Executive Summary
In 2024, economic resilience and artificial intelligence (AI)-driven growth fueled a massive 25% gain in the S&P 500, driven again by mega-cap technology stocks.
The Federal Reserve started to cut rates but discussed a measured pace of future rate cuts, navigating between reducing inflation and supporting growth.
The surprising Republican sweep adds some uncertainty, with potentially inflationary fiscal policies counterbalanced by hopes for economic growth and efficiency gains.
Looking ahead to 2025, the global economy is expected to moderate, with U.S. GDP projected to grow at 2.0–2.5%. While consumer spending and infrastructure investments continue to support economic stability, headwinds such as housing affordability and geopolitical risks persist.
AI remains a central theme, driving productivity across sectors from healthcare and energy to logistics.
In financial markets, 2025 could mark the long-awaited transition from U.S. mega-cap tech dominance to broader market participation. We believe many sectors and asset classes outside of tech, such as small-cap, foreign, and dividend paying stocks, have the potential to gain traction.
We believe investors should remember the importance of flexibility and proactive risk management, as technological innovation and economic uncertainty define the year ahead.
Challenges for fixed income due to persistent inflation could linger, potentially making commodities and dividend paying stocks an attractive alternative. In addition, credit opportunities could continue to perform well if the economy is able to avoid a more substantial slowdown.
Potential Positive Drivers | Potential Risks |
Resiliency: Strength in consumers and labor market, optimism, potential tax cuts | Inflation: Pro-growth policies, increased deficit spending, tariffs lead to resurgence in inflation and higher-for-longer interest rates |
Productivity: Artificial intelligence, automation, efficiency gains and profitability growth | Lag in Rewards from AI Spending: Artificial intelligence hype may not translate to meaningful effects for a few more years |
Price: Many parts of the market reasonably priced, such as high quality small- and mid-cap, foreign companies, dividends | Volatility: Valuations of large cap tech stocks near all-time expensive levels, elevated uncertainty with change in administration |
2024 Summary
We began 2024 optimistic that the economy and markets would avoid recession on the strength of the US labor market, compelling starting valuations for stocks, and the potential for increased productivity gains. We titled our 2024 Outlook “Finally Normal” because it was the first year since the pandemic where things felt close to in balance again (economy standing on its own two feet, interest rates and inflation moderating, stocks reasonably priced). Growth expectations for large technology companies, particularly those associated with artificial intelligence, were a powerful positive force for markets last year. The S&P 500 led the major indices, generating a return of 25%, while other areas such as small cap stocks, foreign stocks, and bonds advanced but gained only 11%, 4% and 1%, respectively.
We expected 2024 to provide broader participation outside of large technology stocks but this did not transpire in part due to a stronger than anticipated economy and longer-term interest rates increasing. The surprise Republican sweep in Washington has led to renewed concerns regarding inflation and the potential for higher-for-longer interest rates in 2025. Much as rising interest rates did in 2022, this impacted interest rate sensitive areas such as small cap stocks and bonds, which declined 8% and 2% in December, respectively.
Because interest rates and inflation were such a dominant factor in 2024, we open the 2025 Outlook with an update here, as this remains a key risk for markets in 2025.
Recap and Outlook for Interest Rates & Inflation
The Federal Reserve (the Fed) is responsible for keeping the economy balanced. Its main goals are to control rising prices (inflation) while maintaining a stable jobs market. To do this, the Fed adjusts short-term interest rates, which are linked to the cost of borrowing money, to either slow down or boost the economy. It is a delicate balancing act; an overheated economy leads to more inflation, but an overly restrictive Fed could throw the economy into a recession. 2024 was a significant pivot year for the Fed following the most aggressive pace of rate hikes in modern history.
While expectations swung wildly throughout the year, the market was generally optimistic that rate cuts were on the way, providing a strong tailwind for risk assets. Looking back, rate cuts did begin in 2024, but at a slower pace than expected and in three distinct phases.
Phase 1: Peak Restrictive Policy (January-July 2024)
As we entered 2024, the Fed’s focus was squarely on bringing down inflation, with the Fed funds target rate at the highest, most restrictive point of this cycle. The economy remained surprisingly resilient during this period, defying many economists and market predictors calling for a recession in 2024 as the inevitable result of higher rates. Driven by surprising strength in consumer spending, the U.S. economy grew for most of the year at an annualized rate of close to 3% (nowhere near a recession), and the unemployment rate ticked up only modestly to 4% (still very low by historical standards) by June.1
Phase 2: Policy Recalibration (August-October 2024)
Encouraged by progress on inflation and with an eye on the cooling jobs market, the Fed shifted into the second phase of policy for 2024 – one which Chair Powell referred to as a “recalibration”. After holding short-term rates steady for over a year, the Fed reduced the target Fed funds rate by 0.50% at the September meeting. This shift and the messaging surrounding it spurred tremendous optimism in the market. The Fed was essentially signaling that we were on our way to the elusive “soft landing”, the ideal outcome of monetary policy that has rarely been achieved. Economic growth was solid, the labor market was still strong, and inflation was moving sustainably towards its 2% target. Stocks marched higher, and bond yields moved lower during this phase in anticipation of additional rate cuts.
