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Fine-Tuning
With 2024 in the rear-view mirror and a new year on the horizon, there may be no better time than the present to step back and assess the current investment environment, along with our plan for the journey ahead. As with most journeys, a periodic temperature check and some fine-tuning can help ensure we are prepared to continue moving forward, despite any bumps in the road, allowing for a safe and timely arrival at our destination.
In this edition of Perspectives, we reflect on the key events that shaped financial markets in 2024, followed by an updated outlook on the economy and markets for the year ahead. Next, TD Epoch explores the parallels and differences between today's Artificial Intelligence (AI) driven market enthusiasm and the tech boom of 1999, offering a measured perspective on this evolving trend.
Lastly, TD Wealth Strategist and Goals Based Leader, Mark Hasenauer delves into key considerations in the financial and estate planning process including financial security needs, legacy goals, and business transition planning.
As you fine-tune your plans for the financial road ahead, TD Wealth is here to steer you in the right direction, to help keep you aligned with your evolving needs and goals.
SECURITIES AND INVESTMENTS |
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NOT A DEPOSIT |
NOT FDIC INSURED |
NOT BANK GUARANTEED |
MAY LOSE VALUE |
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Neal Brandon
Senior Investment Strategist, TD U.S. Wealth Chief Investment Office
In 2005 Apple co-founder and then-CEO, Steve Jobs, addressed the graduating class at Stanford University. Recalling aspects of his unique personal journey and the often-unexpected outcomes, he concluded that "You can’t connect the dots looking forward; you can only connect them looking backwards." Reflecting on 2024, and the year that was, feels much the same. False starts and unexpected outcomes may only be fully appreciated with the benefit of hindsight.
At the start of last year, for example, a combination of historically high interest rates and early signs of inflation rolling over, led to expectations that the Federal Reserve (Fed) would lower rates as fast as they had risen. Instead, inflation pressures remained stubborn for much of the year with financial markets and investors forced to wait until September for the Fed to move off the sidelines. All told, a total of just 3 cuts, with rates lower by 1%, was the extent of easing in 2024.
The health of the U.S. economy also surprised to the upside. Forecasters waiting for a leg lower in the growth of GDP, employment and consumer spending were largely disappointed by the end of the year. Although we know that nothing moves in a straight line, U.S. economic resilience remained the envy of the world and, by many measures, stood out for achieving the elusive, and so-called, soft landing.
Another unexpected outcome - and sign of U.S. exceptionalism - was the performance of domestic stock markets. The S&P 500 Index, a gauge of large-cap U.S. equities, sprinted across the finish line. While a total return gain of 25% for 2024 is exceptional, it is also the fourth year in the last six for the S&P 500 to close above the 20% mark. Drivers of growth, however, remained narrow with a small group of technology-focused companies making outsized contributions over the year, buoyed by enthusiasm for artificial intelligence. Post-election optimism around the Trump administration's pro-growth policies also served to lift equites across the board.
The outcome for other markets was less impressive. Easing by the Fed was broadly supportive of the U.S. bond market, with the slope of the Treasury yield curve finally steepening after an ominous inversion back in 2022. However, the prospect of a more moderate pace of disinflation and ballooning deficits served to push yields, which move inversely with price, higher and weighed on 12-month performance for the fixed income asset class.
Internationally, equity gains were largely overshadowed by a combination of economic divergence and ongoing geopolitical tensions. A surging U.S. dollar, relative to many local currencies, and the potential for proposed U.S. tariffs to disrupt global trade also weighed on annual results.
Connecting the dots leads us to the start of a new year, and we believe the U.S. economy is entering 2025 in a stronger position than many expected. While technology-focused companies are likely to remain a key source of growth, earnings are forecast to accelerate across sectors, underscoring the importance of diversification for investors. Inheriting a solid economic backdrop, we believe that President Trump will likely have every incentive to keep both the economy and stock market humming.
