6%, respectively. This remarkable performance underscores the resilience and adaptability of the market in the face of unprecedented economic conditions, while calling into question the validity of market trend tools like market breadth.

Better Breadth in January

One month is hardly a trend but it is worth noting that market breadth improved in January. The average return for stocks in the index was 3.5% in January alone, and 53% of S&P 500 Index stocks outperformed the index. Notably, some of the top-performing stocks over the past five years, such as Apple, Microsoft, Nvidia, and Tesla, underperformed, with three out of the four posting negative returns. Though various factors can affect individual stock performance, we consider quarterly earnings reports to be particularly significant.

John Butters, a Senior Earnings Analyst at FactSet Research, provided a S&P 500 Index earnings season update last week. With 36% of the companies in the index reporting earnings, the results have been mixed relative to expectations. Seventy-seven percent of the reporting companies beat analysts' estimates, in line with the 5 and 10-year averages, but the magnitude of the beat (5% better than expected) is below average. In terms of revenues, 63% of S&P 500 Index companies reported actual revenues above estimates, below both the 5 and 10-year averages. As was the case with earnings, the magnitude of the revenue beat was below trend. Butters noted that historical averages reflect actual results from all 500 companies, not the actual results from the percentage of companies that have reported through this point in time.[i] Despite the mostly "good news", some stocks declined because expectations were very high. We recognize that the results were varied, but we're optimistic about the future, with double-digit growth anticipated for each quarter in 2025.

Technology Stocks Deep-Sixed

The introduction of DeepSeek, a new set of advanced Artificial Intelligence (AI) models developed by a Chinese startup of the same name, had a notable impact on the stock market and, more specifically, the technology titans well represented in the S&P 500 Index. As Jeff Sommer of the New York Times called out in his weekend Strategies column, DeepSeek's "excellent performance of a new, relatively cheap Chinese artificial intelligence engine raised questions about the strategies of deep-pocketed American companies like Google, Microsoft, Meta and Open AI. They have poured billions into advanced AI hardware that swelled the coffers of the giant chipmakers Nvidia and Broadcom as well as utilities and energy companies with nuclear and power and fossil fuels. The brute force approach to developing advanced artificial intelligence may not make sense if Chinese open-source AI can achieve similar results at a small fraction of the cost."[ii]

The AI paradigm may have shifted but that doesn't mean all AI investment opportunities are lost. As one analyst noted this past week, "The fact that a viable strategic alternative to building the largest (AI data center) cluster physically possible has emerged is, in our view, profoundly bullish for software."[iii] The lower-cost alternative will likely speed up adoption rates as AI becomes increasingly more accessible across the broader economy. While the market's immediate reaction to the news was negative, we believe DeepSeek's triumph will continue to propel the artificial intelligence revolution forward.

Economic Recap and Signs of Economic Weakening

Despite groundbreaking advancements in AI and automation, their anticipated impact on reshaping the job market has yet to materialize, according to the most recent data. The U.S. labor market remained resilient in December, with nonfarm payrolls adding 256,000 jobs, led by gains in health care, government, and retail trade. The unemployment rate held steady at 4.1%, while wage growth continued at a moderate pace, rising 3.9% year-over-year. However, the news was not all good as long-term unemployment remained elevated, and job growth in leisure and hospitality slowed compared to previous years.

Consumer sentiment fell for the first time in six months, reflecting increased concerns about unemployment and inflation, with short-term inflation expectations rising to 3.3%. The S&P Global Composite PMI slipped to 52.4 in January, marking a nine-month low as services activity slowed, while manufacturing showed signs of recovery. GDP growth in Q4 moderated to 2.3%, down from 3.1% in Q3, driven by solid consumer and government spending but offset by weaker investment and exports. Inflation remained a focal point, with the PCE price index rising 2.6% year-over-year in December. While inflationary pressures persisted, the Federal Reserve is expected to maintain its current policy stance, with no imminent rate cuts projected.

The Fed Hits the Pause Button

As anticipated, the Federal Open Market Committee (FOMC) took no rate action at the first meeting of 2025, maintaining the Federal Funds Rate in a range of 4.25% to 4.50%, ending a three-meeting streak of rate cuts. With progress stalled on reducing the inflation rate to the FOMC's target rate of 2% and the unemployment rate remaining low in recent months, the decision to maintain the current policy is logical. At his press conference following the conclusion of the FOMC's January meeting, Federal Reserve Chair Jerome Powell emphasized that the central bank is in no hurry to adjust its policy stance, particularly as the economy remains strong.[iv] When asked about the potential effects of tariffs, Powell responded that there is a wide range of possibilities. Transcripts of FOMC meetings show that officials had other primary concerns than tariffs, specifically the likely hit to growth caused by plummeting business sentiment resulting in a pullback in business investment. Nevertheless, the sheer volume of trade policy proposals is making the FOMC's job more difficult.

Trump Tariffs

This past weekend President Trump followed through with his promise to place tariffs on Canada, Mexico and China in retaliation over immigrants and drug trafficking. Executive orders were signed placing tariffs of 25% on all goods imported from Mexico and Canada, and 10% on Chinese goods and energy imports from Canada. Markets reacted accordingly to the news, with stocks selling off in the first few trading hours Monday. But like the FOMC, Trump hit the pause button. By the end of the day, he announced he was pausing the proposed 25% tariffs on Mexico and Canada. However, the 10% tariffs on China goods went into effect at midnight Tuesday.

The outcome is difficult to predict but we can provide some context on what is at stake. Imports from Canada, Mexico and China account for over 40% of all products and raw materials entering the U.S. If the proposed tariffs are enacted, the effective tariff rate on all U.S. imports rises to 10% from less than 3% today. Some economists estimate that the proposed tariffs may drive inflation up one percentage point and cause a one percentage point drag on the economic growth rate. In other words, the potential impact is meaningful, but perhaps not probable.

"My style of deal-making is quite simple and straightforward. I aim very high, and then I just keep pushing and pushing and pushing to get what I'm after."

-Donald Trump, Trump: The Art of the Deal
 

Looking Ahead

The potential for a trade war creates uncertainty that could hinder production and investment. The fallout could be widespread, and investors should expect "headline" risk to continue. As it pertains to the outlook for the stock market, earnings growth may come under pressure if planned investments are delayed pending a final tariff outcome. Furthermore, a recent surge in the dollar versus foreign currencies has caused many of the U.S. companies we track to call out currency headwinds to the tune of a negative 2% hit to 2025 revenue expectations. The U.S. dollar may continue to strengthen if tariffs go into effect. Tariffs make foreign goods more expensive to import, which typically leads to a decrease in buying goods made abroad. Less foreign currency is needed to buy those goods, so the dollar gets stronger. If tariffs are fully implemented, our confidence level in corporate earnings growing 10% in 2025 will likely fall.

We expect policy clarity to emerge in the coming weeks and months which should narrow the range of possible economic outcomes in 2025. We continue to pay close attention to corporate earnings and guidance and will make the necessary adjustments to our investment strategy when appropriate.

We appreciate your confidence and support and encourage you to reach out to an Old Point team member with any questions.