Weekly Buzz: 🍷 The Fed reined in the party before it got out of hand

Markets were getting into the holiday spirit – rallying on the back of a Republican sweep that promised tax cuts, deregulation, and more business-friendly policies. But just as festivities looked to hit full swing, the Federal Reserve (Fed) stepped in with a dose of sobriety.

The reaction was swift: the S&P 500 dropped 2.9%, the Nasdaq fell 3.6%, and the yields on 10-year US Treasuries rose by 12 basis points (bps), as investors reassessed the longer-term rate outlook.

What happened?

At its last meeting of 2024, the Fed delivered its widely-expected holiday gift – a 25 bps rate cut. The surprise came in its outlook for 2025. As shown in the “dot plot” chart below, officials now expect US interest rates to end next year at 3.9%, versus 3.4% as of its September meeting. Simply put, they're planning fewer rate cuts than originally anticipated.

Why the change of heart? These projections reflect the Fed's forecast of stronger economic growth and more persistent inflation ahead, suggesting a more prudent approach. They likely take into account President-elect Trump's policies, including an extension of his Tax Cuts and Jobs Act (TCJA) and increased government spending. (For more on that, see CIO Update: What another Trump presidency could mean for your investments.)

What’s the takeaway here?

Zooming out, the S&P 500 had climbed 28.6% year-to-date prior to the Fed’s decision – which included a boost after Trump’s win. Even after the Fed’s decision, the US equity market is still up a solid 24.8%.

Market corrections like this are healthy and a normal part of any investment journey, like a much-needed break between holiday feasts. The bigger picture is encouraging: the Fed’s assessment sees solid economic growth ahead, even if inflation is being a bit stubborn.

That’s aligned with the signals from our ERAA™ investment framework, which has been positioned for a regime of “Inflationary Growth” since April of this year – and we expect this environment to continue into 2025. (For more on that, stay tuned for our 2025 Macro Outlook, out early next month.)

So while the Fed might have taken away the punch bowl, the party isn't necessarily over: the central bank simply wants to keep the festivities going, without running the risk of things getting out of hand. Ultimately, it’s about the long-term fundamentals, not the short-term market moves.

💡 Investors’ Corner: Not all returns are created equal

Imagine two investments. Both can deliver a 10% return – but while one may take you on a rollercoaster ride of ups and downs, the other is likely to follow a steadier path. Which would you choose? This is where risk-adjusted returns come in – something the Sharpe ratio, which compares excess returns against their volatility, can measure.

Since 2000, global stocks have delivered about 6.2% annually, but they've also experienced swings, including a maximum loss of 41%. This works out to a Sharpe ratio of around 0.37. By comparison, a portfolio diversified across asset classes can give you similar returns with less dramatic ups and downs.

Another powerful risk stabiliser is simply time in the market. It's like zooming out on a map – what looks like steep hills up close becomes gentler slopes when viewed from afar. After all, investing isn't just about reaching your destination – it's about ensuring you can stay for the entire journey. That’s also why our General Investing portfolios are built across 12 risk levels, each a mix of assets designed to maximise returns while keeping risk constant.

📖 A Little Context: Taking away the punch bowl

The phrase "taking away the punch bowl" entered financial vocabulary in 1955, when Fed Chairman William McChesney Martin compared the central bank to a chaperone at a party. It's a metaphor that captures the Fed's delicate balancing act: supporting economic growth while preventing things from getting too heated. When markets talk about the Fed "removing the punch bowl" today, they're referring to policies that might be unpopular in the short term, but help ensure long-term economic stability.