US Stock Market Outlook Q4 2024: Will the Great Rotation Persist?

Susan Dziubinski: Hello, and welcome to Morningstar’s fourth-quarter 2024 US stock market outlook. My name is Susan Dziubinski, and I’m an investment specialist with Morningstar.com.

Now, the US stock market experienced a bumpy third quarter. The quarter began with a long-awaited rotation out of big-cap growth and AI stocks and into value and smaller company names. Then came a brutal selloff in August, driven by renewed recession fears and other factors.

And in September the Federal Reserve cut interest rates by a larger-than-expected 50 basis points. Now, despite that roller-coaster ride, stocks finished the quarter up 6%. So as we head into the fourth quarter, investors are naturally wondering, will the rotation persist? Will the economy hold up? And what will the Fed’s next move be?

Here today to share their outlooks for the market and the economy are Dave Sekera, chief US market strategist for Morningstar Research Services, and Preston Caldwell, chief US economist with Morningstar Research Services. So, let’s begin.

Dave, over to you.

Dave Sekera: All right. Thank you, Susan. Appreciate the introduction, and good afternoon, everybody. Welcome to our North American market outlook for the fourth quarter of 2024. Can’t believe we’re already doing our fourth-quarter outlook, but let’s go ahead and jump into it.

So I’m going to start off with a review of the US equity market valuation. I’ll review our sector valuations and a couple of our top picks from our equity analyst team. Do a brief overview of valuation by economic moat, and then I’m going to pass the presentation over to Preston, who’ll provide us with his US economic outlook. I’ll go ahead and take control back over again, do a quick review of what’s going on with the mega-cap stocks, provide a quick overview of our fixed-income outlook. And as Susan mentioned, we’re happy to take as many questions as we can as time allows.

So let’s go ahead and jump right into it. So as of Sept. 23, the US market was trading at 1.03 on a price/fair value metric, meaning that the market was trading at a 3% premium over composite of our fair values. Now for those of you that aren’t familiar with how we calculate fair value for the market, we cover over 700 stocks, most of the S&P 500, and we cover them as a fundamental analyst does with the bottom-up basis and assign an intrinsic value to each of those individual stocks.

We then take a composite of all of those intrinsic valuations, and we compare that to where they’re actually trading on a composite basis, the market value of those stocks overall, and that’s how we come up with that price/fair value metric. So truly a bottom-up analysis of market valuation. I think what you typically hear from most market strategists is more of a top-down analysis. What they’ll do is they’ll come up with some sort of model or algorithm to forecast S&P 500 earnings, apply some sort of forward multiple to it, and to me, that always seems to be more of an exercising goal-seeking than anything else. Seems like most strategists are always telling you the market’s 8% to 10% undervalued, but in this case, based on our bottom-up analysis, we do think the market’s trading at a 3% premium.

So it’s still in the area that we consider to be fair value, even at a slight premium, but I would note that really since the end of 2010, the market’s only ever traded at the current premium or more, only 15% of the time, so it’s still a pretty rare occurrence that we’re in this kind of area. Having said that, we’re still looking at a market weight as how we would advocate investors to be positioned in the equity portions of their portfolio today, and we’ll get into why we are looking at that market weight, why we do think there are more tailwinds for the market than headwinds at this point in time.

Now one thing we did note last quarter, a lot of you will remember, is that we had talked about how large-cap AI growth stocks generally at that point in time were either fully valued, if not necessarily overvalued, and from a technical basis getting to be overextended. We asked the rhetorical question at that point in time: Is the AI trade over? We had noted that value stocks were still lagging far behind, small-cap stocks also lagging far behind, and were trading at much more attractive valuations than what we are seeing in large-cap and growth stocks.

In July, we started to see the market really begin to rotate out of those overvalued, overextended large-cap growth stocks and into the small-cap space as well as the mid-cap space and also into the value category. The takeaway here is, based on our valuations, we think that that rotation still has further to run. So taking a look at the market price to fair value on a historical basis, you’ll see where it’s trading today, at that 3% premium, still below where we were coming into 2022 when the market was trading at a 6% premium.

At that point in time, we actually did recommend to underweight equities. We had noted that there were a lot more headwinds to the market than there were tailwinds, but at this point in time, I think there are enough tailwinds that we could see the market stay at these kind of levels as we wait for earnings over time to catch up toward valuations.

