The Road Ahead: Our 2025 Economic Outlook
Wow, 2024 was an amazing year and far better than most economists predicted. The year started with fears about inflation, the magnificent 7 stocks at super high valuations and the uncertainty that always comes in an election year. With such robust performance for the stock market in 2023 and 2024 we believe that the margin for error in financial markets is slim in 2025. With equities largely priced to perfection, discretion will be of paramount importance in pursuing opportunities, but also managing risk.
As it turned out, we had only one meaningful pullback in late July and the Market continued its steady march higher. The pullback in late July/early August lasted only a few days before the market continued its climb. As a result, our portfolios performed very well in 2024. This is great news, but I know that some folks will be frustrated by the tax implications. After two years of the market consistently reaching all-time highs, even strategies such as tax loss harvesting provide very little relief. As investors, we must follow the most basic rules of investing, namely: buy low and sell high. You have heard me say this many times and the result are that our rebalancing throughout the year, in most cases, triggered capital gains instead of losses. This is necessary to manage risk. The result is that you should not be surprised by potentially higher taxes this year. But the good news is that you will owe taxes because you made money.
Think of it this way, would you ever tell your boss not to give you a raise or to not pay you a bonus just because it was going to trigger more taxes. Similarly, your investments performed very well, resulting in some added taxes. At times like this, it is ok to let your investments pay for their own taxes, So, if you need to make a withdrawal at tax time to help pay taxes, please don’t hesitate to call the office and allow us to free up cash to pay taxes. Afterall, if your investments cause taxes, they should be responsible to pay the taxes too.
Another major factor in 2024 was the presidential election.
Once again, our elections reveal that our nation is split over the best way to solve problems that confront us. But please don’t feel that a president has the ability to unduly influence the economy or the market. Here is a chart that shows the performance of the market over the past 80 years. While the stock market has fluctuated under presidents of both parties, the S&P 500 has trended higher over the long term, no matter who’s sitting in the Oval Office.
· Over the past 80 years the stock market as represented by the S&P500 has advanced under every administration.
· The stock market has generally trended higher over the long term, regardless of which party holds the presidency.
· The dynamic U.S. economy has consistently produced successful companies, contributing to economic strength under various administrations. As my mentor in the financial services taught me back in 1987, there has never been a stronger economic engine on earth than the American Economy. He warned me never to bet against American innovation, entrepreneurialism and drive to succeed.
· Factors like earnings growth, economic conditions, and technological advancements can have more influence on market performance than political changes.
· Your investment strategy should align with your goals, time horizon, and risk tolerance—not the outcome of a single election.
What about going forward?
We are optimistic about 2025, although that view is tempered by a healthy dose of caution. Our investment management team believes that while there continues to be great opportunity, there are also multiple uncertainties that could determine how the economy and markets perform next year. However, we strongly believe that active management will be key to successful investing and markets likely will continue to rise and broaden in 2025.
The election of Donald Trump — with his proposed policies including tariffs, tax cuts and deregulation — complicates predictions about 2025. It looks like it’s going to be a pro-market, pro-business administration on the upside. But, on the downside, there is the tariff risk and if the economy heats up too much causing inflation, then the FED will need to raise interest rates which will put a brake on things.
What are we expecting in the coming year?
The market jumped in the days following the election. At that time, I stated that I thought much of the movement was based on emotion, not meaningful data. I also thought that emotion would work its way out of the numbers and that the market would come back down. It seems that the last couple weeks of December followed that pattern.
I believe that the economy remains very healthy. It is hard to find too much data that points toward a recession any time soon. For the past two years the market has been concentrated on the largest stocks, sometimes referred to as the Magnificent Seven. But we are seeing that the market is broadening and that is a very good sign.
The Case for US Equities
One of the biggest questions on investors’ minds is “Can stocks extend their strong performance?”
