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Soft landing—investors have been fixated on those two words for the past 12-plus months. We think the words serve as good context as we look back at the economy and markets in 2024 and where we stand as the calendar rolls into the middle of the decade. 

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To achieve the much-sought soft landing, the Federal Reserve needed to thread the needle by reducing interest rates fast enough to maintain economic growth but not so fast as to undo its hard-fought progress in bringing inflation down from its highest levels since the period of 1966–82. Putting this in the Fed’s terminology, could the Federal Open Markets Committee (FOMC) avoid cutting rates too early and risk reigniting inflationary pressures while not cutting too late and risking a deterioration of the labor market (which has historically been synonymous with economic contractions)?  

Although a rise in inflationary pressures in early 2024 delayed the arrival of Fed rates cuts until September, overall there appears to be good news. Inflation pressures cooled in late spring and throughout the summer, while overall economic growth continued. Most importantly, the labor market has wobbled but not by enough to harm overall economic growth. That’s despite the fact that the unemployment rate rose to 4.3 percent this summer, which tripped the much-discussed Sahm rule. Throw in the fact that we are now past the uncertainty of a highly emotional election season, and most would conclude the soft landing appears to be on target. Put bluntly, our base case outlook of a mild recession in 2024 did not come to pass.  

However, despite progress toward a soft landing, risks remain on the horizon. Most notably, despite the overall success of 2024, we believe the economy and markets are highly bifurcated beneath the surface. We don’t believe the economy or the markets have fully regained balance. The path forward is still uncertain.  

Beneath the surface  

There’s been good news on both the inflation front and the overall economic situation, which has more people seeing the economy’s wheels gently touching down on the runway. But when you look a little more closely, you can see risks that still remain as we head into 2025. 

Consumers and businesses who benefit from (or at least are not adversely affected by) higher interest rates are thriving, while those who are feeling the pinch of elevated rates are lagging.

First, while overall inflation has eased, it is not yet at a sustainable 2 percent level. Indeed, the Fed’s preferred measure, Core Personal Consumption Expenditures (PCE), which exclude volatile food and energy prices, remains at 2.8 percent on a year-over-year basis. Notably, this is just modestly below the 3 percent year-over-year level at the beginning of 2024. And while a restart of progress on the disinflationary front was heralded as good news during the summer, recent trends have raised questions about the future direction of inflation as captured by both PCE and the Consumer Price Index (CPI). Additionally, disinflationary trends vary widely, with most of the easing price pressures in goods, while the services ex-shelter readings are still sticky.  

Second, overall economic growth has remained strong, but it has been heavily bifurcated: Consumers and businesses who benefit from (or at least are not adversely affected by) higher interest rates are thriving, while those who are feeling the pinch of elevated rates are lagging. For example, consider higher-income consumers. Generally, they have: 

Contrast that against lower-income consumers. They’re more likely to have: 

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Indeed, we have seen this segment continue to struggle and, in many cases, become increasingly delinquent on auto and credit card debt. Student loan delinquencies will begin being reported in Q4 2024 and are likely to show higher delinquency rates.  

The upshot is that while overall economic growth appears strong, the aggregate view is masking the reality that the economy is not operating on all growth cylinders, which we logically believe increases economic risks.

A similar dynamic is playing out with businesses. Companies that are more cyclical or small businesses that have bank loans with rising interest rates are struggling compared to companies that had previously termed out their corporate debt at lower rates. Taking it a step further, consider manufacturing versus services. The manufacturing side of the economy, which is typically more interest rate sensitive, has been in a slump for much of the past couple years. Meanwhile, businesses that are tied to services or tied to the secular theme of artificial intelligence have excelled.  