Looking at the market thus far this year, I would just note that really the transformational nature of AI, seeing solid consumer spending has really led to stronger than expected economic growth. We have the tailwind from moderating inflation. We have seen long-term interest rates tick up here since the Fed cut by 50 basis points, but as Preston will talk about in his section, we do expect that we’re still in the beginning of a multiyear stage of long-term interest rates coming back down.

Of course, we do have the easing monetary policy. All of that led us to reevaluate over the course of the year a lot of our fair value estimates. In fact, we increased our fair values on about 60% of our US coverage, and even of that US coverage, about 30% of it, we increased by 10%. Yet the market has risen fast enough that we are still kind of in this 3% premium area.

Just taking a look at some of the results, quarter to date. Really the takeaways here are we did start seeing that rotation into the value category up well over 8%. Growth stocks up as well, but only up 4%. So looking for that outperformance in value in my core stocks, kind of splitting the difference at that 6% increase. Then similarly, when we look at by capitalization, small-cap and mid-cap stocks, both up about 8% over the course of the quarter, and those large-cap stocks only up 4%.

However, when we do look at the market on a longer-term basis, core stocks are up the most. Of course, those are skewed higher by Meta, Broadcom, and Alphabet. Those are up 60%, 57%, and 16%, respectively, when I ran the numbers. Because of just the sheer market capitalization of the size of those companies, they do skew that core category. What I think is most interesting here is looking at the performance of value versus growth. Growth had definitely been leading the market earlier, leading the value category, but we’ve seen enough outperformance out of value that has now caught up to the growth category year-to-date. Then looking by capitalization, of course, those large-cap stocks, significantly outperforming both mid-cap and small cap. Both of those have lagged behind, but based on our valuations, those are the areas that we see the best value today.

Taking a look at how the markets evolved over the course of the year, we came into the year on a price/fair value basis at one, (essentially) the market was trading right at a composite of our fair value estimates. As I noted, the market has gone up faster than we’ve increased our fair values, leading to that 3% premium. It’s really going to be centered in that growth category, and specifically in large-cap growth. Large-cap growth now trading at a very significant premium over our fair values. Depending on your portfolio construction, where you have the ability to, now I think is a great time to look through your portfolio and identify some of those stocks that are overvalued, overextended, look to at least lock in some of the profits there, and take those profits and move them into other areas that we see undervaluation, specifically the value category and the small-cap category.

Taking a look at sector performance, I would just say during the third quarter, sectors most correlated with value stocks are the ones that perform the best in the third quarter. Real estate, which had been the most hated asset class on the Street for probably the past year and a half. It was actually the most undervalued sector last quarter. It’s one that we were advocating investors to overweight; it had a big surge over the course of the third quarter. Really a combination of 1) longer-term interest rates coming down in the third quarter, making those real estate and REITs looking more attractive. But also, I think just from a pure fundamental basis, as investors were taking a second look at real estate, just realizing just how undervalued the real estate sector had become.

The one sector I’m going to caution investors on today is going to be the utility sector. Those stocks have surged. Investors or the market are pricing in a combination of growing electronic demand from AI, as well as declining interest rates. However, I would say that if you’re just getting into the utility sector today based on that increasing demand from AI for electricity, at this point, you’re already a year too late to that trade. Utilities, and we’ll get into the next slide, actually, just let’s go to the next slide.

Utilities, you’ll see, are up over 30% year-to-date. I believe they’re up over 40% since this time last year. They’ve gone from what our utility sector analysts call being some of the most undervalued levels they’d seen over the past decade in October 2023 to now trading at some of the more overvalued levels that we’ve seen. So, again, a very good area within your portfolio. Take a second look, see where you can go ahead, lock in some profits. Now, if you want to keep your exposure in the utility sector, we’ve highlighted in the past a couple of different swap ideas, getting out of those utilities that have run up the furthest and the fastest, and looking for some of those other utilities within the sector like Evergy, maybe NiSource, those stocks that are at least 4 stars or 3-tar stocks, where you’re at least getting them at fair value.

Looking at the other sectors here, just noting the energy and basic materials have been laggards year-to-date. I think the energy sector has a lot of negative sentiment in here, most recently, but that’s also one of the sectors that we still see value in today.

