Forecasting is always a dangerous business. Look at 2023 and 2024, when many economists were predicting a major recession and stock market decline. The recession was a no show and both years ended with a more than 20% increase in the S&P 500. As we begin 2025 the outlook is notably more upbeat than it has been in the last 3 years (which makes us nervous from a contrarian standpoint). Nonetheless, let’s take a look into the future and consider what could go right and wrong during 2025.
Let’s begin with what could go right?
1. Lowering interest rates
The big story of the last 3 years was inflation and the resulting Federal Reserve policies to bring it down. Namely, the Federal Reserve has been on a cycle of dramatically raising interest rates in order to fight inflation for the past 3 years. Most recessions happen during this cycle. As we begin 2025 the Federal Reserve has stopped raising rates and is beginning its cycle of lowering interest rates, which is typically positive for stocks.
2. Productivity Growth
Sometimes it is easy to get caught up in smaller details of the economy, say the next tax policy or interest rate move, and miss the long-term, big picture. When we take a step back, there are still strong positives working in the economy. For example, technology has the ability to drive up productivity, which is the secret sauce of capitalism. I say secret sauce because if each worker is more productive then companies can become more profitable AND workers’ incomes can increase. Productivity growth is the story of…well the last 200+ years of industrialization. Through the years there have been spurts of productivity growth caused by significant technologies. For example, the cotton gin, the steam engine, the railroad, automobiles, aircraft, computers, and the internet resulted in real wealth creation that improved the lives of both workers and created wealth for investors. Could quantum computing, artificial intelligence, and robotics bring a new wave of productivity and wealth creation? Potentially, which is one of the significant reasons that the big stock winners for 2024 were those companies which supplied, and those companies that are investing heavily in these technologies: Nvidia, Microsoft, Apple, Amazon, Google, Tesla, and Meta. Going into 2025 the investments in these technologies could spread to other industries and companies, resulting in a broadening rally.
3. Trump 2.0
Some of you may put Trump 2.0 in the category of ‘what could go wrong’. There are many unknowns about government policy during his next presidency but so far the market appears to be taking the next Trump presidency as a positive. As we have written previously, we believe the prospect of lower taxes, regulation, and energy costs are a tailwind to stocks. The biggest risk remains Trump’s tariff policy, especially if it results in a trade war.
So what could go wrong?
1. Too much bullishness
One concerning development over the past few months is a significant increase in optimism. While this may seem counterintuitive, it is generally better to invest in a market that is full of pessimism since good news will bring in new buyers. Once the good news is already ‘baked in’ to stock prices it is harder for stocks to appreciate. As of December 31st, 2024, Americans had record levels of their wealth invested in stocks.
2. Sticky Inflation
We have listed lowering interest rates in our “what could go right?” category. But what if inflation is sticky and comes back? The Federal Reserve could be forced to reverse course and raise rates once again. This outcome would be bad for stocks. While not our base forecast, it is a risk we need to consider.
3. The US Debt
There have been warnings about the US Debt for years and so far they have been terribly wrong. The US has been able to issue massive amounts of debt, seemingly without negative consequences, resulting in many dismissing the issue. However, there are increasing signs that the bond market is concerned about the path of borrowing in the US. While this may not be a catastrophe, the reality is that deficit spending is highly stimulative to the economy and to stock prices. Even reducing the pace of spending will be a headwind for stocks.
4. Geopolitics
The wars in the Middle East and Ukraine are still waging. There remains a risk that these conflicts ‘spill over’ into a broader conflict that could impact the global economy. For example, a direct conflict between Iran and Israel that threatens global oil supply could be disruptive. That said, the dismantling of Iran’s influence in the middle east could be a long-term positive.
So what?
We continue to believe the future is bright. Certainly, there are risks, but our base case remains another up year in stocks as productivity growth brings new profitability to corporations. This does not mean that it will be a straightforward rise. In fact, the current high level of optimism could bring a pullback to begin the year, but sentiment is only a short-term phenomenon. The longer-term prospects for a growing economy are positive.
Comments