Laura Castleton, CFA, U.S. head of portfolio construction and strategy at Janus Henderson, noted that the economy exceeded expectations in 2024, avoiding a hard landing while stock markets repeatedly surged. Back in January, the median expectation was for the S&P 500 to end the year modestly up at 4,875, she recalled. “And while equity valuations very much remain in focus, the S&P hit 55 new market highs and is hovering around 6,075 today,” Castleton said during the Dec. 6 webinar.
The environment remains positive for US equities. They have been resilient, notwithstanding rising interest rates, since September. There have been geopolitical tensions and a lot of other things that cause people to worry but stocks have not faltered. That tells me that the underlying market structure remains strong.”
But valuations remain very high, how long can that go?
The most important thing to watch for the direction of the market is not just earnings, but whether earnings are accelerating or slowing. For almost 2 years we have seen not only strong earnings but accelerating earnings growth as well. However, in the 4th quarter of 2024, earnings growth began decelerating. This is something that we will need to keep a close eye on.
The Other 493’ Equities
Finance textbooks tell us that investors should diversify their investments. But there is little diversification today when buying the S&P 500. The combined weight of stocks with a weight of 3% or more in the S&P 500 index is at an all-time high and continues to rise,
The bottom line is that buying the S&P 500 gives the impression that you are buying 500 different stocks and diversifying your investments. But the reality is that the high and growing concentration in the S&P 500 continues to be a major problem. In short, investors should ensure that their portfolio is not all levered to Nvidia earnings.
We fully expect that the stock market also will continue to broaden, focusing less on the Magnificent 7 tech stocks. We really started to see — we call them the other 493 — stocks start to perform, in the second half of 2024. Equal-weighted indices have become more competitive against market-cap-weighted indices and in our opinion valuations are attractive.
But which stocks? Small-cap equities, both growth and value, were “left behind” during the rush of the mega cap stocks and now look attractive. Small and mid-caps tend to perform well during a credit-easing cycle and “not so well” in a tightening cycle. Therefore “The tailwinds are at your back here in terms of small and mid-size companies if the expectations that the Federal Reserve will continue cutting interest rates in 2025.
Inflation
Although inflation has become less of a threat than it was two years ago, we question whether it has been fully tamed.
While the Federal Reserve has prevented a recessionary hard landing, it may not be able to bring inflation down to its target — 2%. A year ago, economists and strategists argued about whether we would see a hard landing versus soft landing. Now the question on everyone’s mind is will we see a soft landing or no landing at all?
We are skeptical the Fed will achieve its 2% inflation target. It does not seem like inflation will keep falling. We’re seeing some stickiness in services, food, rents and other necessities. So, there is evidence that inflation could reignite like it did in the 1970’s. Could we experience a second mountain of inflation like we experienced in the 1970s?
Will we see a repeat of the 1970s with the Fed easing policy too quickly, triggering a rise in inflation in 2025?
Recent inflation readings show signs that the decline in inflation has stalled, and there is a risk of reacceleration. Fed and market-implied measures of inflation are all above the Fed’s 2% target and not showing signs of moving down toward the Fed’s 2% inflation target. Short-run and long-run inflation expectations are also moving higher.
The recent uptrend, combined with strong economic momentum, is pointing towards a rebound in inflation in 2025 and not a softening to justify Fed cuts. The probability is rising that the Fed may have to raise interest rates in 2025.
What’s most important to note is that a portfolio comprised of stocks and bonds has historically kept ahead of inflation. For retirees this is critical since it now takes $18 dollars to purchase what $1 would have purchased in 1926.
So, what are the expectations for 2025?
I can point back to many years when top economists and strategists were wrong, but it never hurts to know what they are thinking. So, what are the biggest investment firms predicting for? We have some early indications of Wall Street targets for the S&P 500 index, and, as is always the case, they are primarily optimistic for the coming year. The median estimate is for the market to rise to 6600 next year, which would be a disappointing return of just 8.2% after two years of 20% plus gains. However, the high estimate from Wells Fargo suggests a 14% return, with the low estimate from UBS of just a 5% return. Notably, there is not one estimate available for a negative return.
