Investors may have been disappointed by the performance of equity markets at the end of December, but in our view the outlook is still positive, at least in the US.
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Hopes for a ‘Santa Claus’ rally were dashed as the US S&P 500 index fell by 3% in the last weeks of December. The index had already in the month following the re-election of Donald Trump. Still, for the entire two-month period since the November election, the index managed a 3% gain (see Exhibit 1).
The reason the index fell in the second half of December was largely the same as the reason it rose previously: US economic growth and inflation. On 5 November the market priced in higher rates of both growth and inflation than previously anticipated and equity prices reflected an expected rise in profits.
Initially, US Treasuries did not seem to be reading from the same script. That is, stronger growth and inflation should result in higher nominal yields, but the 10-year US government bond yield rose only slightly after the election and then dropped by 15bp.
At the US Federal Reserve’s December policy meeting, a more hawkish tone from Fed Chair Jerome Powell, and a ‘dot plot’ and Summary of Economic Projections that pointed to a higher policy rate than in the previous iteration changed all that. Investors scaled back the number of cuts in the fed funds rate they foresaw in 2025 and Treasury yields jumped, reaching a level 45bp higher than the previous low.
Earnings should again be key market determinant
The impact of this move in yields on equity markets was to be expected: declines in the most interest-rate sensitive parts of the market, namely, small-cap stocks (due to higher leverage), and tech (due to longer-duration earnings).
Now that equity prices have incorporated the higher discount rate, earnings should reassert themselves as the key determinant of the market’s future direction – at least until there is another big change in bond yields.
The trend in equity prices should be positive if analysts’ estimates of earnings growth in the upcoming quarters are broadly correct (see Exhibit 2). High earnings growth figures for the NASDAQ (both including and excluding the ‘Magnificent 7’ stocks) reflect the meaningful investment taking place in the sector to develop and power artificial intelligence technologies.
For this investment to generate an adequate return, businesses and consumers will eventually need to be willing to pay significant sums to take advantage of the tools developed.
The particularly elevated earnings growth projections for the Russell 2000 small-cap index (44%) do not reflect a sudden change in the outlook following Trump’s re-election – the growth rate was 40% even before November’s election. Rather, it reflects an expected recovery after two years of disappointing earnings growth (and index performance).
Analyst expectations are more modest for other developed markets. Emerging market companies are forecast to boost their earnings by a solid 14%, driven particularly by the technology sector (as in the US). The dilemma for foreign investors is that this earnings growth may turn out to be lower in US dollar terms, given the anticipated strength of the dollar in the year ahead.
Economic data
The key economic numbers released recently were preliminary purchasing managers’ indices (PMIs), which painted a somewhat more optimistic picture for December than they had in the prior month (see Exhibit 3).
Services sector PMIs rose in all the countries covered. The absolute level is notably high in the US (56.8) and Spain (57.3; a figure above 50 indicates expansion and below 50 contraction). In France, the index moved from contraction to expansion as the economy normalises following the summer Olympics.
Exhibit 3
Purchasing managers’ indices (PMI) show expansion in the services sector
PMI reading for December and difference from November reading
Data as at 3 January 2025. *Institute for Supply Management. Source: FactSet, BNP Paribas Asset Management.
The manufacturing sector continues to struggle, however, with all the PMIs indicating contraction except for Spain and China, and in China the index is only slightly above 50. Readings were lower in December than in November in several countries.
It is unusual for one sector of the economy to be expanding while the other is contracting. It is likely they will eventually converge. But whether that happens because the services sector slows, or because the manufacturing sector recovers, is a crucial difference.
