This year begins with an above average level of uncertainty. Policy often impacts the economy and financial markets but 2025 brings heightened policy risks in our estimation. The incoming administration have promised to make sweeping changes to tax, trade and immigration policies. The labor market, which has been a primary driver of strong consumer spending, has cooled. The Fed’s rate cutting campaign may have stalled and market interest rates are at their highest levels since Fall 2023. Recession, 2024’s watchword is barely mentioned. Equity valuations appear stretched and earnings growth expectations frothy. Our crystal ball remains quite cloudy. Investors have long reliably made money by betting on the economy and markets to normalize toward long-term trends. The problem, in this post-pandemic world, it is hard to understand what those trends are.
President-elect Trump ran on a platform emphasizing reduced taxes, higher tariffs and significant restrictions on immigration. A House and Senate under unified GOP control should give the incoming administration a solid chance of enacting its preferred policies. We do not, however, expect Congress to function as a rubber stamp for Trump’s preferences. The election of Senator John Thune, who was not Trump’s favorite for the role, as Senate Majority leader and skepticism among some in the GOP over cabinet picks seem to confirm this view.
Lower taxes would normally be perceived as the easiest of policies for a new administration to enact as cuts are broadly popular. However, with the deficit and federal debt at levels unimaginable just a few years ago, tax cutting may be more constrained. Persistently high market interest rates only make the problem worse as, except in the short-term U.S. Treasury Bills market, all maturing Treasury debt will need to roll over at a higher rate than the existing coupon.
Tariffs were also popular with many voters during the first Trump administration and President Biden continued that policy. Trump has promised sweeping new tariffs on virtually all imports with especially punitive levies on imports from China. Some of the burden of tariffs in the first Trump administration was passed on to consumers while much of the rest was absorbed by the companies that imported goods. After the inflationary surge of the last few years, consumers are likely in no mood to pay up for imports. Companies will want to protect margins. Something will have to give here if new tariffs match Trump’s rhetoric on their broadness and severity. Our assumption is that corporate margins could be vulnerable.
Immigration reform appears to have more widespread support, but it is not without risks. The surge in immigrants, many undocumented and across the southern border, had the effect of boosting the supply of labor at a time when job openings outpaced additions to the native labor force. This allowed strong economic growth without entrenching a wage/price inflationary spiral. The economy can probably stand stricter border controls and visa reform for highly skilled foreign workers. What might pose a challenge economically would be Trump’s promise of mass deportation of undocumented workers. The U.S. labor market has normalized, and wage growth has declined to levels closer to pre-pandemic trends. If immigration policy not only cuts the supply of new labor but removes current workers, GDP growth could suffer, and wage inflation could be rekindled. On both the trade and immigration policy fronts, we are hopeful that Trump and Congress will find a bridge to positive reform that will not throw a wrench in economic growth.
Beyond purely political policy, the Fed’s monetary policies could also have a significant impact on the economy and financial markets this year. Most observers a year ago thought the Fed would have already reduced the target rate to around 4.00% and be set to cut rates another 0.75% to 1.50% in 2025. With persistent above trend economic growth and sticky inflation, it is no longer clear that the Fed will cut rates at all this year let alone 0.75% or more. Coupled with resurgent market interest rates, a higher for longer Fed could be an impediment to both economic growth and risk asset returns. An especially sticky situation could occur were the labor market to weaken materially while inflation remains persistently above 2.5%. The Fed would then have to choose between supporting the labor market through rate cuts or holding tight to keep inflation from rebounding.
Beyond the realm of policy, we believe the two-speed economy we saw on many levels last year will continue in 2025. The services sector should continue its expansion even as the manufacturing economy may find a bottom and begin to rebound. Continued growth in the services sector is key as the sector generates 70% of all U.S. wage income. We also expect that upper income consumers will continue to thrive while those as the lower end of the income spectrum struggle to make ends meet. Finally, we see large businesses doing better than small businesses. While small business optimism has risen around the potential for lower taxes and reduced government regulation, higher for longer interest rates seem likely to penalize earnings potential for small companies that are more heavily dependent on debt capital.
It is usually difficult and even more often unwise to begin a new year anything but bullish on equities. After all, domestic large cap equity prices historically rise over the course of a year about 70% of the time. An expectation of solid economic growth is generally another good sign for prospective equity performance as earnings growth is often correlated with GDP growth. Expectations for profit growth are quite strong for 2025 with the S&P 500 expected to grow earnings per share in aggregate by nearly 15% and growth in 2026 expected to slow only slightly to 13.5%. A sizable portion of the growth is expected to come from margin expansion with profit margins for the index forecast to reach an all-time high. Those types of earnings gains are generally seen when the economy is emerging from recession, not several years into an expansion. In addition to very rosy earnings growth expectations, equity valuations as measured by price/earnings ratios are high. The 12-month forward P/E for the S&P 500 is 21.4. That is 20% above the median for the past decade and within shouting distance of the all-time high for the measure when the late 1990s Tech Bubble is excluded.
Our forecast for equities over the coming 12 months is cautious. We believe that S&P 500 earnings per share are likely to compound at a rate nearer 9% over the next two years rather than the 14% consensus expectation. Keeping the current 21.4 forward P/E constant on those earnings would yield a price return of around 4.5% by the end of 2025. Add in the current dividend yield on the S&P 500 and a total return of 6% to 7% seems achievable. That is higher than current yields available on medium duration U.S. Treasury or investment grade corporate bonds. However, the rise in market interest rates we have seen since the Fed began cutting its target rate in September could prove problematic for equity valuation levels as P/E ratios often fall as interest rates rise. We see valuation as the biggest downside risk for equities. Even with 9% or 10% earnings growth, a two turn decline in the S&P 500’s P/E ratio could lead to low single-digit price declines at the index level and total returns at breakeven or slightly below. Upside risk to our forecast could come from the realization of consensus earnings forecasts which with stable valuations could produce low teens returns on domestic, large cap equities. Either way, we expect equity price volatility to rise in 2025 versus last year.
Equity returns were lopsided in favor of technology-exposed stocks in 2024, especially the Magnificent 7 and those with high exposure to AI. This trend is likely to continue in 2025 although we expect the performance gap to narrow. The Mag 7’s earnings per share growth in 2024 will come in around six times that of the S&P 500 and this outsized earnings performance underlies the superior price performance of the mega-cap index. The Mag 7 should grow earnings faster than the S&P 500 again in 2025 but the growth premium is likely to be cut in half. Relative earnings growth rates for the two indices could reach near parity in 2026.
Our outlook for the bond market is more stable. While we could see additional upward pressure on market yields, we think the 10-year U.S. Treasury yield is likely to top out closer to 5% in 2025 than 6%. Equities remain the best bet for generating long term returns in excess of inflation, but high-quality, short to medium duration bonds should provide stability and positive real (after-inflation) yields in the stable value portion of investors’ portfolios.
Above all, we recommend a focus on high-quality securities for the portfolios of all our Byline Wealth Management clients. We believe quality is the best defense during times of market volatility while also generating attractive returns during rising markets. We appreciate your business and will endeavor to continue to earn your trust in 2025.