Phase 3: Wait and See / Higher for Longer (November-December 2024)
The initial rate reduction in September was followed by two 0.25% cuts in November and December, for a total of 1.00% of easing in 2024. Closing out the year, the Fed started to shift its tone once again, dampening the markets’ optimism of rate cuts to come. The economy was still doing well, however, progress on inflation was stalling. The primary inflation readings moved sideways for the last several months of 2024, hovering around 2.7% year-over-year, while the Fed would like to see it continue trending lower towards 2%.2
Inflation in core services like dining and recreation, along with home and rent prices, have been frustratingly slow to come down. Although there were pockets of encouraging slowing, the bottom line is that inflation progress has stalled over the last few months. Adding to the uncertainty is the upcoming change in administration as President Elect Trump takes office in January. It is far from clear where the President Trump’s initial focus will be, but many of the policies proposed during the campaign trail are perceived to be inflationary, including pro-growth and pro-spending policies, tax cuts, tariffs, and a reduction in immigration. The potentially resulting inflation may be offset if the administration is successful in increasing governmental efficiency and reducing costs.
Looking Ahead
While the Fed has now reduced short term interest rates by 1% over the last three months, officials are signaling that the path of reduction will be slower moving forward due to the murky inflation outlook. At the final meeting of the year in mid-December, Chair Powell highlighted the uncertainty ahead using an analogy of walking through a dark room filled with furniture – “you just slow down”3. The Fed will have to see multiple months of improvement in inflation to feel confident about additional policy easing. Markets expect some additional rate cuts in 2025 as the yield curve continues to normalize, meaning short-term yields could move lower while longer-term yields could remain steady or move slightly higher.4 Currently, market participants are split between expecting one or two additional 0.25% rate cuts in 2025, which would bring the target Fed funds rate to approximately 4%.5
Inflation: The Unwelcome Guest Returns
Several factors point to potentially higher inflation in 2025:
Tight labor markets and wage pressures
Potential new tariffs under a second Trump administration
Rising commodity prices amid stronger global growth
De-globalization trends increasing supply chain costs
While unlikely to reach the 9% levels seen in 2022, we could see a return of inflation uncomfortably above the Fed's 2% target.
Fixed Income Implications
Bond investors face headwinds in 2025:
Continued economic strength in the U.S. keeping short rates higher for longer
Heavy Treasury issuance pressuring long-term yields
Term premium likely to remain elevated
Real yields potentially moving higher
These factors suggest another challenging year for traditional bond allocations, with the Bloomberg Aggregate Bond Index likely to deliver modest returns. For investors, we remain cautious about extending duration (interest rate sensitivity) and continue to view alternative and hedging strategies as attractive supplements to traditional fixed income.
Broader Economic Outlook
The U.S. economy is attempting to strike a delicate balance in 2025, with moderate growth, easing inflation, and a tight labor market shaping the narrative. The U.S. economy expanded in 2024, driven by resilient consumer spending and robust corporate investment in high-growth sectors such as artificial intelligence. However, challenges persist, including housing affordability, regional economic disparities, and the potential for global trade disruptions.
The U.S. economy is forecasted to grow by 2.0–2.5% in 2025,6 a slight deceleration from 2024 as the lagging effects of higher interest rates fully take hold. Forecasted growth is primarily supported by steady consumer spending, infrastructure investments, and technological innovation. However, the overall pace reflects normalization after the post-pandemic recovery boom. Global economic trends play a critical role in shaping U.S. growth. According to the International Monetary Fund (IMF), global GDP growth is projected at 3.0% in 2025, also reflecting slower growth in major economies such as China (4.5%) and the Eurozone (1.8%).
The U.S. labor market remains a bright spot, with the unemployment rate beginning 2025 at just 4.2%. While job creation slows from the rapid pace of prior years, the economy is expected to add an average of 150,000–200,000 jobs per month,7 focusing on high-demand industries. Real wage growth is expected to remain positive at 1–1.5%, supporting household purchasing power.8
The U.S. housing market remains a key area of concern, with affordability challenges persisting. Home prices are forecasted to rise by 2–4%, while mortgage rates remain elevated at 6.5–7%, deterring new buyers.9 New housing starts are expected to average 1.3 million units, up from 1.2 million in 2024, as builders respond to strong demand for affordable housing. Rental markets remain tight, with vacancy rates below 5% nationally.10
The federal budget deficit is projected to remain elevated at $2 trillion in 2025, driven by rising entitlement spending and interest payments on the national debt. However, targeted investments in infrastructure and clean energy may provide long-term economic benefits. For example, the Chips Act and Infrastructure Investment and Jobs Act (IIJA) are expected to contribute 0.3–0.5 percentage points to GDP growth in 2025.11 Furthermore, the initiatives under the IIJA will add an estimated $150 billion in direct spending in 2025, supporting construction jobs and potentially boosting productivity.12
The U.S. economy in 2025 reflects a story of resilience and adaptability. While challenges persist—ranging from global conflicts and policy uncertainties to housing affordability and stubborn inflation —we believe that the combination of steady growth, infrastructure investment, and robust labor markets positions the economy for another solid year.
