Tactical Allocation Viewpoints - January 2025

The Macro Picture

A pickup in uncertainty has overshadowed the start of 2025.  Really, it started shortly after the Federal Reserve’s 50 basis point rate cut in mid-September, when unemployment rates had started to show signs of softening and inflation was becoming less of a concern in the U.S.  As we kick off the new year, economic growth remains robust, employment seems to be gaining strength rather than softening, and interest rates have picked up significantly in recognition of ongoing inflationary pressures including anticipation of President Trump’s policies around tariffs, immigration and tax cuts.  Outside the U.S., consumers are more cautious as growth prospects in places like Europe and China, two of the leading economic blocks, remain challenged.  When lower interest rates were the expectation, there was a much stronger case to be made for all things ex U.S. Large Cap Growth stocks.  Heading into 2025, that thesis must be reconsidered.  What may have seemed like a mispriced opportunity four months ago may prove to be more accurately priced than anticipated – the tailwinds of lower inflation and lower interest rates have reversed course, therefore taming the outlook for U.S. Large Cap Value, Small Caps and Non-U.S. equities.  This still does not relieve the fact that the so-called “Magnificent 7” and other quality U.S. Large Cap Growth stocks are trading at very elevated levels.

United States.  The race between economic growth and government debt is too early and too complicated to call at this point but will be a central focus of investors as they forecast the future.  On the positive side, the new administration is likely to reduce regulation and make doing business domestically more attractive given potential tax cuts.  On the other hand, tariffs and immigration policies may lead to more inflationary pressures.  Earnings growth in 2025 is anticipated to be quite robust, based on analyst expectations, but there are many factors that could either further contribute to or detract from that outlook.  Depending on which way the wind blows, investors may seek to continue to ride the Growth momentum, or, in the case that inflation and interest rates drift lower, may seek opportunities in Value stocks or Small Caps.

While households and corporations remain on solid footing, it is possible that even a modest pullback in markets may weigh on the “Wealth Effect” that has supported high levels of consumer spending in the past year.  An equity market pullback or moderation in housing prices may cause consumers to slow spending, which could impact earnings in certain sectors.

On the corporate side, a lot rests on developments in Artificial Intelligence and whether productivity gains begin to accelerate in 2025 as businesses find ways to leverage AI.  This is where we may see upside surprises in 2025, although note that valuations in large tech companies seem to be pricing that expectation in to some extent.  Another possible contributor to economic growth in the U.S. would be a move towards deregulation, which could boost energy output and allow for more mergers and acquisitions.  The key question for investors today is which of those scenarios might happen and what is priced into markets already?

Europe and Asia.  According to the International Monetary Fund, the European economy is expected to produce about 1% Real GDP growth in 2025, quite a lethargic level.  European competitiveness continues to falter versus the rest of the world and with less demand from China for its goods, an economic uptick may be more dependent on policy changes.  China is dealing with its own challenges, and it too may require some policy changes to jumpstart its economy.  Growing talk of tariffs from many corners of the globe are likely to weigh on the Chinese exporting economy.  At the same time, domestic consumption is limited as households deal with weak housing prices and concerns about youth unemployment.  One thing that China has which Europe is lacking is a strong technology sector that can compete with U.S.-based companies in artificial intelligence, quantum computing, and other technologies.

Geopolitics may play a central role in the years ahead as anti-immigration sentiment and even a shake-up in global partnerships could change the trajectory of winners and losers in the global economy.  Winners in the technology race are likely to have an advantage and that alone may impact the world order.  From an investor’s perspective it should be noted that interest rates are lower, inflation is less of a problem, and valuations are near or even below fair value in many non-U.S. markets, suggesting that any positive developments in those regions could lead to healthy returns for investors.

Fixed Income.  The combination of sticky inflation and concerns about ongoing government deficits in the U.S. have driven interest rates higher in recent months.  Yields are more attractive today than they have been in many years for investment grade bonds.  Ironically, U.S. yields are some of the highest globally as many European (ex U.K.) and Asian market yields are well below U.S. levels.  Ongoing U.S. dollar strength and attractive yields may mean that foreigners are more willing to buy U.S. Treasuries and help to keep rates from going much higher.  The current market reaction to President Trump’s policy proposals suggests a concern that deficits will continue to grow, but how that compares to any offsetting spending cuts and the potential GDP growth rates remains to be seen.  Credit spreads remain quite tight as we enter 2025, likely because of robust earnings expectations.  Corporate earnings growth in 2025 will dictate how spreads evolve as the year progresses.

The Micro (Bottom-up) Picture

We continue to maintain a bias towards Value stocks in our U.S. Large Cap and Developed non-U.S. equity exposures as valuations and earnings expectations support higher expected returns.  As we highlighted in the introduction to this tactical memo, we are actively evaluating alternatives to equities, where concentration and valuation risks are persistent.  Our thesis is that we anticipate solid growth still ahead for the economy, but a high bar for equities in terms of earnings expectations creates worries of the repricing that could happen if companies fail to meet that bar.  As an alternative, credit-related investments may offer equity-like returns without the sensitivity to meeting a heightened earnings outlook.