2025 is expected to be an interesting year for financial markets. Stocks have had a great 2-year run, Trump 2.0 begins, global central banks are cutting interest rates, and the US economy remains resilient. Despite the positive momentum and tailwinds, 2025 is sure to bring some surprises, uncertainty and volatility, which will make it important to try to balance return opportunities and risk.
Here are five pressing questions that will help determine how financial markets will fare in 2025.
1. How will the Fed handle inflation in 2025?
The direction of inflation will continue to be a hot topic in 2025. Prices have fallen significantly in the last two years. However, the journey to 2% has stalled and will be bumpy and uncertain. The biggest question regarding monetary policy will be the Federal Reserve's (Fed's) inflation policy – will the Fed risk letting inflation rise above its 2% target while continuing its tapering cycle? of the norm? Or will the Fed risk slowing the economy by stopping its tapering cycle early in its bid to get inflation down to 2%? Also, the White House and the Republican-controlled Congress play a role in driving inflation.
If Trump is able to quickly implement his pro-growth policy initiatives of cutting taxes, implementing trade tariffs, reducing immigration and reducing government regulations, it will make the Fed's job to reach inflation more difficult. 2%. In addition to boosting economic growth, the policies are likely to raise interest rates.
Due to Trump's initiatives, a solid labor market and a relatively healthy consumer, I believe the economy will continue to remain resilient in 2025. Positive economic growth combined with additional inflationary pressures and fiscal spending will result in an early halt to rate cut policy by the Fed. After cutting interest rates a full percentage point from their peak, (at the time of this writing the Fed funds rate was cut to 4.25% – 4.50%), the Fed is forecasting two more 25 bps cuts in 2025 , which is a huge draw. from the Fed's previous forecast of four more cuts. The Fed is now projecting 2.5% inflation (PCE inflation) in 2025, which is much higher than most expected. I believe that the economy will remain stable and inflationary pressures will remain high due to the items listed above. The main risk is that inflation heats up again, so I believe the Fed will remain cautious and stop its rate-cutting cycle earlier than expected and will only cut rates, at most, twice as much in 2025.
2. Can stocks continue their streak of +20% returns in 2025?
Stocks have had a very strong 2-year run, and before the recent sell-off in December, the S&P 500 index was on top of producing a +60% cumulative return over 2 years, 2023 and 2024. If the index rises, a cumulative return of 2 -year of +60% is not out of the question and would mark only the fourth time since 1970 that the S&P 500 produced a +60% cumulative return over consecutive years (Figure 1).
The last time stocks produced this strong consecutive calendar year return was in the late 1990s, when the S&P 500 index posted five consecutive years of +20% returns (1995, 1996, 1997, 1998, 1999) (Figure 2 ).
Additionally, stocks tend to perform well during inauguration years, regardless of which party is in control. In fact, the S&P 500 index posted returns of over 20% over the last four years of its inauguration (2021, 2017, 2013 and 2009). Additionally, there have been 12 inaugurations since 1977, in which four of those inaugural years resulted in over 30% returns for the S&P 500 index (2013, 1997, 1989, 1985). The last time we had an inauguration for President-elect Donald Trump, the S&P 500 Index subsequently posted a return of +21.8% (2017) (Figure 3).
While history suggests that 2025 should be a good year for stocks, there are some reasons to dash expectations for another year of +20% returns. While Trump's pro-business policies may spur economic growth and result in higher capital prices; these policies may result in inflationary pressures such as rising wages and rising yields. These policies could also result in advancing the US federal debt above the current level of $36 trillion and raising interest rates.
The other major driver of equity performance is monetary policy. Equity performance during a rate cut cycle is mixed and largely depends on the health of the economy. Over the past five rate cut cycles, the average return for the S&P 500 index was slightly negative over the 12 months following the first rate cut (Figure 4). Meanwhile, stocks typically perform well during a non-recessionary rate-cutting cycle, while performing poorly during a recessionary downtrend cycle. The current decline in interest rates has been driven by falling inflation rather than a recession, which has been positive for stocks. However, an environment where rates fall further due to recessionary pressures, or if inflation begins to rise, stocks will be negatively impacted.
