Bad Omen for Sticky Inflation

Key Highlights from the Institute for Supply Management (ISM) Report on Business:

• Economic activity in both the manufacturing and services sectors improved in December relative to the previous month. However, the manufacturing diffusion index remains below 50. Index levels above 50 imply growth; below 50 imply contraction.
• Purchasing managers — those with boots on the ground — reported another increase in prices paid, a sign of nagging inflation pressures for both those in the manufacturing sector and those in the services sector.
• A rebound in manufacturing new orders drove most of the increase in the manufacturing index. Businesses likely pulled forward demand given uncertainty around the future trade environment.
• Bottom Line: New orders spiked in December as firms pulled forward demand in anticipation of imminent tariffs. Rising new orders hint at solid growth in corporate capital expenditures and a driver of gross domestic product (GDP) growth in 2025.

Services Sector More Important

The services sector plays a dominant role in the U.S. economy and highlights the structural shift toward a service-oriented economy. In contrast, the manufacturing sector has seen a decline in its share of the economy and currently represents only about 11% of GDP. However, it’s still worth highlighting both parts of the economy since manufacturing remains crucial for innovation and can provide good opportunities for high-skilled jobs.

Higher Prices Hit Purchasing Managers

Higher prices paid by services organizations signal a troubling inflationary outlook. The rise in prices was widespread, with 15 of the 18 industries reporting an increase in prices paid during December. This broad-based increase suggests that both the Federal Reserve (Fed) and bond investors will need to adjust their expectations regarding inflation dynamics for 2025.

Services inflation remains particularly persistent, indicating the Fed is likely to keep interest rates unchanged at its next meeting. This stickiness in services inflation poses challenges for managing economic stability and controlling overall inflation rates.

What About Growth and Earnings?

Economic growth is closely intertwined with earnings growth. When the economy grows, firms experience greater demand for their products and services, leading to higher revenue and, consequently, higher operating earnings. This positive correlation means that as nominal GDP expands, operating earnings of companies tend to grow as well, benefiting from the broader economic momentum.

As The Economy Goes, So Go Corporate Profits

Nominal Gross Domestic Product vs. Annual S&P 500 Operating Earnings Growth

Source: LPL Research, Bureau of Economic Analysis, Standard and Poors 12/31/24

However, the relationship is not always perfectly aligned. Various factors can cause deviations, such as changes in corporate profit margins, cost structures, and external shocks such as pandemics or financial crises. Global economic dynamics, technological advancements, and industry-specific trends can influence how closely operating earnings track nominal GDP growth. For this New Year, we expect nominal growth to slow closer to 5%, which hints at earnings hitting high single- to lower double-digit growth.

As discussed in our Outlook 2025: Pragmatic Optimism, we expect stocks to move modestly higher in 2025, while acknowledging reasonable upside and downside scenarios. We cannot rule out the possibility of short-term weakness as sentiment remains stretched and a lot of good news is priced into markets. Upside support could come from economic growth, a supportive Fed, strong corporate profits, and supportive policies from the Trump administration. The most likely downside scenarios involve re-accelerating inflation, higher interest rates, and geopolitical threats that do economic harm. If inflation re-accelerates, equities may need to readjust to what could be a slower and shallower Fed rate-cutting cycle than markets are currently pricing in.