The other thing to note is with this rotation into value, with this rotation into small caps, returns have definitely been broadening out across the market. When we ran the numbers here, looking at the 10 stocks that, doing an attribution analysis, had the greatest impact on the market overall, these top 10 stocks now only account for 50% of the market gains. When we ran this last quarter, they had accounted for 67%, and I think earlier this year, they were even as high as over 75%. We’re definitely seeing the broadening out of these gains as these stocks get to the point where their fair values are, if not fully valued, in some cases getting to be overvalued.

Just taking a look at our valuations on the stock since the beginning of the year. Two that, I would highlight here are going to be Microsoft and Alphabet. Both of these stocks have really just been hitting on all cylinders this year. In fact, with Microsoft for their cloud business, their Azure business, we’re actually looking for that not only to continue, to keep growing, but actually growing at an accelerated rate in the second half of the year. Both of these companies are ones that we’ve increased our fair values pretty substantially over the past quarter here. Both 4-star-rated stocks that we think are attractive.

However, looking at a lot of these other stocks here, we do think that they are overvalued. Apple, for one, is becoming slightly more overvalued in our view. Eli Lilly, now a 1-star stock. Again, phenomenal performance here in the fundamentals in the short term, but we think the market is way overestimating the long-term growth of their diet drugs. Also, looking at Berkshire having gone from a 4-star-rated stock to now a 2-star rated stock. Similarly, J.P. Morgan, a 3-star stock at the beginning of the year, now a 2-star rated stock. Not expecting a whole lot out of this group other than Microsoft and Alphabet.

Some of the tailwinds that we see in the market, and Preston will go into this more, generally we still expect inflation will continue to keep moderating this year, as well as into 2025 and thereafter. Looking at the economy, really the only headwind in the market I see right now is that we are expecting the rate of economic growth to slow sequentially. It should bottom out in the second quarter of 2025, but we are in that soft landing camp. Again, while it’s a bit of a headwind from earnings growth perspective over the next couple of quarters, we’re not concerned about a recession.

We don’t think that’s in the cards at this point in time. We’re looking for the economy to start reaccelerating in the second half of 2025, once the interest-rate cuts and the easing monetary policy from the Fed really starts to flow into the broader economy.

Just taking a quick step back, looking at why we expect value stocks and small-cap stocks to outperform going forward, why we expect this rotation to continue. I put together two graphs. This shows on a relative value basis where the price/fair value of value stocks are compared to the broad market. You can see here that while we’re not necessarily at the bottom of that range, we did get a pretty good bounceback over the past two months here. But when you go back prior to 2019, you can still see that on average value stocks typically don’t trade at this much of a discount to the broad market. So again, still looking for more normalization there, especially as the economy grows and maybe you get a little bit of pullback in those growth stocks as they fail to meet some of those growth expectations in the next couple quarters, whereas value stocks based on their valuation on an absolute as well as a relative value basis should outperform. And then small-cap stocks, really going all the way back to 2010, rarely have we ever seen them trade at this much of a discount. Again, we got a little bit of a bounce off of that bottom. I think it was in June. But again, we still think that this rotation has much further to go.

Taking a quick look at our sector valuations, here we just break out sector by the percentage of stocks in each of our rating categories. I would just note that with the market as high as it is, getting to a bit of a premium above our fair values, it just gets harder and harder to find undervalued opportunities. The undervalued opportunities today are typically more idiosyncratic in nature or they are different types of story stocks, stocks you need to understand why maybe they look unattractive to the market here in the short term but have better long-term outlooks and prospects.

A couple of the sectors to highlight would just be communications, basic materials, and maybe healthcare areas where we see a higher percentage of stocks under our coverage that are rated 4 and 5 stars. Where sectors like the industrial sector, you see a very large number of those stocks trading in that 1- and 2-star category. To some degree, I think the market is overestimating the strength in the economy at this point in time. While the economy has definitely outperformed in the second quarter and is probably stronger here in the third quarter than what most people expected coming into the quarter, from a long-term fundamental basis, we think those stocks are overvalued. Similarly, the utility sector with as much as that’s run up thus far this year, another area where a large number of those stocks are now trading in that 1- and 2-star area.