TD Economics expects policies will come fast and furious in 2025, be it changes to immigration, regulations, taxes, or the overlay and expanded use of tariffs. Ultimately, analysts and financial markets are likely to incorporate a wider range of outcomes, with more judgement needed to assess a broad swath of new policies and their influence on the year ahead.
Major Market Index Returns (Based in USD)
Source: Morningstar Direct as of December 31, 2024. Returns are presented on a total return basis. Returns greater than 1-year are annualized.
ChatGPT was released in late-2022 and almost immediately ignited a capital expenditure (capex) surge reminiscent of the late-1990s. Spending by the top three hyperscalers had increased steadily from 2017 but then rose by an eye-popping 53% in 2024 with the trio forecasting a 27% increase in 2025 (Chart 1). Similar to the internet boom, capex is soaring even though it is unclear when there will be a return to the massive amounts of capital being invested.
Chart 1: Capital expenditures by the big three hyper-scalers (US)
Source: Bloomberg, December 2024
e: estimate.
Technology leadership is fully committed to AI because they rightly view it as a highly disruptive, general-purpose technology that will be the key driver of their free cash flow (FCF) over the next decade. The tech titans also realize they face an existential risk in that falling behind in the AI race means their market leadership is likely to atrophy and they could ultimately go the way of Kodak and Blockbuster. That is, their choice is to spend massively, and to some extent recklessly, or risk fading into obscurity.
Although there are many similarities between today's AI frenzy and the internet boom, there are three reasons why we believe it is not yet 1999. First, investment booms invariably last longer than two years (for example, seven years for the internet and six years for housing in the prolog to 2007).
Second, the Federal Reserve (Fed) is currently cutting interest rates, ensuring liquidity remains plentiful. By contrast, the internet and housing booms ended nine months and three years, respectively, after the Fed began hiking (Chart 2). The key risk to this view is that the disinflation process that began around mid-2022 appears to have stalled over the last six months or so. This could cause the Fed to dial back its dovish guidance and, in an extreme scenario, make a U-turn and prepare markets for policy tightening.
Chart 2: The AI boom is unlikely to end until the Fed pivots away from easing and begins to hike aggressively
Source: Bloomberg
M7: AAP, AMZN, GOOGL, META, MSFT, NVDA, TSLA. Indexed to 100 on 01/2019
Third, President Trump has adopted a staggeringly pro-tech stance, surrounding himself with triumphant entrepreneurs and announcing a swarm of policies that should provide a salutary tailwind for the tech sector, at least through 2025 and likely well beyond.1 The key theme is "It's Time to Build", favoring AI, crypto, drones, defense-tech, biotech, and so on.
Will a small number of tech titans continue to dominate?
Excessive control and command is another exigent policy theme. Over the last decade, a few tech behemoths have experienced exponential growth in their FCF, market cap, power, and influence. Their continued dominance will depend on two developments.
First, antitrust, which had been essentially dormant in the decades prior to 2021. However, the Biden administration aggressively cranked up the volume and currently 43% of the S&P 500 is under antitrust investigation. This enforcement blast reflects a view that big tech has grown more by acquisition and erecting unfair barriers than by innovation and superior products.2 All indications are that the Trump administration will dial back antitrust enforcement significantly, which means Mergers and Acquisitions (M&A) activity is likely to rebound sharply.3 However, the perception that tech is too powerful is widespread and the content moderation policies of social media are thoroughly reviled within the Grand Old Party (GOP).
The second factor is the innovator's dilemma which, by definition, comes into play during periods of rapid disruption. Few titans in 1970 (PCs) or 2000 (internet) were still there twenty-five years later. To illustrate, of the top twenty global tech companies in 2000, only three remain on the list today (Microsoft, Oracle, Cisco). This begs the question: What will the 2035 list look like? One lesson from history is that it is always the case that titans rise and titans fall, but it happens especially quickly in tech. That is, we should expect a majority of today's tech giants to fall from grace over the next decade, to be replaced by startups that are currently viewed as quirky and obscure, known only to a small number of customers and investors.
