Income diversification for uncertain times

Resilient economy and monetary policy shift

The US economy experienced a Goldilocks scenario in 2024, not too hot and not too cold. The economy remained resilient, and fears of a hard landing—let alone a soft landing—turned out to be a “no landing.” A healthy labor market, wage growth, personal income increases and record-high household net worth drove broad consumer strength during the year.

The US economy experienced significant disinflation from peak levels in 2022 that continued into 2023 and 2024. Although some market participants were concerned about a stall in this disinflation trend, a second wave of inflationary pressures did not materialize in 2024. Additionally, while the unemployment rate rose slightly to 4.1% in December 2024, it remains at a moderately low level based on historical standards.

This modest softening in the labor market has allowed the US Federal Reserve (Fed) to shift toward normalizing monetary policy from its restrictive stance. After a prolonged pause, the Fed reduced interest rates by 100 basis points (bps) from September to December 2024. Further rate cuts are expected this year, consistent with the Fed’s message from its January 2025 meeting, when it left rates unchanged. In our opinion, this normalization of monetary policy will drive not just the economy, but it will also impact financial markets.

Interest-rate volatility and opportunities in fixed income

Over the past 6-12 months, the fixed income market experienced significant interest-rate volatility. The benchmark 10-year US Treasury yield fluctuated from a low of 3.6% in September 2024 to a high of 4.8%, settling to around 4.5% at the end of January 2025. This rate is still well above the average of recent years, so fixed income investments remain attractive to us as income investors.

Within fixed income sectors, investment-grade corporate bonds have seen credit spreads decline from about 160 bps 2.5 years ago to around 80 basis points at the end of December 2024.¹ This trend has reduced the compensation for credit risk and made this segment less attractive to us. Similarly, high-yield corporate bonds have seen credit spreads drop from more than 500 bps to around 260-270 bps for the same period.² In contrast, valuations or spreads within agency mortgage-backed securities (MBS) have not seen the same kind of contraction or move lower as corporate bonds. In our analysis, agency MBS is an area where yields look attractive.

Broadening equity markets and opportunities

Meanwhile, the US equity markets have seen historic gains, with the S&P 500 Index up more than 25% per year in 2023 and 2024.³ However, when we look at the S&P 500 on an equal-weighted basis, or focus on high-dividend stocks as measured by the MSCI USA High Dividend Yield Index, the annual returns drop to about 13% and 9%, respectively, over the same two-year period.⁴ This demonstrates that a narrow set of stocks drove the strong performance, particularly mega-cap-technology growth names. However, toward the end of 2024, the equity market began to broaden, offering more diverse opportunities.

Another thing we focus on is forward valuation levels. Whenever the broader market can deliver strong returns, it is usually due to a combination of factors, such as companies experiencing earnings growth as well as valuation multiple expansion. While this was evident in some areas, particularly with mega-cap-technology companies that drove the S&P market-cap weighted index, the forward price-to-earnings ratios for the equal-weighted index and high-dividend stocks remain more reasonable and less elevated, in our analysis.⁵

Thus, as 2024 progressed, we increased our allocation to equities as we decreased our allocation to fixed income. We currently hold a more balanced view between equities and fixed income and see expanded opportunities in both asset classes. Within equities, we favor the following sectors: information technology, health care, energy, consumer staples and industrials.

Positive outlook for 2025

The resilient growth that the US economy experienced in 2024—driven by strong consumer spending, robust corporate profits and a relatively stable labor market—serves as a favorable backdrop as we begin 2025. We expect this momentum to continue even if the economy were to decelerate to more sustainable long-term growth rates. We will remain focused on potential uncertainties, particularly around policies from the new administration. Overall, however, our outlook remains positive.