From a sector perspective, at this point, only communications and energy remain undervalued. The one I really want to highlight here is going to be the consumer defensive sector as being significantly overvalued. Now, this is a sector where you have to really break out the sector from the individual stocks. Within the consumer defensive sector, Walmart and Costco are two stocks that have very large market caps. They’re two stocks that fundamentally have actually done very well the past couple of quarters, but from a long-term intrinsic viewpoint, when you rink about how they will perform on a normalized basis, not just this year, but over the next five to 10 years, those stocks are significantly overvalued. Both rated 1 star. And we can talk about those if people have an interest. The utility sectors we’ve already talked about and industrials both overvalued as well.

Here’s our picks from our analytical team. We have a number of new picks this quarter, so Dow and FMC. These are both interesting in that we are looking for really a turnaround in the underlying fundamentals of both companies. Looking for top-line growth to increase later this year, going into 2025, and also looking for margin improvement as that top-line improves as well. We’re looking for some pretty good earnings growth for both of those stocks.

Bath and Body Works, unfortunately, I think this is a stock the market just has thrown out. To some degree, we have seen a lot of pressure on consumer discretionary spending thus far this year. We’ve noted that in some of our prior quarterly calls, but we think the market is just overly penalizing Bath and Body Works. We see a lot of attractive attributes for their product base and their price points, so we think they’ll probably actually have a much better holiday season than I think what the market is currently pricing in.

Nike, again, has been a stock where it’s been under a lot of pressure thus far this year. In my mind, I think Nike is a bit of a story stock. It might take a while for this stock really to start to work. There’s going to definitely be pressure on that name here in the short term. They have been losing some market share to some of the other brands out there. Brooks, On, and Hoka have definitely taken some market share away, but with our view that the company has a wide economic moat, we believe that, over the long term, as they rejuvenate their portfolio, that they’ll be able to claim some of that market share back over time.

The REIT sector, hard to find undervalued opportunities there. This quarter, we’ve got HealthPeak. That’s one I like just because not only is it undervalued but it’s really much more of a defensive pick within the real estate sector. Its portfolio really going to be focused on a lot of healthcare names that’s going to be in research and development, medical offices, things that are going to be much more defensive in nature.

And then a new pick here is going to be Sun Communities. So I think this one’s interesting in that the market is underappreciating the revenue growth that we’re expecting over the next couple of years. They focus on RVs, secondary home areas, as well as marinas.

Again, Alphabet, a stock where we did increase pretty substantially this past quarter, our fair value up to $209 per share, putting it well into that 4-star category. So a lot of attraction here. To some degree, I think the market is probably overestimating some of the antitrust issues. I know there was news out from the DOJ earlier today about possibly trying to break Alphabet up. But again, according to our valuations, you are buying it at more than enough margin of safety that even if there are some antitrust issues here, they are going to be pushed off for years as they work through the system. And we think that there are a number of different levers that Alphabet will have in order to be able to fight some of those antitrust regulations.

A number of new industrial names. In fact, all four industrial names here are new to the list. And then in the technology sector, are two new names, Microsoft and NXP. Again, Microsoft really still just doing very well, seeing good acceleration in their AI cloud business going into the second half of the year. And among the large-cap semi names, NXP is really probably the only one, other than STM, of course, that we do see this kind of margin of safety from our intrinsic valuations.

And just to wrap it up here, a couple of new picks in the defensive sectors. Dollar General has been under a lot of pressure thus far this year. Of course, Dollar General is going to serve more low-income households, which have been under pressure from inflation for the past 18 to 24 months, with wages lagging inflation over that time period. They’ve been pressured as far as the type of spending that they make. Dollar General noted that a lot more spending is going into food items, away from discretionary items. So not only putting pressure on their top line, but it’s put a lot of pressure on their margins, as discretionary goods that they sell have much higher operating margins.

So again, as this starts to normalize, as wages start catching back up to how much inflation has risen over the past 18 months, and spending starts to normalize, we’d expect much better operating margins there going forward. Evergy, probably the last of the 4-star-rated stocks in the utility sector, granted it’s only trading at a 5% discount from fair value, but again, it is one that’s at least trading at a discount as opposed to some of the other utilities that we’re seeing trading at 20% plus, 30% type of premiums over fair value. And then NiSource, a 3-star-rated stock and WEC Energy, also 3-star-rated, but at least trading at a couple of percent discounts, and I know both of those also pay pretty good dividend yields.

