INSIGHTS

On February 18, 2025

AAM Viewpoints — 2025 Economic & Market Outlook

BOTTOM LINE UP FRONT

We continue to maintain our strategy of exposure to the “Magnificent Seven” technology companies (Apple, Amazon, Meta, Microsoft, Alphabet, Nvidia, and Tesla), Artificial Intelligence and its supply chain, as well as broadening out our positions to take advantage of earnings growth in the remainder of the market while evaluating opportunities in U.S. small and mid-cap companies as rolling recessions continue to evolve into rolling recoveries. We are continuing to lean short duration on our fixed income in anticipation of stronger growth and expansionary deficits.

INTRODUCTION

After a nervy summer for investors, markets, and economic prognosticators, the economy regained steam in the final months of 2024 after the Federal Reserve delivered on a long-awaited series of rate cuts. With the election of Donald Trump as the 47th President of the United States, investors are also grappling with the likelihood of a material change in policy relative to the last four years.

We are positive on the outlook for economic growth in 2025. The labor market showed important stabilization in December, while various measures of economic sentiment have seen a significant lift in recent months. There is little in economic data indicating a slowdown in 2025, and consumer spending showed an important lift in the 2024 holiday season. For markets, 2025 is set to be another year of record earnings as profit growth continues to broaden across the index.

While the backdrop is positive overall, that does not mean that 2025 is without risk. A resilient economy, and stubborn inflation, limits the magnitude of rate cuts that the Federal Reserve can deliver, while elevated valuations could prove a headwind to returns. A probable change in U.S. government policy toward economic protectionism and expansionary tax cuts likely makes the Fed’s job harder still. While a rate hike by the Fed in 2025 is a very low probability outcome, the economy at present is showing little sign that interest rates are as restrictive as the Fed thinks.

MARKETS

Despite two years of more than 20% returns for the first time since 2000, we continue to see opportunities in markets. Companies continue to beat earnings expectations, and a broadening profit recovery throughout the S&P 500 is one of the better reasons to be optimistic on markets in our view. Earnings for the overall index are currently estimated to grow 12.5% in calendar year 2025 to $272 a share, which would be a second year of accelerating earnings growth and the highest rate of growth since the reopening of the economy in 2021.

Critically, the bulk of this acceleration in earnings will be driven by a broadening of growth across the index — with earnings growth at the 493 companies outside of the “Magnificent Seven” technology companies set to hit 11% in 2025, almost three times the rate of growth seen at the group in 2024. We view this as an important foundation for markets due to the diminished reliance on the fortunes of the seven largest technology companies for market performance. Since the end of 2022, the S&P 500 has returned roughly 58% including dividends — more than half of total returns over that period are attributable to the Magnificent Seven alone.

While we believe growth will slow for the Magnificent Seven in 2025 relative to the last few years of supercharged growth, the mega-cap technology companies continue to show above-market levels of profit improvement at 18% earnings per share (EPS) growth and are likely to see an acceleration in revenue growth this year. We also think that record spending on Artificial Intelligence (AI) Capital Expenditures from the hyperscale data center operators is a theme that continues throughout 2025. We are seeing indicators that AI spending is generating revenue growth, and company comments indicate continued willingness to increase spending.

While markets certainly have a lot of positives in 2025, there are risks that could pose headwinds to returns and could see choppy trading throughout the year. Multiples commanded in U.S. stock markets are elevated, both relative to historical comparisons and the rest of the globe. The S&P 500 has also grown increasingly reliant on the fortunes of just a handful of companies with 27% of the index composed of the five largest members, up from just 11% in 2013.

Source: Pence Capital Management

A change in the outlook for AI spending or idiosyncratic issues at any of the five companies could be challenging for markets, even if the smaller companies in the index perform. Finally, strength in the economy could leave the Federal Reserve on a prolonged hold, though a strong economy that limits Fed action is better than the alternative — a weak economy that necessitates decisive action from the Federal Reserve.

ECONOMY, THE FEDERAL RESERVE, AND PRESIDENT TRUMP

We think there is little room for the Federal Reserve to reduce interest rates this year, largely because economic growth data continues to not only show resilience but is showing early signs of further improvement. The Fed’s Beige Book has shown improvements to economic activity in the last three releases, while consumer confidence and Small Business confidence have seen notable lifts. Since the election, the National Federation of Independent Business’s Small Business Optimism index has seen its largest two-month jump in the history of the survey. We think the Fed’s December forecast of 2.1% GDP growth for 2025 is likely low and stands in stark contrast to the International Monetary Fund’s estimate of 2.7% for the year.Source: Pence Capital Management

When the Federal Reserve embarked on the 100 basis points of rate cuts they delivered in 2024, the reasoning involved a dramatic slowdown in job creation, a jump in the unemployment rate, and several months of soft inflation. Since the Fed embarked on these rate cuts, the July spike to a 4.3% unemployment rate has been revised down, July’s payroll additions were revised up from their initial release, and inflation readings have been firm for several months. Bond yields have also increased precipitously from when the Fed first cut interest rates, with the 10-year Treasury yield up nearly a full percentage point, while the Federal Funds Rate dropped by a full percentage point over the same period. The data revisions and recent strength in economic data has led markets to question whether an overly data dependent Federal Reserve was overzealous in its reaction to noisy economic data over the summer and fall, and what exactly the path for rates is going forward.

