Trending
Written by: Scott Colyer | Advisor Asset Management
2024 Review
As we close in on the final days of 2024 U.S. equity markets are trading at or very near record levels, as are several other asset classes including cryptocurrencies and precious metals. Many markets have benefited from a “soft landing” engineered by the Federal Reserve (Fed) as well as record government spending from the outgoing administration, while the Artificial Intelligence (A.I.) trend pushed technology stocks to the forefront and led several major indexes to record levels.
Yes, technology stocks were big winners this year, but there were also relative losers as Energy, Healthcare, Government Bonds and international stocks generally trailed in their performance. From an international perspective, Japan was the outstanding performer, as geographic neighbor China/Hong Kong fought the major headwinds of a sputtering economy.
2025 Outlook
Investors looking forward to 2025 are trying to discern if U.S. equity markets will continue to lead the world in performance, or if a mean reversion trade would make better sense. On the whole, we are cautiously optimistic on asset price growth continuing in 2025 and our outlook continues to favor the U.S. over international stocks (although we do think that there are compelling reasons to consider an allocation abroad.)
In 2024, the United States led the world in economic growth (the rest of the world generally experienced economic slowing,) but that could change next year as global central banks look to continue lowering interest rates to stimulate their economies. In fact, with the single exception of Japan, global developed and emerging economies have been easing monetary policy making capital cheaper and more plentiful to access. And since economic recoveries are generally a good time to review your asset allocation models, this may be a good time to consider adding add some international exposure to your portfolio.
Easing monetary policy, coupled with historically low valuations of many European and Asian markets makes us think it could be time for international markets to play catch-up. For example, the Euro Stoxx 50 Index is selling at a forward price/earnings ratio of 14.2x, while the U.S. market, as measured by the S&P 500, is trading at a forward price/earnings ratio of 25.3x, a historically high divergence. Furthermore, we believe that Europe and China will respond to monetary stimulus and that those markets either have bottomed or are likely bottoming. We understand the elevated risks around investing in China are many, but we think those have been adequately priced in for the bolder investors. We believe that a recovery in China will help Europe pull out of its downturn and the combination could be very good for investors.
As far as the U.S. goes, we think that the Fed will be challenged to cut rates too much in 2025 because of the stubbornly resilient inflation pressures. More specifically, while the Fed will likely want to continue to cut rates to support the labor markets and GDP, their ability to do so might be hindered by elevated inflation. Thus, we think that short-term rates will likely fall with any reduction in the Fed Funds rate, but longer-term rates are likely to remain elevated. We think that GDP will chug along between 2% and 3% next year, which is a good harbinger for corporate profits. We think that fears over the possible impact of President-elect Trump’s tariffs are overblown, as they were in his first term, and are merely his modus operandi for tough trade negotiation. He is a pro-growth president who cares greatly about his record on the economy and the markets.
Given this outlook, we continue to favor Financials, Consumer Discretionary, Technology and Industrials, and believe there is real value in Healthcare and Energy — both have superior earnings potential and are well underpriced versus their long-term averages. Utilities could continue to do well in a benign interest rate world given the huge need for power generation growth in the U.S. Materials and cyclicals could thrive if global demand begins to grow.
Bonds may be a bit more difficult to navigate given our forecast and the extremely tight spreads of investment grade and high yield bonds to Treasury securities. Thus, we look to the mortgage-backed securities (MBS) markets where spreads are much more generous, and which tend to carry some of the highest credit ratings available. For the more adventurous, we think high yield will deliver but would rather look to the private markets (think BDCs — Business Development Companies) for higher risk-adjusted returns.
What could go wrong with our predictions?
There are three areas where our cautiously optimistic outlook for 2025 could be vulnerable.
1. First is the fixed income market. The U.S. Treasury’s debt-to-GDP is now well north of 120%. We are seeing volatility increase in the Treasury markets as well as other sovereign bond markets. Just this week Aruf Husein, the CIO of T. Rowe Price, doubled down on his call for higher longer-term U.S. Treasury yields next year. Husein was quoted this week saying that a 6% yield on the 10-year note would not be surprising. He notes that Trump’s policies are inflationary and that his policies could very well push up longer yields. He says that a 6% 10-year note won’t be seriously discussed until the note surpasses 5% next year. As of the writing of this article, the U.S. 10-year note was yielding 4.37%. A jump in yields to that level would certainly introduce volatility into the rest of the financial markets. Markets don’t appear to have yet priced in this level of yields.
2. The next area is Trump’s foreign trade policy. Trump has clearly stated that he wants to use tariffs for more than trade negotiations. He is suggesting that tariffs would supply much-needed revenue to the U.S. government, which is spending at a record deficit. He wants to extend the original Trump tax cuts and lower the corporate income tax rate. Tariffs would shift the tax burden from income to consumption (much like a national sales tax) and likely could be inflationary as well. If growth in the U.S. economy sputters next year and inflation remains stubbornly elevated, then we could face a difficult condition called “stagflation.” Stagflation is a period during an economic cycle when both interest rates and inflation remain high. Central banks have little ability to lower rates during this period to boost economic growth as lower rates stoke the flames of inflation. The U.K. is currently suffering from a bout of stagflation and has been struggling to overcome its damage.
3. Finally, the world currently has two wars being waged. One in Ukraine and one in the Middle East. The U.S. is supporting both Ukraine and Israel with armaments and munitions which has been increasing the government deficit substantially. Small wars are expensive; big wars are really expensive. Wars can be unpredictable, to say the least. Should those conflicts spread substantially it could have a dampening effect on the U.S. economy and global economies. Trump seems to want to end these conflicts, but how much influence he has is in question.
In summation, we believe that the U.S. economy will grow between 2% and 3% in 2025 given current earnings growth estimates of U.S. companies. We believe that the concentrated performance in the large cap indices (due to technology and A.I.) will continue, but stock price performance will likely moderate. We think the rally will broaden and expect that quality and dividends will matter. We think that the European and Chinese markets are very inexpensive and that their economies will bottom in 2025. We believe bond duration should be kept short of the benchmark and that short duration MBS, private credit and/or BDCs have the potential to perform well with an expanding economy. We temper our expectations with three areas that potentially could sideline the growth and dampen equity performance.
Related: The 4 Most Common Client Questions for Financial Advisors in 2024