U.S. Equities Catch a Chill

Temperatures have finally thawed in the Northeast, yet the markets seem to have caught a chill. Cooling sentiment, sticky inflation, and underwhelming corporate earnings guidance have caused the U.S. equity market to stall. Meanwhile, the momentum of the market has shifted relative to last year, with international equities outpacing the U.S. and non-tech beating the Magnificent 7. Policy uncertainty is high, with prospects for tariffs clouding the future for many businesses and consumers. As we round out February, we continue to see “ladders” for the economy and markets, but equity valuations generally look to be underpricing potential “chutes.” As a result, investors are not being compensated for taking on excess risk in this environment. Nonetheless, due to the historic high level of uncertainty, we continue to keep portfolios closely aligned to long-term targets.

Degradation to the growth outlook

Economic data to start the year has been disappointing. A combination of deteriorating consumer sentiment and sticky inflation data has shifted the narrative (Figure 1). The post-election euphoria seen in consumer sentiment indicators has evaporated, with details of the University of Michigan and Conference Board indicators suggesting the flurry of policy-related news is at least partially to blame. Consumers are showing reduced expectations for future job prospects, business activity, durable purchases, and even vacation plans.

Figure 1: Consumer sentiment sours on outlook, inflation

University of Michigan consumer expectations for economic outlook (left) and 5-10-year inflation (right)

^{As of January 31, 2025. Source: Bloomberg.}

The economy now looks more vulnerable than it did to start the year. Consumers and businesses are, understandably, unsure of how to proceed in an uncertain trade landscape. The outcome of tariff discussions with Canada, Mexico, Europe, and China could be the difference between a solid year of trend-like economic growth and a recession. The stakes are that high.

Last week, the equity markets also let out a sigh of disappointment regarding prospects for regulation. Lighter regulation and potential for increased merger & acquisition (M&A) activity was, and could still be, an economic and market ladder. However, the Trump administration’s adoption of the Biden-era corporate merger guidelines puts a damper on future deal activity, as least for larger companies. Opportunities to consolidate and scale could be greater for smaller companies in less concentrated industries.

While impossible to truly untangle policy uncertainty from the economic web, the underlying fundamentals of the economy remain intact. In other words, the economy and markets could do well as long as policy uncertainty doesn’t send the train off the tracks. We expect cooling inflation and a moderately looser job market to support the consumer. Businesses could see relief from lower interest rates as the Federal Reserve (Fed) is expected to cut their policy rate four times this year (the market is currently expecting only two cuts). Appetite for productivity-enhancing tech spending remains high, benefiting tech companies but also the future earnings prospects for tech-consuming companies. We expect GDP growth of 1.8% in 2025.

Shifting Winds in the markets

While there is always a temptation to double down on what has worked most recently, we see a change in market leadership taking shape. Two areas stand out: mega-cap technology and international equities. The good news is that these shifting winds can benefit the value-seeking, diversified investor cohort to which we proudly belong.

Starting with technology, the Magnificent 7 have pulled back in aggregate 10% from the December highs as the recent earnings season (fourth quarter 2024 earnings reported in January and February, so far) has been one of more muted investor enthusiasm. The DeepSeek revelation continues to impugn the opportunity associated with the artificial intelligence (AI) build out even as hyperscalers Alphabet, Amazon, and Meta have increased their capex expectations for 2025 and 2026 by double digits just since the start of the year.^[1] Returns on incremental capital spending are high but declining.^[2] Valuations have not moved much in the past couple of years given remarkable earnings growth, but earnings growth for tech and non-tech companies are expected to converge in 2025 and 2026. Investors are finally allocating incremental capital into other parts of the market. Tech is the worst-performing sector year to date, while the market is being led by communication services, materials, and financials stocks.^[3]

We think continued exposure to mega-cap tech is critical given the undeniable secular growth prospects for technology and AI. However, most of our diversified portfolios hold a below-benchmark allocation given market concentration and valuation risks.

The other trend that has reversed is the dominance of U.S. equities. To start the year, non-U.S. equities have been outpacing U.S. equities by 5.4% (Figure 2). The U.S. markets are much more exposed to technology than many international equity markets, so the cooling sentiment on tech discussed above is a major contributor to the leadership reversal. Valuations are also part of the picture. International equities trade at a historic discount relative to the U.S.^[4]

Figure 2: U.S. equities look un-exceptional to start the year

S&P 500 and MSCI ACWI ex-U.S. Index Total Return, in USD, indexed to 100 on December 31, 2024.

^{As of February 25, 2025. Source: Bloomberg.}

We have long stated that valuations alone will not dictate market direction or even leadership. A catalyst is needed, but once it takes hold, the mean reversion can be swift. U.S.-driven trade uncertainty and a hawkish Fed may prove to be that catalyst. We are also seeing a shift in economic activity relative to expectations at the start of this year. While the U.S. economic data have disappointed to start the year, the data in Europe, for example, are beating expectations (even if from a much less impressive starting point and potentially overstated by demand being pulled forward ahead of tariffs).^[5]

Positioning

Economic policy uncertainty is high, and markets are typically “allergic to” uncertainty. We do not expect uncertainty to disappear (it never does, even without such dramatic leadership change in Washington), but we do think the news cycle will lengthen and become more muted as we move through the year.  Consequently, we strongly encourage investors to remain invested and diversified. For new investors, setting a plan and methodically averaging into all asset types still makes sense. Our research and experience show that, historically, tranching in new money over a period of three to six months strikes is a sound strategy even in a higher volatility environment.

It is always easier to identify the downside risks than the upside market catalysts. We remain cautiously optimistic that the Fed cutting rates, resolution on some fronts of the trade war, and higher productivity growth will support mid-to-high-single-digit returns for U.S. equities this year.

