As we all know, we live in a bifurcated world. Since the election, people have either been celebrating Trump’s victory or mourning Harris’ loss. That translates to the economy. Enthusiasts point to tax cuts, deregulation, DOGE, and overall benefits of disruptive change. Those predicting pending disaster suggest multiple foxes will be let loose within the chicken coop. As always, the truth lies in between.
The reality is that we know we will see increased tariffs but we don’t know the extent. We know tax cuts will be extended but all the requests combined are too much and some will have to be scaled back. Items like the SALT deduction revival are not favored by the masses but some concessions may be needed in a tight House majority to get legislation over the finish line. Republicans want to get as much done as possible early in 2025 while they have political capital to get things done. But whether that will happen or not is an open question. If they get bogged down, how will markets react? We don’t know.
On Wall Street, it always comes down to earnings, interest rates, and inflation. Some of the noise and debates taking up space on the front page matter little when it comes to earnings, interest rates and inflation. Who runs the FBI, for instance, is economically irrelevant. But investors do care and have to take a wait and see attitude about other issues. For instance, immigration is important. Economic activity clearly relates to the number of mouths that must be fed or having an adequate number of workers to pick crops. The rhetoric or bluster about mass deportations or using the National Guard to effectuate policy is probably an overstatement. But closing borders and accelerating deportations will be an economic headwind. How much and when, again, to be determined.
These questions set the stage for this week’s FOMC meeting. Fed Fund futures suggest well over 90% odds that the Fed will cut the Fed Funds rate by another 25 basis points on Wednesday. The Fed virtually never surprises markets and there is no reason to suggest it will do so on Wednesday. Thus, despite recent data suggesting inflation is sticky around 3%, a fact that could, on the surface support no action this week, a cut is almost inevitable. 25 basis points, one direction or the other, won’t matter much in the long term.
Rather than focus on the rate decision itself, investors are going to look at the accompanying dot plots and post-meeting comments from Jerome Powell to try and determine the future path of rates in 2025. Before going further, both the Fed and markets have notoriously poor records predicting the future path of Fed Funds rates, even over as short a period as a year. About a year ago, for instance, some members were suggesting the possibility that the Fed Funds rate could be below 3% by the end of 2025. Now, it is quite possible that it won’t be below 4%.
The Fed is notoriously reactive rather than proactive. Members have no desire to predict the timing or impact of Trump team actions that will impact economic growth or inflation, the two economic factors the Fed has the ability to impact via interest rate policy. Staff is busy doing predictive studies of possible impacts of changes in tax or immigration policy, but the Committee won’t act until after actions are taken and data starts to show impact.
That means we enter a period of increasing uncertainty. Even if the direction proves favorable, i.e. taxes stay low, regulatory pressure decreases, and tariffs are imposed., many of the bigger issues simply are too complex to be solved immediately. For instance, extending all the tax cuts that expired at the end of 2025 plus making Social Security receipts, tip wages, and overtime pay tax-free, plus putting SALT deductions back on the table would be absolute budget busters that won’t fly. They won’t fly in Congress and they won’t fly with the Congressional Budget Office that must score all economic bills. Adding $6 trillion to the national debt over and beyond what will be added by $1.5-2.0 trillion annual deficits is sheer economic lunacy. Trying to predict the tradeoffs today is sheer speculation. As for timing, while Republican leadership would like to get everything tied up with a nice bow by mid-year, history says nothing happens quickly in Washington except for reaction to a crisis.
Again, back to earnings, interest rates, and inflation. Earnings are likely to rise at an accelerated pace in 2025 according to Street estimates. Right now, consensus says 14% growth on top of 10% this year. That may be a touch optimistic for two reasons. First, the biggest driver of earnings growth has been the massive capital spending to accommodate the future needs of AI (artificial intelligence). While capex will still grow in 2025, it’s hard to argue that the pace of growth will remain equal to the pace of the past 18 months. Second, population growth in the U.S., spurred by the accelerated border crossings from 2022 through mid-2024, is going to slow. Border crossings are already declining and will decline further while deportations will rise. One can argue the extent but not the direction.