Valuation by economic moat, not necessarily a lot to talk about here. We have seen wide-moat stocks perform very well this year. The Morningstar Wide Moat Composite Index up well over the US market return over the same time period. So again, getting more and more difficult trying to find those stocks that we think have long-term durable competitive advantages that are trading at a discount. So again, you need to go into that small-cap category or into the value category in order to try to find those. But of course, I always advise caution if you are going into that no-moat category, just make sure that you’re buying those with more than enough margin of safety from their intrinsic valuation. Those would be the ones that, to the downside, they would expect to get hit the hardest if we do have more of a downturn in the economy than what we’re necessarily looking for at this point.

And again, using whatever Morningstar platform it is, you can do different types of screens. In this case, I looked for undervalued large-cap stocks with a wide economic moat, those with a Low or Medium Uncertainty Rating, and then rank-order these from the most undervalued on up. So a number of new names coming onto the list of this quarter. I do the same screen for mid-cap stocks, although because there are fewer mid-cap stocks with wide economic moats, I also include narrow economic moats. Number of new names hitting the screens of this quarter as well. And then lastly, same thing with small-cap stocks—again, by the nature of the small-cap companies, not as many with a wide moat. So we include the narrow-moat stocks in that screen as well. And to some degree, you probably need to go more into the high risk or High Uncertainty category to find additional opportunities in that small-cap space.

So with that, let me pass it over to Preston to provide us with his US economic outlook.

Preston Caldwell: Thank you, Dave. Good morning, everyone.

So at a high level, we continue to expect a soft landing as we have for several years now. Throughout this postpandemic business cycle, we’ve been consistently calling for a soft landing that is a normalization of inflation without the economy undergoing a recession. And that’s clear now more than ever based off the latest data.

One other thing I would really highlight is now more than ever with the latest GDP data that we’ve gotten from the BEA, they underwent their annual update a couple weeks ago, is the strength of GDP growth. GDP was revised up by about a percentage point two weeks ago. It now shows that US real GDP has grown at a 2.3% annual rate cumulatively since, or on average, since the fourth quarter of 2019.

That means the economy has not only recovered from the pandemic, but indeed has exceeded prepandemic expectations of what economic growth was going to be. The CBO in January 2020, for example, was projecting 1.8% annual growth. That’s quite an achievement. It sets the US apart from other economies, which have demonstrated much weaker growth over the last few years. There’s a few different causes for that that we could go into.

We are expecting a slight weakening in growth, nonetheless, going into 2025 as several factors, which propped up growth over the last couple years, will start to fade. But then as the Fed’s monetary easing starts to kick in, we expect growth to reaccelerate over 2026 to 2028. Looking at our inflation expectations, we have seen, in 2024, inflation return essentially back to normal. We’re expecting the annual average rate to come in at about 2.4% for the overall PCE Price Index. But if there’s any room for doubt, then if our forecast play out next year and the year after that, when you can see we expect inflation to dip below the Fed’s 2% target, it will be very clear at that point that the battle against high inflation has been won.

The reason why we expect inflation to continue to come down is ongoing relief on the supply side; that factoring the prices, as well as this slowdown in GDP growth that we expect, that will add further deflationary momentum to the economy.

Comparing our views to consensus, we track pretty close on GDP in the near term, but on a five-year time horizon, we do expect a cumulative almost 2% more real GDP growth owing to our views on the supply side, principally labor supply. On inflation, we and consensus are both expecting a normalization of inflation, but we expect inflation to run still even a little bit below consensus in 2025 and 2026, which is one factor for why we expect interest rates to ultimately go a bit lower than current market expectations.

So, turning to interest rates, what you see here is charted our annual average expectations for key interest rates, and the federal-funds rate, we ultimately expect to fall over 300 basis points compared to peak levels, hitting an eventual target range of 2.00 to 2.25 by the end of 2026. Much of this is baked into the curve at this point, but we do expect long-run interest rates to fall a bit further as well, with the 10-year yield going from the current about 4.00% to eventually 3.00% by 2027, which is also a long-run expectation. We think even longer run rates need to fall a bit further in order to drive mortgage rates lower and other key borrowing rates throughout the economy, I think, in particular, lower mortgage rates will be needed to sustain a recovery in the housing market.

Turning to the near term, again, GDP growth has been quite strong, up 3% year over year as of the second quarter. Based on the Atlanta Fed’s Nowcast, third-quarter growth is expected at 3.2%. We forecast a little bit lower at 2.5% but still fairly robust. In any case, the bulk of third-quarter growth is being driven by consumption. Now, despite this resilience, we’re still expecting growth to slow over the next year or so, with the year-over-year rate, as you can see on the bottom chart, trending down eventually to a trough of 1.5% year-over-year by the third quarter of 2025. There’s several drivers for that.