After several years of a one-way trade in markets (U.S. mega-cap tech) and increased correlation between stocks and bonds, diversified investors are once again being rewarded. With the outlook as clouded as it is, we are sticking to benchmark weights across all asset classes. It is very unusual for our Investment Committee to recommend a neutral allocation across the board (Figure 3), but that speaks to the current investment landscape. Maintaining a risk-managed approach is critical. Markets this year will likely exhibit more volatility than observed in the prior two years. We will continue to evaluate the ever-changing environment, looking to shift capital as high-conviction opportunities emerge.

Figure 3: Neutral tactical positioning across asset classes

^{Data as of February 25, 2025. Positioning reflects our monthly tactical asset allocation (TAA) versus the long-term strategic asset allocation (SAA) benchmark. For an overview of our asset allocation strategies, please see the disclosures.}

^{*Private markets are only available to investors that meet Securities and Exchange Commission standards and are qualified and accredited. We recommend a strategic allocation to private markets we do not tactically adjust this asset class.} 

^{[1] Empirical Research, Portfolio Strategy February 2025.}

^{[2] Empirical Research, Portfolio Strategy February 2025.}

^{[3] Source: Bloomberg, as of February 14, 2025.}

^{[4] The MSCI Emerging Markets Index is trading in the 1st percentile relative to the Russell 1000 Index, looking back over the last 25 years. Similarly, the MSCI Europe Index is trading in the 3rd percentile. Source: Bloomberg, as of February 14, 2025.}

^{[5] This references the Citi Economic Surprise Index for the U.S. vs Europe.} 

Disclosures

Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. M&T Bank and Wilmington Trust have established information barriers between their various business groups. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports.

The information on Wilmington Wire has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed.

References to specific securities are not intended and should not be relied upon as the basis for anyone to buy, sell, or hold any security. Holdings and sector allocations may not be representative of the portfolio manager’s current or future investment and are subject to change at any time. Reference to the company names mentioned in this material are merely for explaining the market view and should not be construed as investment advice or investment recommendations of those companies.

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Indexes are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses such as management fees and transaction costs which will reduce returns.

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Investments that focus on alternative assets are subject to increased risk and loss of principal and are not suitable for all investors.

Wilmington Trust periodically adjusts the policy weights’ target allocations and may shift from the target allocations within certain ranges.

The asset classes and their current proxies are: • Large–cap U.S. stocks: Russell 1000® Index • Small–cap U.S. stocks: Russell 2000® Index • Developed international stocks: MSCI EAFE® (Net) Index • Emerging market stocks: MSCI Emerging Markets Index • U.S. inflation-linked bonds: Bloomberg US Treasury Inflation Notes TR Index Value Unhedged* • International inflation-linked bonds: Bloomberg World ex US ILB (Hedged) Index • Commodity-related securities: Bloomberg Commodity Index • U.S. REITs: S&P US REIT Index • International REITs: Dow Jones Global ex US Select RESI Index • Private markets: S&P Listed Private Equity Index • Hedge funds: HFRX Global Hedge Fund Index • U.S. taxable, investment-grade bonds: Bloomberg U.S. Aggregate Index • U.S. high-yield corporate bonds: Bloomberg U.S. Corporate High Yield Index • U.S. municipal, investment-grade bonds: S&P Municipal Bond Index • U.S. municipal high-yield bonds: 60% Bloomberg High Yield Municipal Bond Index / 40% Municipal Bond Index • International taxable, investment-grade bonds: Bloomberg Global Aggregate ex US • Emerging bond markets: Bloomberg EM USD Aggregate • Cash equivalent: 30-day U.S. Treasury bill rate.

Index Descriptions

The Bloomberg U.S. Aggregate Index measures the performance of the entire U.S. market of taxable, fixed-rate, investment-grade bonds. Each issue in the index has at least one year left until maturity and an outstanding par value of at least $250 million.

The Bloomberg U.S. High Yield Corporate Index, formerly known as Lehman Brothers U.S. High Yield Corporate Index, measures the performance of taxable, fixed-rate bonds issued by industrial, utility, and financial companies and rated below investment grade. Each issue in the index has at least one year left until maturity and an outstanding par value of at least $150 million.

The Bloomberg World Government Inflation-Linked Bond (WGILB) Index measures the performance of investment grade, government inflation-linked debt from 12 different developed market countries.

Bloomberg Commodity Index measures the performance of 19 futures contracts on physical commodities.  As of the annual reweighting of the components, no related group of commodities (for example, energy, precious metals, livestock, and grains) may constitute more than 33% of the index and no single commodity may constitute less than 2% or more than 15% of the index.

The Dow Jones Global ex-U.S. Index is an equal-weighted stock index composed of the stocks of 150 top companies from around the world (excluding the U.S.) as selected by Dow Jones editors and based on the companies' long history of success and popularity among investors. The Global Dow is designed to reflect the global stock market and gives preferences to companies with global reach.

The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is composed of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.

The MSCI All-Country World Index ex USA measures the performance of large- and mid-capitalization stocks in approximately 50 developed and emerging equity markets, excluding the United States.

The MSCI EAFE^® (net) Index measures the performance of approximately 20 developed equity markets, excluding those of the United States and Canada. The total returns of the index are net of the maximum tax withholding rates that apply in many countries to dividends paid to nonresident investors. 

The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging markets countries. With 1,198 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in each country.

Russell 1000^® Growth Index measures the performance of those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values.

Russell 1000^® Value Index measures the performance of those Russell 1000 Index companies with lower price-to-book ratios and lower forecasted growth values.

The Russell 2000^® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. As of its latest reconstitution, the index had a total market capitalization range of approximately $128 million to $1.3 billion. 

The S&P 500 Index is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.