Two risks to our constructive view: Valuations and the timeline for killer apps
We believe the information technology sector will continue to lead the overall equity market higher, at least through 2025. One risk to this view is valuations (Chart 3). While not yet as stretched as 1999, multiples are at extreme levels, as is equity market concentration and sentiment toward stocks. Further, MSCI US currently trades on a forward price-to-earnings of 26x vs 15x for the rest of the world. This is a record gap and emphasizes how vulnerable today's lofty valuations are to a macro shock.
Chart 3: U.S. equity market valuations were only higher once over the last 125 years
Source: Bloomberg, December 2024
The second risk concerns how long it will take before the first AI-enabled killer apps arrive and begin producing serious FCF. Optimists believe this will happen during the next couple years and will then power markets to even loftier heights. On the other hand, pessimists emphasize the experience with the internet investment boom, which ran from 1994 to 2000. In particular, massive FCF and respectable return on invested capital (ROIC) did not arrive until well after a decade, and many of the beneficiaries were recent startups rather than the firms that had stumped up all the capex. On balance we side with the pessimists but expect it to become an issue for markets later rather than earlier.
Conclusions for Investors
We expect tech to remain the key driver of equity markets, but with elevated volatility reflecting a number of the challenges and issues raised above. We are constructive on many areas of tech, including select hyperscalers and semiconductor companies, as well as firms involved in data centers and electricity generation. Finally, we remain positive on equities overall, with the U.S. topping our ranking of markets, followed by Japan and the UK. We have a less favorable view on the outlook for stocks in Europe and China.
Mark Hasenauer
Wealth Strategist & Goals Based Leader
When preparing a comprehensive financial and estate plan, the most important considerations are:
- How do I maintain financial security during life?
- How do I structure an estate plan to meet legacy goals?
- Where applicable, how do I provide for a smooth transition of a business asset?
Financial Planning Models
The term "financial planning" can encompass a wide variety of services and processes associated with the financial industry. In this section, we will focus on how financial planning can help individuals refine and recalibrate important considerations to help them meet their long-term financial goals which may include funding education expenses, building a retirement nest egg, wealth transfer to family members and gifts to philanthropic organizations. While these plans look at hypothetical outcomes and cannot predict actual outcomes, they can provide information to the client that may encourage current changes to savings and/or investing for current and retirement expenses and adjustments to target retirement dates, wealth transfer goals and gifts to charity. A financial plan can also provide clarity around the need for life insurance, long-term care insurance, or the benefit of creating a short or long-term reliable source of income in the future. For clients who are considering whether to sell a business or investment real estate, a financial plan can provide an estimated projection for future receipt of sale proceeds, show the potential impact of taxes due from the sale, and model the long-term health of the remaining assets depending on how they are invested and future spending needs. The plan can help a business owner take into consideration, ahead of a potential sale, whether or not the net proceeds can support their continued level of spending. This may assist the seller in deciding if they can defer the sale until a future date when their spending needs are not as great or take measures to increase the value of the business. As a compliment to an estate plan, a financial plan can show the potential benefits of funding a trust and how that trust may impact the client making the transfer as well as the beneficiaries. The plan can illustrate an individual's likelihood in meeting their own financial needs, reflect the impact of future estate taxes, model potential asset growth within the trust, and the probability of achieving wealth transfer goals for beneficiaries.
Estate Planning
The foundation for any estate plan should begin with identifying the plan's objectives. Is the plan's creator planning to transfer wealth to family members, or other individuals? Do they have causes, including charities and/or foundations, that they want to support now and after passing? What types of assets do they own? How are those assets titled? Are federal estate taxes an issue to be planned for? What about state estate or inheritance taxes and complications with probate? Finally, are there any circumstances unique to achieving that client’s legacy that we need to take into consideration?
