Markets vigorously adjusted expectations for a new regulatory, economic, and geopolitical landscape driven by U.S. politics. But going forward, technological innovation and economic resilience has far more impact on investors over the long, and even intermediate term. The economy features consistent growth, slowly moderating inflation, and a strong labor market. These support a positive long-term outlook for the market, but do not guarantee short-term returns, as the market will react to economic and policy changes.

Market Analysis

2024 in review

2024 didn’t happen as expected. The year began with recession fears, inflation optimism and little consideration of the possibility of a Republican political sweep and its implication. Therefore, 2024 was touted as a year for bond investing where Fed rate cuts would boost prices across the asset class. However, as the year unfolded, bond markets were repeatedly underwhelmed as new economic data dissuaded the Fed from expected rate cuts that had once been priced into the market with “100% probability.” As a result, the Fed lowered rates cautiously, and aggregate bonds underperformed cash while stocks rose again.

Fixed Income Review

Fixed income markets experienced volatility but ended the year relatively flat. U.S. aggregate bonds eked out a 1% return, as high starting yields offset the impact of rising rates. Cash remained competitive, offering 5% risk-free yields and outperforming most bonds. The widely promoted move out of cash to lock in high rates proved premature, as intermediate and long-term yields continued rising. Reduced recession concerns, increasing inflation risk, and outlook uncertainty led to projections of fewer rate cuts in 2025 and the 10-Year Treasury yield rising 70bps during the quarter to end at 4.58%.

Declining Rates and Rising Yields

In the last four months of 2024, 10-year rates rose nearly 1% despite the Fed reducing the Funds Rate by 1%. This could be seen as a surprise by some, especially those remembering the painful rise in long term yields in 2022 as the Fed rapidly raised rates. But in 2024, as in 2022, the driving force moving long-term interest rates was not the Fed, but the economy. The causal direction should be clear – the Fed and the market both interpret economic data and react to it.

U.S. Treasury Yield Curves (%)

Source: U.S. Department of the Treasury. U.S. Treasury 10-year yield is at their low point on September 16 - two days before the Fed announced its first 50-basis-point rate cut.

Loosely speaking, a long-term yield can be broken down into three components: inflation expectations, real yield, and term premium. 

The change in 10-year inflation expectations given by the breakeven between inflation-linked and nominal Treasurys: Dec 2024 - Sept 2024 = 2.33 - 2.09 = +24bp

The change in 10-year real yield estimated by a Fed model that uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectation: Dec 2024 - Sept 2024 = 2.24 - 1.54 = +70bp

The rise of 10-year rates can be attributed to higher growth and inflation expectations, as well as a risk-driven adjustment from investors demanding a higher premium for holding longer maturities (the term premium shifted from negative to positive during the last quarter). In particular, recession risks have been largely priced out with lessening demand for long-term Treasury guarantees. This rise in the 10-year yield may be unusual in a historical context, but unlike typical rate-cutting cycles that respond to recessions, the recent rate cuts came amid solid growth. In that context, a rising 10-year yield driven by current expectations of growth is not necessarily a bad thing, though any signs of weakness in the economy can quickly shift sentiment. 

Finally, the yield curve may have steepened because investors are demanding higher compensation for inflation risk and greater uncertainty in the outlook. The last mile of the inflation battle has proven challenging, and possible tariffs, policy shifts, and rising debt levels have added to uncertainty. If the 10-year yield continues to rise due to inflation risks and economic/fiscal uncertainties, higher borrowing costs could eventually slow economic growth and pressure asset valuations. 

Summary points:

•       The Fed controls short-term rates, but the economy determines long-term yields.
•        The Fed reacts to economic data, so the economy indirectly determines short-term rates.
•        2024 was never going to be the opposite of 2022:

o   2022 was very unusual when short- and long-term rates rose dramatically together due to inflation surprises. 

o   2024 was only a little unusual when short- and long-term moved moderately in different directions.

o   The magnitude of 2024’s 10-year rate change is 0.70%, this is almost exactly one standard deviation of historical interest rate volatility, and therefore not exceptional.

•        Long-term rates rose due to economic changes:

o   Higher inflation expectations

o   Lower recession risk

•       Treasury yields are high compared to the last 20 years, but not the last 50.
•        Long yields are only slightly higher than short. Odds are the curve will steepen further over time.