The upshot is that while overall economic growth appears strong, the aggregate view is masking the reality that the economy is not operating on all growth cylinders, which we logically believe increases economic risks. Investors have been willing to look past this risk on the expectation that the Federal Reserve will continue cutting rates, which should alleviate pressure on the interest rate-sensitive areas of the economy. However, as the past few months have shown, the Fed controls only shorter-term rates, while market participants and banks determine rates on longer-term bonds. Indeed, since September the Fed has cut rates by a total of 75 basis points. Yet much of the Treasury rate curve is higher by about 60 basis points. To pull this impact back into economic “dis-equilibrium” terms, according to Bankrate.com, the 30-year fixed national average mortgage rate has moved from 6.58 percent on the day of the first rate cut in September to 7.12 percent as of the end of November. The Fed has cut rates, yet mortgage rates have moved higher, which continues to put pressure on the housing market and has led to existing homes sales hitting a 14-year low at the end of the third quarter.  

While there have been plenty of twists and turns throughout 2024, we believe that the biggest question in 2025 remains the same as it was this year. Will the direction of inflation allow the Fed to continue cutting rates, which would likely lead to a broadening of economic growth? Or will inflation remain stubborn? If inflation persists, this may force the Fed to leave rates higher, which would keep pressure on the interest rate-sensitive parts of the economy and raise the risk of the impact of higher rates seeping deeper into other segments of the economy as debt and debt-dependent assets like commercial real estate are repriced.  

The labor market 

Despite the overall strong 2024 narrative, economic scares have flared throughout the year. The labor market offers a prime example. Absent an unexpected shock such as we saw during COVID, economic weakness typically gains momentum gradually. A slowdown leads to further erosion of demand and weakness in the labor market. Eventually, layoffs reach a critical mass, and economic growth unravels into an economic contraction. We believe this is why the unemployment rate is a trending indicator. 

As the Fed continuously notes, there is a point at which gradual labor market weakness becomes non-linear, meaning the pace of job losses accelerates. The job market is typically the last thing to go, and once it reaches a certain point its decline, at least historically, the unemployment rate rises rapidly. 

We believe this is why the Fed not only cut rates in September after expressing doubt about rate cuts throughout the summer but did so by a surprising 50 basis points. We believe this was in direct response to the rise in the unemployment rate to 4.3 percent, up from 3.7 percent to begin the year and 3.4 percent in January and April of 2023. This push higher caused a breach of the Sahm Rule, created by former Fed economist Claudia Sahm to quantify where the risk of movement from gradual to trending had historically begun.  

While the past few months have seen the unemployment rate move down from 4.3 percent to 4.2 percent, the fact remains that the labor market has trended lower. While much has been made about the increase in the size of the labor market (the denominator) driving that increase, we note that total employment as measured by the Bureau of Labor Statistics’ Household employment data (the numerator) is nearly flat since June 2023 and down by 725,000 on a year-over-year basis.  We also note that the number of those unemployed for greater than 27 weeks has risen sharply since April, rising from 1.25 million to November’s 1.66 million. Historically speaking, these two realities have been warning signs of additional future labor market weakness.  

Many investors still point to the other measure of total employment (the Nonfarm payrolls figure as measured by the establishment survey) and note its relative strength over the same time period. We note that trends here are also slowing. The impacts of two major hurricanes that made landfall in late September and early October are evident in recent employment reports, but in June through August the Nonfarm payroll reports all showed monthly private payroll growth below 100,000, with August checking in at mere 37,000 added to private payrolls.  We note that the three- and six-month pace of private-sector job growth has slowed to 138,000 and 108,000, respectively. The reality is that despite the current optimism about a soft landing, a review of the labor market shows that risks remain.  

A brief word on politics  

While much has been made about the so-called “Trump trade” and the prospects for a more business-friendly economic backdrop, we believe that the impact of the entirety of the new administration’s policies remain uncertain. Investors appear to be currently focused on the pro-growth potential stemming from an expected business-friendly regulatory environment. While existing tax rates that were approved as part of the Tax Cut and Jobs Act are most likely to be maintained for the most part, given the current budget situation, additional tax cuts are unlikely. The impact of the other policy promises is highly uncertain. Most notable is how tariffs would affect economic growth and inflation. Lastly, immigration and its impact on the labor market remain uncertain.  