Some examples of objectives could be defined as the desire to maintain someone's own financial security during life (as well as for their spouse/partner), minimize estate and income taxes, provide for charity, maintain family harmony, provide for the future success of a family business; and promote a productive lifestyle for future generations.
Once established, the key objectives will provide the basis for any assessment of the current plan in relation to those goals and what, if any, changes might be considered in terms of documents and strategies needed to meet those objectives. At a minimum, an individual should consider having a Last Will and Testament, Financial Power of Attorney, Health Care Power of Attorney, and Advanced Healthcare Directives. These basic documents which also identify the individuals to be called into service upon death or disability (such as an executor, guardian, agent under a power of attorney or trustee) and re-titling assets consistent with those documents may be all that is needed for an individual's estate plan. However, depending upon an individual's net worth and other circumstances, a plan may be much more complex and can include additional planning strategies including entity formation, capital restructuring, and the lifetime transfer of assets to various individuals and/or trusts.
The effectiveness of an estate plan will not only be driven by the various planning objectives, but also by an individual's willingness to engage in various transactions and follow recommendations provided by their accountant and attorney. Plans are often broken down into phases which form a larger comprehensive strategy over time and rarely is a complex estate plan completed all at once.
Business Transition Planning
Some assets may require more planning than others. This is particularly true when the asset is an operating business, whether manufacturing widgets or managing real estate.
Understanding the cash flows from the business, how long the client plans for those cash flows to continue, when and how the business will be transitioned, and what impact that will have on future cash flows are all important in providing sound planning advice.
Like the estate planning process, it is important to establish the objectives for the business as well as any facts and circumstances that may impact the ability to meet those objectives. Does the individual intend to exit from a business? Are there multiple owners? Are there key employees and are they owners? Is there a buy-sell agreement, or other governing operating documents in place? When will the transition event take place? Who would the business go to? Who should benefit from the proceeds? If employees are involved, are they able to purchase the business outright or through an Employee Stock Ownership Plan (ESOP)? How does that transaction integrate with the estate plan? What obstacles might impede a smooth transition? What rules should be put in place for future operations/ownership?
General Considerations for an Effective Plan
Understanding what advice is needed for a comprehensive plan and where to effectively get that advice is critical. Estate and gift taxes, individual income taxes, partnership and S corporation taxes, individual state trust laws and asset protection laws, laws impacting planning for public benefits, laws impacting the ownership and operation of business entities, and Employee Retirement Income Security Act (ERISA) and other employee benefit laws are examples of what may need to be considered in forming strategies for a complex situation.
While an attorney is essential in drafting legal documents, the team of advisors may include an accountant or other specialty tax advisor, insurance expert, valuation expert and a registered investment advisor professional and other financial advisors. Additionally, where residential or commercial debt exists, it is a good idea to understand whether any asset transfers or other planning steps may violate loan covenants or impact credit facilities. In those instances, it is good to expand the team to include your commercial and personal banking advisors. Finally, where a business sale is being considered, it is prudent to engage with experts in the M&A field to help maximize value received for the business.
There are a few last items that are essential to an effective plan. If you create a trust during life, fund it. Make sure that assets are titled in a manner consistent with the plan. This includes confirming the beneficiary designations for retirement assets and life insurance and updating them, if necessary. Be organized and keep a copy of all essential planning documents in a secure location where key people can find them. Include a balance sheet with account numbers and keep a record of digital assets and online passwords in a secured site. If there are tangible items of personal property that an individual wants to give to certain individuals, an updated list reflecting these wishes should be maintained. Keep a list of key individuals and their contact information, including any fiduciaries named in the documents, attorneys, accountants, and financial advisors. Finally, life happens, and it is important to periodically review the plan to make sure that it continues to meet relevant goals and objectives.
Connect with a TD Wealth Advisor
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