Throughout this rate cycle, the magnitude of rate cuts that have been priced into markets has been consistent with recessions, not soft landings. Now, with December’s 25 basis point rate cut, the Federal Reserve has already undertaken a level of rate reductions consistent with the soft landings of 1994–1996 and 2015–2019. The bias for the Federal Reserve continues to be for lower interest rates, and they maintain that interest rates remain in meaningfully restrictive territory, but we think the data over the year will likely challenge the Fed’s estimate of two cuts in 2025.

The labor market — which has been a key focus for the Fed — showed important stabilization in December and there are signs that the job market could be accelerating. Surveys from the Institute for Supply Management show continued improvement in the Manufacturing sector while Services activity remains robust. Small business sentiment, which has been particularly gloomy, recently broke a 22-year record with the highest share of small businesses expecting better conditions since 2002. Consumer spending closed out 2024 with substantial growth in December retail sales, while holiday sales also showed strength.

When looking at the totality of available data, there is already very little evidence in the data that monetary policy is as overwhelmingly restrictive as the Fed believes — and there is good chance that the pro-growth policies signaled by the Trump Administration lift activity in areas that have struggled over the last several years. Other floated policies — such as tariffs and immigration restrictions — are likely to challenge progress on disinflation and balancing the labor market. The wildfires in Los Angeles may also have a measurable impact on inflation given the scale of destruction, the high net worth of the residents displaced, and anecdotes around exponential increases in market rents in surrounding areas. 2005’s Hurricane Katrina meaningfully boosted housing inflation for several months, and shelter costs have been one of the main hopes for further progress on disinflation.

It is still early days for the Trump Administration, but recent indications are that tariff policy is likely to be more measured than statements made on the campaign trail. A “Day One Universal Tariff” did not materialize, and threats for 25% tariffs on Mexico and Canada and 10% tariffs on China appear to be opening salvos toward a renegotiation of trade deals already on the books. While an expansion of tariffs is likely, we don’t see an extreme jump in inflation through potential tariffs, but they do likely lift inflation from where it is or place a floor on how low inflation could fall. 2018’s trade war did not result in a material lift to inflation — though certain tariffed goods did see elevated price increases relative to others — and the Biden Administration not only kept Trump’s tariffs, but in many cases expanded them.

On immigration, the outlook is less sanguine. One of the Federal Reserve’s key indicators for labor market balance has been the ratio between unemployed workers and the number of job openings in the economy, which has roughly halved from its high in 2022 and now sits below pre-pandemic levels as job openings have fallen and unemployment has risen. However, the primary driver of the rise in unemployment has not been layoffs — which are historically low — but rather labor force additions, of which immigration has been a key ingredient.

Labor Force growth has outpaced employment gains by over 1.1 million people since 2023, and over that period we have seen a softening in wage increases and a decrease in the Quits Rate — the share of employees quitting for different jobs. President Trump’s immigration policies would likely significantly alter that math, and there is fairly overwhelming support for his stances on immigration from the broader public. Today, the share of Americans who think that immigration should be decreased sits at its highest since October 2001, immediately following the September 11 attacks, and 55% of Americans recently told the New York Times they support deporting all immigrants who are here illegally — a notable number in the context of today’s political division. With a smaller pool of available labor, businesses are more likely to compete for workers in the form of higher wages, particularly at a time when businesses see the economic environment as a good time to expand and hire additional workers.

CONCLUSION

While it is still too early to tell the full impact of policies from the new administration and the ultimate effect they may have on the outlook for monetary policy, the Federal Reserve limiting rate reductions because of a strong economy is not an implicitly bad thing. Difficulty in justifying rate cuts also imply a better outlook for corporate profits and wage growth. We are optimistic on the outlook for 2025 due to earnings growth and a broadening profit recovery, but the path for markets is unlikely to be as smoothly upward as over the last two years. There are opportunities in markets, but themes for 2025 — such as high valuations and a resilient economy limiting Fed action — means markets likely don’t exhibit the same magnitude of returns we’ve seen over the last two years.

CRN: 2025-0203-12287 R

The opinions and views of this commentary are that of Pence Capital Management and are not necessarily that of Advisors Asset Management.