We are reaching valuations on the S&P 500 which are like the great bubble at the end of the 1990’s. More reason to diversify away from the S&P 500 which has become so highly concentrated with a handful of tech giants.
U.S. Fixed Income
Despite the slightly greater emphasis on equities, fixed income remains an important hedge in the face of uncertainty, “With a wide range of outcomes, or, what if we’re a bit wrong? A margin of safety, that’s what fixed income is for.”
The outlook for bonds depends on whether inflation and interest rates remain in check.
Many people are worried the U.S. deficit will become unsustainable, but it is doubtful that’s going to bust the economy in the next year or two. If the economy is strong, unsustainable deficits pose no immediate threat. We will lean toward shorter duration if we are worried at all about the reignition of inflation because short term bonds experience less downside pressure when interest rates rise.
International Outlook
People keep waiting for the year when international is going to outperform the U.S., and maybe that day never comes. However, international stocks have been broadening, like U.S. stocks and there could be some opportunities.
US Equities market cap now accounts for 2/3rds of the global world market cap. That’s a complete reverse from the 1990’s when I started in this business when US large companies accounted for less than 40% of global market capitalization.
During the early 2000s European and emerging-market equities went on a bull run. By March 2008 America had entered recession and its financial crisis was under way. The country’s stocks accounted for less than 40% of the world’s total stock market capitalization.
Fast-forward to today and things look rather different. America’s share of the world’s stock market capitalization has climbed consistently over the past decade and a half, and sharply this year. It now stands at 61%. That is astonishing dominance for a country which accounts for just over a quarter of global GDP. The extent of market concentration is more extreme given what is happening within the American stock market itself. Just three companies—Apple, Microsoft and Nvidia—make up a tenth of the market value of global stocks.
When it comes to America’s current dominance, the driving force is entirely familiar: strong companies in new markets have become highly profitable. Although diversification remains a worthy goal, diversifying away from success is unlikely to leave investors very happy.
Let me summarize a few of the risks that I see going into 2025. Here is a list of seven risks and my personal probability estimate that they will occur along with the implications:
Tariffs coming: 90%
Could slow down global economy
Nvidia earnings disappoint expectations: 85%
Nvidia is now almost 7% of the S&P 500 index
US Economy Reaccelerates: 80%
Overheated economy could cause rising inflation which in turn could cause interest rates to rise
Inflation does not slow to FED 2% target but rises instead: 50%
This would force the FED to raise interest rates
FED raises interest rates in 3rd or 4th quarter: 50%
Rising interest rates are a headwind for both bonds and stocks. 2022 repeat?
Recession in Europe or China: 35%
Global slowdown could put the brakes on USA growth
Recession in USA: 10%
Let me wrap up my comments with a summary of how we have our portfolios positioned going into 2025.
While I remain optimistic about the economy, I cannot ignore the threats that I just listed. As a result, we have deliberately made changes in 2024 to prepare for any dislocations that we may see in the market in 2025. Historically, our portfolios include significant holding with active managers who could make tactical decisions daily to complement our asset allocation strategies. For a couple of years, we have focused on less expensive index and ETF strategies, but I feel strongly that active management will help us to outperform in the future. In addition, we have added back about 20% in alternative assets that zig when the market zags. Simply put, we have deliberately added investments with low correlation to stocks and bonds. Things like precious metals, commodities and tactical trading strategies add both diversification and alpha to our portfolios. You have heard me say that adding alpha to your portfolio is like adding octane to your fuel. It will help it to perform better.
I am very pleased with the team who is helping me to manage the portfolios and to implement these strategies which have been proven over the test of time. I believe that we are delivering the best portfolio that I have in my career, and we are well situated for whatever arises in the future.
As always, thank you for the trust and confidence that you have placed in me and my team. We look forward to serving you in 2025.
Donald E. Simmons, CFP