When balancing risk and return works

Fixed income markets may not have worked out as expected by many, but they worked well in an optimized portfolio. New Frontier does not time markets or speculate in asset classes, but we understood the inverted Treasury yield curve to suggest high return and very low risk for Treasury Bills and Floating Rate Notes, while longer maturities have significant interest rate risk with little associated premium. For other risky fixed income, such as high yield and emerging bonds, we also identified risk, but with a premium. Taken together, thoughtful optimization was able to add significant value by allocating to the fixed income ETFs most likely to contribute to the overall portfolio. Furthermore, investors attempting to time the bond market by pivoting to longer-term securities suffered. 

Equity markets, however, were a challenge. Concentrated exposure to AI provided extraordinary returns with little associated drawdowns. Diversification and measured exposure to risky assets did not pay off.

Overall, however, New Frontier portfolios performed to their investment goals, with conservative portfolios avoiding unmanageable positions in high-risk assets, and aggressive portfolios holding proportionately greater weight in the same high-risk assets.

Equity Review

Few expected 2024 to be another year for the S&P 500 to gain 24% after a 23% rise in 2023, yet here we are with continued U.S. economic strength and AI optimism pushing up equity markets. Despite a December pullback leading to a negative quarter, most equities posted double-digit annual returns, led by U.S. large-cap growth (+33%), followed by value stocks, small-caps and international stocks (+13% in local currency). While Q3 saw a broadening market rally, Q4 renewed U.S. big tech concentration, alongside dollar strengthening, accounting for all of the currency's 7% appreciation in 2024. The stronger dollar weighed on international assets' returns in USD terms. Emerging Market and Asia-Pacific markets returned more than 6% annually, while European equities gained just 1.4%. Gold had a particularly stellar year, rising 27% on strong demand as both a risk hedge and store of value.

New Frontier Strategy Performance

New Frontier's ETF portfolios delivered strong 2024 returns across the board despite Q4 weakness:

Global Core portfolios benefited from allocations to Treasury floating rate bonds, gold, and high-yield bonds both quarterly and annually. Our decision to maintain shorter duration positioning, based on risk-return trade-offs from the yield curve, proved beneficial despite the popular trend of adding duration. While the portfolios' lack of concentration in U.S. large-cap growth stocks detracted from relative performance, portfolios adhered to their mandate of diversified absolute return and performed well. Tax-Sensitive portfolios largely mirrored Global Core's performance, albeit with slightly lower returns as short-term municipal bonds lagged their taxable counterparts. High-yield municipal bonds provided positive contributions.

Multi-Asset Income (MAI) portfolios once again achieved their expected yield and excelled both absolutely and relatively, benefiting from diversified selections of high-dividend ETFs across markets, particularly in U.S. high-dividend stocks. Allocations to high-yield bonds, Emerging Market debt, and preferred stocks further enhanced both relative performance and portfolio yield. While dividend stocks retreated in Q4, positive contributions from S&P 500 covered call and convertible bond positions helped partially offset this weakness. Currently, MAI portfolios offer attractive yields ranging from 4.7% to 5.3%, maintaining their income-focused objective.

Overall, staying invested through 2024 proved highly rewarding, setting the stage for another dynamic year ahead.

Model Portfolios’ Asset Allocations
New Frontier uses Intelligent RebalancingTM, the Michaud-Esch portfolio rebalance test, to guide portfolio reallocation and rebalancing decisions. This framework allows us to simultaneously consider changes to the risk characteristics of portfolios from price movements, and changes to optimal portfolio exposures from new capital market expectations. 

No models were rebalanced this quarter as the overall portfolio risk exposures were within the statistically optimal zone. Portfolio fixed income exposures continue to be monitored and optimally positioned for anticipated future interest rate cuts and policy changes. Likewise, other asset classes continue to represent a balanced exposure to equity risk factors and asset classes. Current portfolios were further tested against portfolios optimized using risk and return expectations updated for current volatility and conservatively adjusted for anticipated rates. Continued monitoring against these assumptions will ensure continued statistical optimality of our portfolios with respect to the duration of fixed income and balance among all asset classes.

The Economy

Inflation 
Inflation has been a news item so long, it’s worth a reminder why we care. In a consumer driven economy, inflation affects behavior. Willingness to consume, invest, and even basic productivity can be affected by inflation-driven sentiment. 

Inflation continued its global plateau between 2% and 3%. While this could be seen as reasonable rate of inflation, it remains firmly above the Fed’s 2% target. This is bad news for those hoping for economic growth getting boosted by lower rates. The inflation plateau could also be discouraging for politicians hoping to enact potentially inflationary policies such as tariffs and tax cuts. At this range, the Fed will balance economic growth and inflation through cautious interest rate cuts.

Source: Financial Times. Annual Percent change in CPI as of 12/2024 for Eurozone; US, Japan and UK as of 11/24.