Stock Market Outlook
After the remarkable rally of 2023-2024, driven largely by mega-cap tech stocks and AI enthusiasm, 2025 is shaping up to be a year of transitions and changing market leadership. The dominance of U.S. mega-cap tech has reached extraordinary levels. This has largely been justified by strong revenue and profitability growth, but we believe that at current valuations, the best performing stocks over the last couple of years are due for a breather.
According to Bloomberg data, the combined market value of the "Magnificent Seven" tech companies now exceeds $16.4 trillion - larger than the entire Stoxx 600 European stock market capitalization of $13.7 trillion. This concentration of market capitalization presents both opportunities and risks for investors in 2025.
Recent research from Bridgewater Associates highlights that many of the tailwinds that supported U.S. equity outperformance over the past decade - including globalization benefits, tax cuts, and massive fiscal support - may be shifting. The hurdle for continued outperformance is particularly high for tech stocks, which need sustained high earnings growth to justify current valuations.
Empirical Research Partners notes that momentum stocks are on a "barnstorming run," with the highest quintile of price momentum outperforming by a massive 23% over the past year. Historically, such extreme momentum typically moderates in the following year, suggesting more modest returns ahead for the previous market leadership.
A Broadening Recovery
The good news? Market participation appears to be broadening beyond mega-tech. The financial sector, particularly banks, has seen increasing momentum as yields have risen. This sector rotation could accelerate in 2025 if inflation proves stickier than expected. "The diversity of the momentum cohort has improved because tech's dominance has subsided," notes Empirical Research Partners. "Now it's the financials, and especially the banks, that are overrepresented in the momentum club."
We expect mid-cap and higher quality small cap stocks to outperform the mega-caps and favor the equal-weighted S&P 500 over the market cap-weighted version of the index.
Europe Reawakens?
European stocks have dramatically underperformed U.S. markets for a decade and a half.
However, several catalysts could drive better relative performance in 2025:
Attractive absolute valuations as well as relative to U.S. stocks
Potential benefit from higher commodity prices and lower representation of technology stocks
A weaker U.S. dollar could add a currency tailwind that has been absent for over a decade
Green shoots of structural political, economic, and capital markets reform could start to appear
Extremely pessimistic investor sentiment
Risks to Market Performance in 2025
Geopolitical shocks (Taiwan, Middle East)
Recession in the U.S. or globally
Policy mistakes (fiscal or monetary)
Systemic financial stress
AI disappointment leading to tech selloff
Recapping our Outlook
U.S. Equity Returns are positive but Moderate
Better Performance Outside the Mega-Caps
Fixed Income (especially longer duration) faces challenges
Inflation risks accelerating if growth plans are successful
Commodities provide an attractive hedge against inflation and geopolitical risk
U.S. Dollar Weakens
Europe Reawakens
After years of U.S. mega-cap tech dominance, 2025 could mark a transition toward broader market leadership. While overall returns may moderate, opportunities exist in previously unloved areas like dividend paying stocks, European stocks, commodities, and quality mid-small caps. The key will be maintaining flexibility and watching for signs that the anticipated rotation is actually materializing.
Thank you for allowing us the privilege to steward your wealth. We remain committed to providing you with thoughtful, data-driven insights as we navigate an ever-changing and exciting world of opportunities.
Sources
YCharts, Bloomberg, Goldman Sachs Global Investment Research, BofA Global Investment Strategy, Empirical Research Partners, Bridgewater Associates.
[1] Bloomberg
[2] JP Morgan Guide to the Markets as of December 11, 2024.
[4] As we wrote in our recent piece, What Is Driving The Bond Market?, the Fed sets the target rate which most directly impacts the short-term maturities of the Treasury curve, while market expectations related to inflation and the economy drive long-term rates.
[5] Bloomberg World Interest Rate Probability as of December 23, 2024
[7] Bureau of Labor Statistics
[8] https://www.wtwco.com/en-us/news/2024/07/employers-more-conservative-with-salary-budgets-as-employee-base-stabilizes
[11] https://www.cushmanwakefield.com/en/united-states/insights/infrastructure-investment-and-jobs-act?utm_source=chatgpt.com
[12] Congressional Budget Office
Important Disclosures
Past performance may not be representative of future results and all investments are subject to loss. Forecasts regarding the market or economy are subject to a wide range of possible outcomes. These views are as of the date listed on the material and are subject to change based on changes in fundamental economic or market-related data. Please note: ChatGPT was utilized in the efforts to create this article. ChatGPT is a widely available artificial intelligence tool. In this case, ChatGPT was used for the purposes of confirming research sources and structuring the article for drafting purposes. The actual written product is from our firm’s professionals. These materials are not intended as any form of substitute for individualized investment advice. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.
Comments