Pro-growth fiscal policies, accommodative monetary policies and expanded corporate income growth will be positive for stocks. However, stretched equity valuations, uncertainty around the implementation of fiscal policies, the potential for a Fed error, inflation and yield volatility will make it unlikely that stocks will achieve +20% returns for a third straight year. With that said, the biggest risk to stocks is a Fed misstep and changing messaging as it continues to fight inflation.
3. Who wins the fixed income draw war
2025 will offer opportunities for fixed income investors, however it will not be without some turbulence. Normalized interest rates, narrow spreads, attractive yields and a positively sloped yield curve will be positive for fixed income investors. However, interest rate risk will be the biggest risk to fixed income in 2025 and one that financial advisors must try and balance.
While credit risk and duration are the main drivers of bond performance, performance in 2025 will be driven by duration or interest rates. Bonds perform well during inauguration years and rate cut cycles; however, Trump's policies are likely to offset some of the tailwinds bond prices could gain from falling interest rates.
Despite expectations for a higher federal deficit and increased inflationary pressures due to the aforementioned policies under President Trump, I think 10-year Treasury yields will continue to be volatile but settle near 4%. Yield volatility will add to uncertainty and current forecasts from the Fed. However, the volatility will give investors an opportunity to capitalize on the duration. Most importantly, it will be important for financial advisors to be able to balance the ability to capitalize at lower rates while also protecting against the potential for economic and credit instability.
4. Will the gap between the “haves” and “have nots” narrow?
It is well reported that the technology sector has been a major contributor to the returns of the S&P 500. In fact, the information technology sector contributed 38% of the S&P 500's YTD return of 28.07% through November 29. More specifically, the magnificent 7 contributed 12.5% of the total return of 28.07%. The gap between the haves and have-nots was even more pronounced in 2023, when the information technology sector contributed over 55% to the S&P 500 index's 26.3% return (Source: S&P Global). This attribution of high performance has not hurt the overall market; however, market health and stability will benefit from an increase in market breadth and inclusion.
Markets expect S&P 500 corporate earnings to grow 15% in 2025, while forecasters expect strong earnings for tech mega-companies to slow some. Lower borrowing costs will benefit a wider range of companies and result in more capital spending benefiting the materials and industrials sectors. Finances should also get a boost from rising yield curves, deregulation and credit growth. This expansion in earnings, combined with stable economic fundamentals and accommodative monetary policy will help increase the breadth of the market leaders.
Finally, I expect value-oriented names to benefit from lower bond yields as income from dividend-paying value stocks becomes more attractive to income-seeking investors. While I believe stock market breadth will increase resulting in a more stable market, tech stocks, especially AI-focused names and mega-tech stocks will remain popular.
5. Should we worry about asset allocation in 2025?
Diversification is usually criticized during times of financial crisis, precisely when diversification is most needed, as all investors run for the exits. Diversification has also come under fire since the COVID pandemic, as stocks have outperformed bonds, growth over value and domestic over international. The big bond selloff in 2023 also resulted in the so-called “death” of the 60-40 portfolio.
Given the uncertainty of monetary policy and the potential for a Fed error, the red tide that is about to overwhelm Washington, and the backdrop of financial market normalization, I expect the benefits of asset allocation to win in 2025.
While some investors may be able to achieve their financial goals by overweighting winners like mega tech stocks or AI-related companies. It will be important for financial advisors to reassess their client's risk tolerances, objectives and goals in 2025. Building diversified asset allocations will help improve the probability that the client will achieve their goals in a way less agitated.
Asset allocation benefits will be maximized as interest rates rise on their way to settling at their neutral levels, equity gainers widen and asset class correlations return to their long-term averages (Figure 5). . Bonds will regain their important role as a diversifier of the investment portfolio and buffer against capital volatility. Increasing access to alternatives through SMAs, ETFs and gap funds will help make diversified asset allocations more accessible to retail investors, resulting in less turbulence during a very uncertain year.
In closing, 2025 is shaping up to be a very interesting year with a lot of uncertainty due to a new political landscape and monetary policy. Regardless of what your expectations or projections are, it's important to focus on asset allocation and your clients' long-term goals and objectives. While 2025 could end up being a solid year for investors, it's not the time to make big bets, but instead stay in line with your client's investment objectives.
Ryan Nauman is a Market Strategist at zephyr