What’s in store for 2025?
The natural place to start is to extrapolate some of the 2024 trends. Growth will be steady, maybe slowing a little, but there will be some modest rate relief in the US and Australia. Trump’s policy agenda probably means continued growth in the US, most likely at the expense of other markets. The consensus would seem to be for modest, high single digit returns from equities, some rotation into cheaper assets including mid/small caps while the view on Europe is more cautious given political instability and slower growth. Each year there are new developments, some we have already pondered but have not been seriously priced in, some that are unintended consequences of recent policy changes and events, while others are external shocks which by definition, are difficult to predict.
At the risk of oversimplifying the challenges for investors, there are three big questions.
- Will growth remain in the reasonable range?
- Will inflation reach, and sustain, an acceptable 2-2.5% range in the US, 2.5-3.25% in Australia?
- Are investors paying the appropriate price?
Growth and inflation expectations
My inclination, and our reading of the data and policy positions, is to say yes to the first two questions, although of course there are risks around these. After halving from early 2022, core US inflation has been stuck at 3.3% for the past four months. This raises the possibility that economic growth could remain resilient, delaying inflation’s return to the central bank's target range. In such a scenario, central banks may pause rate cuts or even hike rates again. We currently assign a 20–25% probability to this outcome. If this happens, it would undermine the “goldilocks” narrative, but how damaging would it be? The impact relates to the third question, the appropriate valuation. For assets priced finely for perfection relative to bond yields, it would create headwinds but for many equities, a bit of inflation is acceptable. This scenario probably changes the types of equities held rather than the overall exposure. Steady cash rates could be absorbed but a return to tightening would be a different story.
Let’s talk about recession risk
Does the risk of recession remain? It’s still a plausible scenario but most likely requires several compounding factors to materialise. These include a trade war disrupting economic activity, a slow policy response from the Fed prioritising inflation control over economic growth, while China refrains from large stimulus given the authorities focus on high debt levels.
What hidden risks could surface in 2025?
One potential risk area is that the margin expansion and earnings growth that has underpinned strong Return on Equity and elevated Price to Earnings multiples for US large cap stocks, come under pressure. A significant slowdown in earnings growth from current elevated levels could see these stocks, and the overall market, de-rated.
Of course, the election of Donald Trump brings a significantly different policy agenda and although this has been partially factored into markets already, what if he actually followed through with his full tariff agenda? Both growth and inflation could be worse off, undermining equity markets. Most observers, however, believe that this worst-case scenario is a low probability and that tariffs will be part of a protracted negotiation process, and will be watered down, possibly reflecting the influence of Trump’s appointment of the more “balanced” Scott Bessent, as Treasury Secretary.
If US inflation remains persistent because of solid growth and tariff related CPI increases, and the USD keeps rising, we should expect tensions between the President, who prefers a weaker USD, and the Fed’s Jay Powell, to rise. This could be an ongoing issue in 2025 but as long as Fed independence is not undermined, any damage to market confidence is likely to be contained.
China moves to defence tactics for growth
China may be too slow in coming to the rescue of its ailing household and property sector. With tariffs imposed by the US, China could respond in several ways, by unleashing a substantial fiscal stimulus, by shutting off exports of some critical minerals, or by currency devaluation, all with different implications for markets. But it seems to us that China is now serious about protecting the downside to its economy and is acting accordingly, a positive for markets.
Geopolitical impacts
Middle East tensions are elevated, the situation is fluid and could take another turn for the worse but surprisingly, oil prices have been remarkably stable. The Ukraine-Russia war continues and while Trump has stated he will resolve the conflict, it’s not clear what the implications would be for Ukraine, Europe and NATO.
What about upside surprise?
There are signs that investment spending is lifting and, in the US at least, productivity has improved. Rising productivity would help square off the often-conflicting goals of strong growth and low or anchored inflation, allowing bond yields to remain relatively low and for equities to rise with solid earnings. Indeed, markets are perhaps reflecting this possibility already.
What about our homebase outlook?
For Australia, it’s a little more challenging. We have an election by May 2025, and while our elections often seem less impactful for our markets than US elections, we feel there is more to it this time. Will a more populist agenda win, will the fiscal lever continue to be pulled and what does that mean for the RBA? Have we seen the floor in growth? We think so, particularly if the RBA is allowed to ease a couple of times in 2025. The economy will probably be better, but not great.
Bringing it back to our portfolios
From an asset allocators perspective and in trying to build robust portfolios, one of the keys is understanding the diversification benefits of bonds. We believe the relationship between bonds and equities has changed and, in this environment, bonds can’t always be relied upon to provide the diversification they have in the past 20 years. Investors require a “third bucket” to complement the growth drivers and the recession hedges, and this bucket is built on inflation hedges and assets tied to growth in nominal GDP. This will be a major theme in our upcoming SAA review.
2025 shapes up to be another interesting and challenging year for investors but sorting the noise from the trends, or the trees from forest will be, as always, the key.