Balancing Caution and Optimism: Navigating 2025’s Market Dynamics
As we step into 2025, it’s time to revisit our expectations for the markets and provide an updated perspective for investors. Over the past several months, we’ve consistently highlighted the potential for the market to grind higher in the short term, driven by resilient consumer spending and accommodative fiscal policies. However, as we’ve seen the probability of some bearish events increase recently, we’ve become incrementally more cautious. While long-term opportunities still exist, the risks on the horizon warrant a more bearish tone than in prior updates.
Inflation remains a central concern, and as we’ve previously discussed, the disinflation narrative is showing cracks. December CPI data—while reported by some in the media as “low” for all items less food and energy—tells a more nuanced story. The 3-month annualized growth rate for all items less food and energy came in at 3.24%, indicating persistent inflationary pressures. Meanwhile, categories like energy services and utility gas showed sharp increases, with annualized rates of 4.47% and 10.19%, respectively. Energy overall has spiked during the winter months, as we anticipated earlier last year, driven by seasonal demand and global supply dynamics. Further, the headline number’s 3-month annualized growth rate was 3.65%, much higher than the Fed’s comfort zone. These figures underscore that inflationary pressures remain broad-based and are unlikely to dissipate without a significant recession. Structural factors such as persistent consumer spending and expansive government deficits further fuel this trend, creating an environment where risks are skewed to the downside.
The Federal Reserve’s stance will play a critical role in shaping market dynamics. While the Fed may not adopt an overtly hawkish posture, it is increasingly clear that rate cuts anticipated for late 2025 are less likely. Employment data will be critical in determining the Fed’s course of action. While we expect employment data to continue to moderate, if it does not, the Fed cannot stick its head in the sand with respect to firming inflation and will likely have to take a more hawkish tone. This tempered hawkishness, combined with a potential shift in Treasury financing policy—favoring bonds over bills—could strain liquidity, particularly in the first half of the year. If we see a spend-down, the rebuilding of the Treasury General Account (TGA) will likely absorb substantial liquidity, exacerbating pressures on global financial markets. As a result, we are growing more concerned about the potential for a market selloff early in the year, which could serve as a wake-up call for investors.
The incoming administration’s potential implementation of tariffs could prompt significant responses from trading partners, likely in the form of currency devaluations. These devaluations would strengthen the U.S. dollar, constraining global liquidity and creating tighter financial conditions. This stronger dollar, combined with a more hawkish Fed, could create a challenging environment for risk assets.
Despite these headwinds, there are reasons to believe the global and US economy will remain resilient. One key factor is the insulation of consumers from higher interest rates. A substantial portion of household debt, including mortgages, was locked in at historically low rates, providing a cushion against restrictive monetary policy. Additionally, unusually large pro-cyclical government deficits—now increasingly driven by the outsized interest on the national debt—are likely to inject further stimulus into the economy. If tax cuts materialize later in 2025, they could temporarily bolster consumer spending and economic activity.