Interest rates will depend on the pace of inflation. Most importantly, the rate on longer maturities will depend on long-term expectations. Long-term inflation expectations have been anchored for years close to the Fed’s 2% target. Recently, inflation has started to become stuck closer to 3%. There are arguments, pro and con, whether the Fed can get inflation down to 2% while keeping the economy on a growth path close to 3%. Recently progress has been supported by above average productivity growth. Over time, it is hoped that AI will support higher productivity gains but one can’t attribute recent improvement to AI. Lots of alternative explanations have been offered. Perhaps the most cogent ones suggest a return to normal working conditions post-Covid is a factor. If so, those gains won’t continue for much longer.
If the rule of thumb that long-term rates reflect the sum of real growth plus long-term inflation expectations, 10-year Treasury yields could fluctuate within a 4-5% range with some risk that they drift higher should inflation turn higher.
As for equity markets overall, while the Trump honeymoon continues, converting dreams to reality almost always encounters some roadblocks. Getting Congressional consensus with narrow Republican majorities in both the Senate and House won’t be simple. While Trump’s team can control lots of factors, it can’t dictate inflation or interest rates. One should remember that while all the talk today is about efficiencies, little such progress was made during Trump’s first term while deficits rose each year. No doubt, the team is much better prepared this time. But members of Congress are elected officials. Reducing costs means reducing headcount. That means job cuts. Those losing jobs are unlikely to be happy future voters. Cutting funding for local projects has the same impact. Thus, every member of Congress is going to ask, “What is the impact in my district?” That’s why getting over the finish line won’t be easy. Goals are easier to set than it is to attain them.
No one on Wall Street is predicting a bear market. Nor am I. But rather than simply paint a picture that extends 20%+ annual stock market gains into an infinite future, I question whether a market priced to perfection at 22+ times 2025 estimated earnings can sustain itself without hitting a few potholes. We saw nothing close to a 10% correction in 2024. The worst we saw were 1-2 week blips. Change is always a setup for disruption. That is why the first year of a Presidential term is often a bumpy one on Wall Street. Again, that’s not an outright prediction, but rather a voice of caution in an environment where euphoria is more evident than caution.
As for specifics, only two of the Magnificent 7 sell for less than 30 times estimated earnings. Growth rates for most will slow in 2025. Trees don’t grow to the sky. Expect some consolidation in 2025. The place where the majority have turned to so far this year has been the financials. Unwinding a negative yield curve and a hope for more investment banking activity in a deregulated world, has helped the financial sector. The main risk would be much higher long-term rates if inflation resurfaces. Again, that’s a risk, not a prediction. Other arenas that did well in 2024 that offer promise in 2025 are manufacturing, assuming more reshoring, defense, utilities, data centers, and home builders. All continue to have solid outlooks, but equity valuations are high.
Where are the bargains? I’ll offer two examples from 2024 to demonstrate where to look. When the Fed steadily increased interest rates, conventional wisdom said that was bad for the housing outlook. Indeed, if one looked at total home sales, that conclusion was accurate. But what was overlooked was the dearth and lack of quality of homes for sale driving many buyers toward new homes. Homebuilders flourished. Wall Street got it wrong and the contrarians were the winners.
Maybe no economic sector faced a worse outlook as 2023 was ending than the New York City office market. Everyone loved working from home. But, as it turned out, working from home wasn’t always the most productive alternative. In addition, New York’s economic success is keyed off of the success of the financial world. 2024 turned out to be pretty good. Big businesses want first class space with amenities that attract workers. Fast forward a year, and first-class space in New York is in high demand with several high-profile properties fully leased. Again, consensus was wrong and contrarians won. Where does one look today? This isn’t a market letter that recommends stocks, but I would suggest sifting through the weakest sectors of 2024 to find a few gems.
Today, ZZ Top’s Billy Gibbons turns 75.
James M. Meyer, CFA 610-260-2220