Regulation: economic help or hinderance?
Bitcoin advocates hail the lack of regulation in the coming administration, but should we invest in something without regulation? Regulation can reduce the unknown and hard –to-measure risks of an asset and thereby make it more, not less, valuable – particularly in the case of a non-tangible and poorly understood asset. On the other hand, crypto has limited liquidity and supply. If the government stockpiles crypto, there will be a price impact. This price impact will largely happen before the actual purchase happens.

The good news for crypto is that bitcoin ETFs have been a success. Bitcoin ETFs gathered over $100B in less than a year; IBIT’s $50B AUM makes it the fastest growing new ETF in history; the bitcoin ETFs provided liquidity and perfectly tracked the price of the underlying asset – in fact, bitcoin ETFs have dramatically lowered the cost of trading bitcoin. The introduction of bitcoin ETFs demonstrates how more structure can make an asset more valuable. 

While Bitcoin provides a provoking thought experiment for regulation, most conventional regulation has the basic tradeoff of protection vs friction. Regulations can be frustrating obstacles to growth, but others are important protections for consumers and investors.

Political Change: Perception or Reality
On inflation expectations, the University of Michigan poll shows a remarkable relationship between political affiliation and perception of the economic situation. Below we see Democratic respondents changing inflation expectations from slightly below 2% before the election to over 4% after it. At the same time, Republicans revised their views strongly in the opposite direction, expecting virtually no inflation in the year after the election. Clearly both views cannot be correct.

A Look Ahead

Will 2025 be a third year of an AI driven market? Past returns were driven by a combination of fear and imagination – some invested as a hedge for an unknown future out of fear that existing industries and established companies will be left behind; others invested to capture the seemingly unlimited rewards of owning part of an AI-driven future. AI may well be transformative for society, but the financial reality of AI’s future is more likely to be about automation and efficiency. 

Enthusiasm may be further dampened by reminders that markets often overvalue leaders. A leader today has a better chance than most to be a leader in the future, but its position is not certain. Moderna, Zoom, Cisco and others – deemed smart investments that were well positioned for the future – turned out to be optimistic investments. The largest technology companies already have substantial revenue and the economy is dependent on these firms both at work and at home, making further expansion difficult. It’s unclear how much growth will come from cannibalization within big tech, and how much is a transfer of earnings away from traditional industries and towards highly scaled tech companies.

There’s reason to expect broader market returns. Nascent productivity gains from AI are becoming ubiquitous and may show up in 2025. The U.S. is now valued as 67% of the global stock market. Interestingly, nearly every major asset manager releasing capital market expectations shows higher return expectations internationally than in the U.S. These may be based on simplified valuation-based forecasting methods, but backed by reasonable skepticism that this time is different. 

A dollar reversal is also a risk for future underperformance of the U.S. market. The dollar rose a large 7% against other currencies in 2024, with most of the appreciation coinciding with the late-year change in the market’s expectations of a Republican agenda featuring protectionist policies. This period coincided with a slowing of rate cuts in the U.S. while most of the world aggressively lowers rates, further supporting the dollar. 

Featured Insights

ETF watch:

·       Buffered ETFs are misused. They are generally poor long-term investments for wealth accumulation, but can be useful for risk management or income generating purposes in a portfolio.

·       Buffered ETFs show the limitations of market returns. Despite being misused and generally misunderstood, buffered ETFs implement straightforward options strategies that demonstrate the value of upside return or downside protection. The clear consequence of downside protection is limited return potential, to the point where an equity is transformed into an investment similar to fixed income in both risk and return. A full understanding of buffered ETFs can show the limits of what investments such as variable annuities can provide.

·       Bitcoin is affected by liquidity. Bitcoin ETFs are working as intended, but demand affects price. Large trades can trigger ETF creation or redemptions, which can dramatically affect price. As a result, major inflows or outflows can cause persistent price movement.

·       Gold had a good year. Rather than being made obsolete by crypto as some had predicted, it was put in the spotlight, supported by strong demand as a risk management asset.

Market Predictions

The new year brings in market predictions. These predictions come in many forms, but one popular category is predicting a market drawdown (or rise). It’s always safe to predict the market will rise (otherwise all stockholders are wrong in aggregate), or markets will experience volatility, but these predictions have little information content. To illustrate, the following chart shows the proportion of simulations which exhibit a market drawdown of at least a given percentage in a year, out of 10,000 simulations of daily data based on a nominal annual return of 10% and standard deviation of 16%.  In the chart, we see that declines of up to 7% are near statistical certainties and predicting a 10% decline, commonly referred to as a “correction,” is a layup, with an 88% probability of being correct in a given year. However, predicting a “Bear market” decline of 20% is quite risky for your career as a prognosticator, with only a 20% chance of being correct.

