A belated Happy New Year to all! Wall Street often talks about a January barometer. What happens in January is a prelude to what happens over the next twelve months. While there is a statistical bias that supports that idea, and a certain logic as well, its validity depends on how accurate January 1 predictions turn out to be. Right now, consensus forecasts suggest continued economic growth along roughly the same path as last year with long-term interest rates holding near current levels. In a recent survey of institutional investors by one prominent Wall Street firm, only 5% of respondents felt the 10-year Treasury yield would be over 5% by the end of 2025. The majority saw it staying in a relatively narrow range between 4.25% and 4.75%. The Federal Reserve likewise is looking for only modest changes in rates and inflation predicting just two small rate adjustments needed in 2025.
With that said, the focus over the next three months will shift to Washington. While the Trump campaign rhetoric was shrill and pointed, already the reality is softened and a bit muddled. Republicans enter the new Congress with a 217-215 majority, at least until April 1 when two special elections will likely add two to their majority. Last Congress, with a slightly larger majority, Republicans could do little. The tussle last week over recertifying Mike Johnson as speaker shows how tenuous their majority is. Right now. the new administration is leaning toward trying to pass one huge bill during the first 90 days that will fund border security and defense along with tax cut extensions and whatever else it feels needs to go in that bucket. Those 90-100 days are the honeymoon period. Can Republicans unite to get all they want done that quickly? Your guess is as good as mine. But history shows getting anything complex done quickly in Congress is a monumental task.
Markets will respond and volatility may increase a bit as the prospects of passage ebb and flow. Certainly, taxes are very important. The impact of border security and immigration will impact the labor supply long-term but the immediate impact will be hard to measure and likely very small. The same is true with defense spending. Bureaucracy has a way of slowing the pace of activity. Look how little of Biden’s infrastructure bill has actually been spent years later.
A big key to watch is the size of future deficits. Those are important for several reasons. First, higher deficits require more funding without a known increase in the base of buyers. More supply without more demand means lower bond prices and higher interest rates. Higher rates, in turn, mean more debt service and even higher future deficits. Among Republicans, there are dozens of self-committed deficit hawks. Trump in the past has talked of fiscal conservatism but his record shows that he likes to spend (as most do in Washington) and isn’t particularly focused on deficits. But markets sometimes care and the core of deficit hawks within Congress care a lot. Whatever comes up for passage, therefore, must in the end placate this faction to some degree in order to get anything done through reconciliation with just 50% approval.
As I look toward the new year, I see two keys that will impact the path of equity prices. The first, which I just dwelled on, is the path of the 10-year Treasury yield. A higher rate is a headwind to equity prices. This morning, the rate stands at just over 4.6%. On November 5th, Election Day, it was 4.25%. Obviously, investors share some concern that Trump’s economic policies will be somewhat inflationary. Have the adjustments in yield already built in such fears sufficiently? That’s a major question for the year ahead.
The other factor that has been helping markets and the economy is the surprising strength in productivity. Since World War II, productivity has averaged close to 2% in a range of 0-4% with only brief outlier periods above and below that range, often associated with recessions and sharp changes in the employment picture. Since mid-2023 however, there has been an upward bias with productivity rising more than 2%. It’s too early for AI to be a factor. Some attribute the improvement to a post-Covid return to the office. Others point to a shift away from non-productive staff/white collar positions as companies focus of profit margins. So far, there has been no definitive answer. But the trend is important and if it is sustainable, that would be very positive for the economy. All the DOGE talk is really about improving productivity at the government level. Whatever success Musk and Ramaswamy have will be a net plus.
As for earnings themselves, they appear to have grown close to 10% last year and there is no apparent reason that growth can’t be repeated in 2025. On the plus side, are positive consumers, the aforementioned gains in productivity, and the prospects for some success from DOGE and other deregulation steps. Rising M&A activity will also build optimism and possibly accelerate the velocity of capital. On the negative side, the key factors will center on the ability of Congress to get anything done, the size of the deficit, and the possibility that the upward path for long-term Treasury yields continues.
Finally, I want to remind all, that there is a long list of Trump promises that he plans to execute in some fashion right after inauguration January 20. Markets will only focus on the ones with economic consequences. We will let Fox News and The New York Times fester on the rest. Clearly, tariffs are a prime focus. Forget the talk to date. It’s the actions that will matter. Threats of high tariffs have already gotten some policy responses in Trump’s favor that will mitigate the size of pending tariffs. In some cases, Trump’s focus will be on balance of payments. That will impact actions he takes vis a vis China, the EU, Mexico, Canada and Vietnam. Politics will impact others including his posture toward Iran, Russia, and China. Markets know tariffs are coming but don’t know the extent. We also don’t know how Trump plans to tie tariffs to his tax policies. Clearly, he will need a revenue offset if he pushes for the full package of tax cuts and incentives he suggested during the campaign. While no one expects, for instance, that all Social Security benefits will be tax-free, even if some are, revenue offsets will be needed to get the deficit hawks in line. While chatter last week focused on a unified House passing a huge economic package with all the tax incentives included, a far more likely path suggests that if the package gets too complicated, the easier parts will be culled out and passed giving Trump an early victory saving the hard parts for later. Maybe quite a bit later.
Last week’s 2025 start was only two days. But Friday was clearly positive and futures point higher in pre-market trading overnight. Valuation may appear expensive but remember that the average stock in the S&P 500 rose in line with earnings last year. While it is hard to expect the companies at the top of the S&P 500 to repeat their sharp early gains of 2024, the Mag 7, excepting Tesla, expects solid earnings growth both this year and next. I don’t see markets abandoning them to go fishing to deep valued names that have been lagging for years.
Once again AI will be a focus. Most corporations are sticking their toes in the water but few have committed major capital spending toward AI projects. But that will change and, when it does, it will change rapidly. The big hyperscalers are committed to expanding capacity and tools to supports what’s to come. Microsoft# alone is planning to spend $80 billion in capex this year alone. How big is $80 billion? It exceeds the annual revenues of Boeing, Caterpillar, or American Express#! Thus, AI is a huge bet. Unlike in the 1980s when the Internet bubble was emerging, funding was largely by venture capital and debt, today’s AI infrastructure buildout is funded by cash flow, both from suppliers and customers. It’s real and the size of the AI market is growing exponentially. Wall Street won’t ignore it.
Thus, the year starts off hopeful. If you are a bottom fisher looking through last year’s losers for opportunities (and there will be many!) ignore companies that continue to underperform in January. Otherwise, looking at the broad market, remember that stock prices track revenue and earnings growth over time rather closely. We live in a changing world. What worked yesterday isn’t necessarily going to work tomorrow. There is a graveyard filled with great names of the past like Kodak. Linear TV, newspapers and small retail chains are following that pathway. Increasing focus on healthcare costs is a barrier but companies that can improve healthcare efficiency can flourish. Keep hunting. You don’t have to pick precise bottoms to make money but you do have to pick companies and industries that have bright futures, not storied pasts.
Today, actor Eddie Redmayne is 43. Golfing legend Nancy Lopez is 68.
James M. Meyer, CFA 610-260-2220