One, you have state and local government spending ramping down as the surpluses accumulated during the pandemic had been spent. The manufacturing building boom, which was largely spurred by subsidies and clean energy in other areas, that is plateauing in impact, and it won’t contribute further to growth. We’ll see likely continued pressure in commercial real estate, even with monetary easing. We’ll see, I think, some slowdown in activity there. And then also I expect a bit of a consumer slowdown ahead.

Looking at the economy from a supply-side perspective, one key reason I think why the growth rate of the economy has been so strong over the last couple of years is productivity has been the supply side expansion of the economy enabled, especially by productivity.

Indeed, productivity growth was 2.6% year-over-year in the second quarter of this year. That’s been driven by several factors. It’s possible AI is playing a role. I would also say that may be a little bit early for that to be a major explanation. A bigger factor just might be the tight labor markets that we’ve seen have driven increased investment in laborsaving technologies. Whatever the explanation is, I think to some extent supply is creating its own demand and that helps explain why GDP growth has been so resilient, so strong over the last couple years.

Another point is that, because of the strong productivity growth as well as now labor supply additions coming from various factors, it looks like the potential growth rate in GDP is running around 2.5% to 3% if not higher in the foreseeable future. And what that means is that even with the economy only slowing to a 1.8% growth rate, which seems decent in 2025, because that’s still below the potential growth rate in GDP, that will create some slack in the economy and will help add further deflationary momentum and bring inflation down to the Fed’s target and a bit below as we forecast. So you actually don’t have to trigger a recession in order to create a deflationary impulse. You just have to pull the growth rate in GDP below its potential growth rate.

So turning to consumption, despite the anecdotes, the data has shown continued strength in consumption growth up 2.8% year over year. And we did see a bit of a slowdown in the earlier part of 2024, but it’s bounced back, and the year-over-year growth rate has remained fairly stable throughout this whole time period. Nonetheless, I do continue to expect a modest slowdown in consumption growth. Now, this is not as much as I was expecting before because we have seen a major revision in the data. As I mentioned earlier, the BEA did their annual update a couple of weeks ago and one of the major changes was a large upward revision in income estimates and therefore personal savings.

Personal savings was revised up, as you can see on the bottom chart, by about 200 basis points to about 5% on average in the past three months. Nonetheless, that’s still significantly below the prepandemic 2019 average of 7.4%. It’s also the case that most of this extra income that was revised upward is capital income, not labor income. And of course, capital income is quite unequally distributed across households. So I do think there’s still some pressure on the consumer, some impetus to increase savings rates. We see this pressure manifest in rising credit card delinquencies, for example. So I do expect some consumer retrenchment still over the next year or so.

Turning to labor markets, the first thing I would start with is the nonfarm payroll data, which I chart out growth in year-over-year terms on the top chart. If you look at the official data, which I’ve labeled “old” here on the chart, growth is about 1.6% year-over-year as of the September data. There have been a lot of wild swings if we just look at the month-over-month changes, but that’s very volatile. So it’s prudent to look past that month-to-month volatility. The year-over-year growth rate has been pretty stable.

But one caveat that I would note is that, back in August, the BLS released a preliminary version of their benchmark revision, which won’t be incorporated in the official data until February 2025, but we’ve gone ahead and factored it into our models. And you can see our estimate of the revised data on the top chart would pull that growth rate in nonfarm payroll employment down by half a percentage point. So at 1.1% year over year, that’s still a fairly, nonetheless, solid rate of growth for nonfarm payrolls. That’s consistent with an economy that’s growing at a normal pace. So in that light, it is a bit odd that we’ve seen this upward trend in unemployment highlighted on the bottom chart. That can partly be explained by the fact that unemployment is derived from a separate survey as the survey that gives us the nonfarm payroll data. So it could just be that the unemployment data is erroneous, and that the survey, which generates the nonfarm payroll data, is the more accurate read on the labor market.

But even to the extent that the rise in unemployment is a genuine rise, it does seem to be driven more so by additions to labor supply. It’s certainly not driven by an increase in layoffs, which we haven’t seen in the data at all. So even with this triggering of the so-called Sahm rule, I don’t think that that should cause us to majorly upward revise our estimates of recession probability. It’s not something that concerns me at this standpoint.