Source: New Frontier

We can make additional probable market predictions:

1.       Markets will go up, but by less than 20% this year.

2.       Bonds will also be positive, but less than stocks.

3.       For the first time in three years, T-bills will not be the best performing bond.

4.       The market will experience a decline of at least 10% (this is an 88% likelihood, not a prediction)

5.       Inflation will not reach the Fed’s 2% target.

6.       The market will hit new highs this year.

7.       The 10-year interest rate rise above its present level, but it will also fall by 50 basis points this year.

8.       It will not be a stock picker’s year.

9.       Bitcoin will decline by 20%. Lack of regulatory scrutiny will contribute to Bitcoin having a regulatory or security issue.

10.   China will enact stimulative economic policies. These policies will excite equity markets, and may stop a real estate collapse, but will not be enough to significantly boost the economy.

At least six of these predictions will be correct including this one.

Conclusions

As we conclude our analysis of 2024, it is evident that the year defied expectations, driven by a resilient economy and the transformative potential of technological innovation. The S&P 500's remarkable 24% gain, alongside gold's impressive 27% rise, underscores the dynamic shifts in market sentiment and investor behavior. While the initial fears of recession loomed large, the economic landscape evolved, revealing steady growth and moderating inflation. This environment led to a significant turnaround for interest rate-sensitive assets, contributing to a strong quarter for diversified multi-asset portfolios.

Looking ahead to 2025, we anticipate continued volatility and opportunities as AI and other technological advancements reshape market dynamics. While the U.S. remains a dominant player in the global stock market, there is growing optimism for international equities as asset managers project higher returns outside the U.S. However, potential risks such as a dollar reversal and overvaluation of market leaders remind us to remain cautious. Our commitment to thoughtful optimization and risk management will guide our strategies as we navigate this complex landscape, ensuring that we are well-positioned to capitalize on emerging opportunities while mitigating risks for our clients.

Key takeaways

•    The Fed will balance economic growth and inflation through cautious interest rate cuts. 
•    Despite another rate cut, intermediate and long-term rates rose sharply resulting in an upward sloping yield curve for the first time since early 2022.
•    There’s no such thing as a magic number. 2% inflation, 5% 10-year Treasurys, and $100k bitcoin are all just numbers with no special significance attached.
•    Regulation can impede growth, but it also protects consumers and investors. Let’s not throw the baby out with the bathwater.
•    Differentiate between enduring growth opportunities and fads or overreactions. AI isn’t a fad, but there are overreactions.
•    The U.S. economy features consistent growth, slowly moderating inflation, and a strong labor market. These support a positive long-term outlook for the market, but does not guarantee short-term returns, as the market will react to economic and policy changes.
•    The U.S. is valued as 67% of the global stock market. A little international diversification is likely to be good for preserving and growing long term wealth.

Supplement: Asset Class Insights
We’ve discussed the benefit of balancing risk and expected return in fixed income and avoided additional exposure to interest rate risk. Here’s an overview of asset classes:

Large growth stocks (i.e. U.S. big tech) remain the most exciting asset class for many. While still concentrated and volatile, investment in AI, and hence return potential, has not subsided. A question is how much further can U.S. large tech companies grow given they’re making massive investments to compete with each other. Microsoft, for example, has committed to an additional $80 billion investment in 2025 alone. 

U.S. Stocks The main argument for investing in the U.S. is twofold: it’s the innovation nexus of the world; and a broad well-regulated economy with a culture rewarding investors for economic growth. So while I still recommend a globally diversified portfolio, the U.S. may continue to be the top performing market.

Small cap stocks theoretically have a higher cost of capital due to greater risk, which should reward investors, on average, who demand higher rates of return in exchange. Concerns of small companies struggling to compete with large technology companies should be priced in and lead to higher return expectations. This is a risk however, and may not pay off for investors.

Value, Dividend and other non-Mag-7 stocks have broadly performed well. There’s more to the U.S. economy than just technology—consistent economic growth along with investor-friendly regulations and corporate culture continue to bode well for these asset classes long term.

International Stocks similarly performed well in local terms, but underperformed the U.S. due to the rising dollar and contribution of Magnificent-7 stocks.

Emerging markets performed well thanks to the remarkable contribution of China. Going forward, emerging markets represent diverse and growing economies making them valuable in a portfolio.