Looking Ahead 2025

Prediction is very difficult, especially if it’s about the future.
Neils Bohr, Danish physicist,(1885-1962).

Question: What are your thoughts for financial markets and the year ahead?

Answer: As we enter 2025 it’s worth noting during the past two years, financial markets have performed impressively. Making predictions is a dangerous endeavor, especially with a new administration on deck adding to uncertainty.

There’s optimism in the air bringing hopes for favorable government policies and solid earnings growth. Business, investor, and consumer confidence are all up after the election. Ultimately, the timing and extent of new polices that will impact the economy.

After the strength we’ve experienced in equity markets, it's time for corporate earnings to catch up and support the price appreciation. Support may be found with strong job growth, a resilient labor market, and business friendly policies expected to support growth. In addition, household balance sheets are relatively strong supported by lower interest rates and wage growth. Consumer and government spending are healthy, and expenditures on artificial intelligence (AI) continue to grow.

The Federal Reserve has hinted at two rate cuts in 2025. If growth slows, the Fed could possibly reduce rates to support growth. Expect the US to have stronger growth than other economies based on demographics and productivity. Deregulation and tax cuts are two additional forces that could add to growth.

One risk is the potential inflationary impact of tariffs. President elect Trump is known for his Art of the Deal Negotiation style for shock value to gain attention and start discussions for compromises. With tariffs, Trump has already bartered down penalties for those willing to bring production and manufacturing back to the US from overseas.

If we experience tariff driven inflation, interest rates potentially could be driven higher to slow inflation. Something that may counterbalance any tariff driven inflation is the having DOGE (Department of Government Efficiency) at the ready to cut excess government spending. Rates could possibly come down if there is increased market volatility and moderate to low growth. Longer-term interest rates are expected to remain range-bound the rest of the year with the 10-year Treasury yield in the 4.50% area.

Earnings growth has driven much of the market activity these past two years; but has price appreciation overtaken fundamental valuations? Earnings growth needs to continue to justify valuations. Select stock prices are expected to rise, albeit at a slower pace, as company’s earnings continue to grow and catch up to current prices.

Market Cap

Company market capitalization is divided into three categories: small ($300 million to $2 billion), medium ($2-10 billion), and large $10 billion and above).Large-caps have dominated these past two years, Small-caps recently improved benefitting from Fed interest rate cuts. Overlooked mid-caps are positioned to outperform. Mid-caps benefit from economic strength and are somewhat insulated from tariff exposure. This is true because mid-caps receive 76% of their revenue inside the US compared to 59% for large caps. Mid-caps are trading at nearly the largest discount to large caps in the last 20 years.

The financing structure for mid-caps is more favorable than that for small caps that hold 53% of their debt in floating rate instruments versus 41% for mid-cap debt meaning small caps may not enjoy the same benefits from lower interest rates. Also, mid-cap companies tend to report more stable earnings with less volatility. Lastly, mid-caps have great exposure to Technology and Industrial names. Mid-caps just might be the sweet spot for 2025 balancing growth potential and attractive valuations. Large caps maintain their position in portfolios with outlooks for a broadening in market cap participation.

Sectors

Now on to sectors and the basics of earning potential. Macroeconomics tells us to focus on earnings potential. Focus this year is on Technology, Health Care, and Industrials.

With AI expansion, Technology leads with innovation, and continuous corporate investment. Health Care is a sleeping giant with earnings power growth based on demographic trends and needs. Industrials are the steady-eddies, reliable names that benefit from continued government spending, the reindustrialization of the US, AI buildout, and the re-electrification of our power system. According to Goldman Sachs, a Chat GPT (AI) search uses up to ten times as much energy as a common Google search.