Now, with that being said, we are expecting labor markets to slow incrementally over the next year, given slowing GDP growth, as I mentioned, as well as the fact that if we look over the past year or so, employers have been already cutting back quite heavily on average weekly hours per employee. So there’s not much further that employers can cut back average hours. And so in order to continue to contain growth and labor costs, they’re actually going to have to pare back hiring. And so as a result, we do expect growth and employment to slow to about 0.5% year over year by the fourth quarter of 2025. That should soften labor markets further and allow wage growth to normalize, reaching levels consistent with 2% inflation.

Based on our composite measure shown on the bottom chart, wage growth is tracking at about 4.5% year over year, which is, if we assume 1.5% productivity growth, consistent with a 3% rate of inflation because we just subtract productivity from wage growth in order to get the implied inflation measure. However, if productivity is running a bit stronger and also if we were to see an increase in labor share of GDP, we could even see a period where wage growth remains at current levels and inflation nonetheless normalizes for a period of time at least. But regardless, we do expect wage growth to drop a bit further as the labor market cools.

So turning to inflation, core PCE inflation has averaged 2.1% annualized in the past three months. Nonetheless, just given that uptick that we saw in the earlier part of 2024, the year-over-year measure, looking at the last 12 months of growth is at 2.7% for core PCE inflation. However, I would note that if we exclude housing, it’s up merely 2.1% year over year. So you could say that really housing is the sole driver of continued high inflation at this standpoint. As you see on the bottom chart, we are expecting core inflation to eventually drop back to the Fed’s 2% target in the first quarter of 2025 on a year-over-year basis.

Looking at our forecast here, it shows our annual forecast breaking out into a key category of good. And we expect a continued period of excess deflation and durable goods compared to the prepandemic average driven by supply chain loosening continuing to work its way into goods prices. And then in the other component I would highlight as well is housing inflation, which peaked in 2023, but we expect a drop back to normal by 2025 next year.

And a big reason why that’s the case is, looking at the top chart, we see that the purple line, which is market rents, which is a leading edge indicator for the housing component of the inflation indexes, those market rents have already dropped back to fairly tepid rates of growth, at about 2% year-over-year, looking at the latest data with our composite measure of market rents. So basically what’s going on right now is that the housing component of the inflation index is still responding to that runup in market rents that we saw in 2021 and 2022. But now, with that gap between the two closing, it’s really inevitable that housing inflation moderates eventually. The timing is somewhat uncertain, admittedly. We still see supply chain conditions being quite favorable even with some of the disruptions we’ve seen. They haven’t driven supply chain conditions to anything like they were in the deteriorated condition back in 2021 and 2022.

Turning to our federal-funds rate expectations, as of right now, the market’s actually shifted over the last week. And now we’re really about right in line with the market over the next year. Just on the whole, if you look over the past six months, the market has converged greatly toward our view of aggressive interest-rate cuts playing out. But at this standpoint, we’re expecting a year-end 2025 federal-funds rate of 3.00 to 3.25 target range, which is pretty close to the market’s expectation. There still is a gap between us and the market in 2026. We expect continued cutting of the federal-funds rate into 2026 owing to this weakening in GDP growth that I’ve talked about, unemployment remaining stubbornly high well into 2026 at about 4.5%.

And also inflation, most importantly, inflation going below the Fed’s 2% target. Also, I would just note that I wouldn’t make too much out of the Fed’s decision to cut by 50 basis points instead of 25 basis points in their last meeting. It’s very likely that they’re going to cut by 25 basis points going forward. And really, we didn’t see that decision move markets very much, given that, if you look at the trajectory of the federal-funds rate that was charted out in the latest FOMC projections, it wasn’t much different from what the market was baking in already.

So I’m going to conclude with some thoughts on the upcoming election, focusing on trade policy. And I’m focusing there not because there aren’t any other policy changes that Trump or Harris have discussed, which could impact the economy for good or bad. But major policy change generally requires new legislation. And even if you have unified control over government, which is not a given, anything that does pass Congress is likely to be heavily watered down in the negotiating process. So it’s just very premature to be talking about most policy changes.

But trade is very different. The president can drastically increase tariff rates with the stroke of a pen.