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Additionally, as our research shows, the country’s position in an economic cycle when a president takes office is key to how the economy behaves during the administration’s tenure. The economic cycle is always ticking in the background, and that helps shape the impact of administrations. Once again, we point to the current economy, which appears to be late in a growth cycle, when inflationary pressures are elevated and interest rates have risen. 

Notably, the cost of servicing the deficit is expanding, with the federal government’s net interest outlays exceeding annual defense spending.

Most importantly, the U.S. fiscal situation may shape future policies. Currently, the U.S. is running a historically large budget deficit equal to 6.9 percent of economic output. In the past, similar levels have been reserved for economic contractions, not expansions. Notably, the cost of servicing the deficit is expanding, with the federal government’s net interest outlays exceeding annual defense spending. The average interest rate on current nominal Treasury debt is 3.36 percent. We note that the entirety of the Treasury yield curve is above this rate, which means that as debt matures and Washington adds more, the interest outlays will rise.  

Since the election, the markets have focused on the potentially positive impacts of the new administration’s expected market-friendly policies. While we aren’t making a judgment on whether this focus is right or wrong, given the economic realities that are ticking in the background, we think it’s prudent to take a wait-and-see approach. We also note that President-elect Trump embraces uncertainty and uses it as a negotiating tool, which in his prior term often caused market volatility. Policy is important, and we pay heed to it, but it is only one factor among many that we use to inform our decisions about asset weighting in our portfolios.  

Closing words on the economy 

The reality remains: The U.S. economy appears to be later in the business cycle with a large divergence between areas that are growing and those that are struggling. Later in the business cycle inflation often remains an issue. Any increase in demand must be met with the ability to create new supply. Despite recent increases, unemployment remains low at a time when new workers are hard to find. Historically, this can cause wages to rise to levels that are inconsistent with sustainable 2 percent inflation. Indeed, the Fed has previously noted that wage growth needs to be in the 3.0 to 3.5 percent range to keep inflation from exceeding 2 percent.  

The good news is that worker productivity has increased—likely thanks to artificial intelligence (AI)—and has muted the impact of wages on inflation. However, the question remains: What ultimately is the payback for companies currently rushing to get AI implemented? We are optimistic about AI and believe that, much like the internet in the late 1990s, the benefits will eventually shift from those that enable the technology to broader companies and society, which will reap the productivity benefits.  

Allow us to return to our earlier comments about the progression toward an economic contraction and tie it into our views on AI. Over the past few years, the Fed rate hikes seeped through the economy in a normal manner, starting with manufacturing and other interest rate-sensitive segments of the economy. However, this progression hit a brick wall likely tied to some combination of the following factors:  

Certainly, the current economic cycle could continue. Indeed, while we have been concerned about the potential for this cycle to end, we’ve also noted that it could go into overtime, much as it did in the late 1990s. However, we believe that a narrower economy increases risks and that those risks could persist absent a broadening of growth and a return to a better balance among industries, companies and consumers. But the question remains: How long can the cycle continue in its current unbalanced state?  

While the current environment seems calm, there are many questions yet to be answered, and we believe that at a minimum volatility is likely to tick higher in the coming year.

Unfortunately, there are always relative winners and losers, but the divergence appears to be growing. The housing market is unaffordable and undersupplied. Prices have fallen but remain elevated, which is pinching the budgets of many and pushing individuals into delinquency. Government debt has exploded, and the country is running large deficits that have likely helped fuel the growth of the recent past.  

The hope is that rates move lower, and the economy is able to broaden out. While the strong parts of the economy were resilient in 2024 and supported overall economic growth, how will the dynamic play out in 2025? While the current environment seems calm, there are many questions yet to be answered, and we believe that at a minimum volatility is likely to tick higher in the coming year. We believe that any outlook for continued economic growth in 2025 must include a broadening of its components.