And it’s also one issue where economists are pretty much unified in saying that high tariff rates are bad. They’re highly distortionary relative to the free market equilibrium. So evaluating the two major tariff ideas voiced by former President Trump, we see those as if they were to be enacted subtracting 1.9% from the long run level of GDP. However, we see even if Trump wins, these tariffs being far from certain to be enacted. I think there’s a high probability that especially the 10% uniform tariff hike is just campaign bluster.

And there’s other reasons, too, for this that I could go into, but altogether, I see the probability-weighted impact as being—which is just multiplying the probabilities times the impact in the leftmost column—as being 0.13% for the two tariff policies. Then if we add also a higher kind of baseline risk of tariffs, regardless of which party wins the election, altogether we’ve subtracted about 0.2% from our long run estimate of GDP as a result of higher tariffs. This also could have an impact on inflation or interest rates. But that depends also on a host of other factors like how the tariff revenue is used in terms of if it’s used for paying down the deficit or if it’s used for tax cuts or something else and how the Fed responds to it. So it’s a little too early to talk about, but the impact on real GDP is unambiguously negative.

So with that, I’ll kick it back over to Dave to conclude the presentation.

Sekera: All right. Thank you very much, Preston. Yeah, as Susan mentioned at the beginning, we are happy to take as many questions as we can at the end of the presentation. I see that we’ve actually got a number of them coming in already. So please go ahead and put your question in there, and we’ll try to get to as many as we can.

And in that spirit, I want to actually go through these last couple of slides very quickly, taking a look at the mega-cap stocks. I think most of these slides are going to be pretty self-explanatory, in this case, showing those undervalued mega-cap stocks, which to some degree have actually been lagging the broad market return thus far this year. So again, still a couple of opportunities here. The updated list of undervalued mega-cap stocks, just with the nature of the market as it is right now, trading at a slight premium, large-cap stocks overall being overvalued, harder and harder to find mega-cap stocks that we think are significantly undervalued. We do see more overvalued mega-cap stocks at this point. So again, you can see how these have performed. I’d say generally, the ones that we thought coming into the year were overvalued, in many cases have become actually even further overvalued. So again, if these are stocks that you own, I’d highly encourage you to take a look at it and see where in your portfolio maybe you should be looking to take some profit, lock in some profit. Again, the old adage, no one ever went broke taking a profit, I think certainly applies here. And again, the updated list of mega-cap stocks, a couple of new additions to the list here this quarter.

Taking a look at our fixed-income outlook: Fixed income had performed through Sept. 23 relatively well. The US Core Bond Index was up 4.7%. The Core Bond Index is our proxy for the broad overall bond market. But even within that, things like corporate bonds and high-yield bonds have done relatively well thus far this year. A lot of that was because the US Treasury had tightened 14 basis points through the 23rd to 3.74. However, since the Fed cut by 50, we have seen a backup in long-term yields, with the 10-year now slightly over 4%. But based on Preston’s outlook with the US Treasury going down to that 3% level by 2027, we continue to look to say more overweight, long duration bonds, lock in these rates while you can.

Having said that, I would actually focus more on the Treasury part of the market than the corporate bond part of the market. When we look at corporate bond spreads, they’re very tight. When I look at these historically, over the past 24 years, less than 14% of time have investment-grade spreads been here or tighter. And in the high-yield markets even less, only 12% of the time have high-yield spreads been at or below the current level. Again, this is through the 23rd. I know that, since then, the high-yield market’s actually even gotten tighter. I think it’s closer to 300 basis points at this point in time.

And to put this in perspective, going back all the way to the year 2000, only in a few instances can you see spreads being at these type of levels. I just don’t think that you’re getting paid for the risk in investment-grade and specifically high-yield at this point in time. Now, we do have that soft landing expectation for the economy. So we’re not necessarily expecting to see default rates really to skyrocket in the short term. But again, in high-yield especially, just because you don’t have companies defaulting, doesn’t mean that in a slow growth environment, you might see more downgrades than upgrades.

So you could see all those double B bonds slipping into single B or single B rated bonds slipping into triple C category, all of which would put a lot of pressure on where we see credit spreads today.

Dziubinski: Well, I’d like to thank Dave and Preston for their time today and thank everyone for joining Morningstar’s fourth-quarter 2024 US stock market outlook webinar. We hope you’ll join us next quarter. Happy investing.