17 Jan 2025
Markets had entered Q4 2024 on an optimistic note, focused on the prospect of continued economic growth and further rate cuts during 2025 across most major economies excluding Japan. Sentiment to global equity markets remains driven by the US and the Federal Reserve meeting of mid-December and caused investors to stop and think as Fed officials pulled back on projections of continued rapid cuts to interest rates this year. As a result, the consensus from the Fed dot chart showed only two, rather than four rate cuts next year and an increase in the terminal interest rate to 3.0%.
When investors looked at the output of the Fed meeting, one of the key factors to decide upon is whether this is just a one-off recalibration, for want of a better word, of 2025 rate expectations, or something which will be longer lasting in terms of the stickiness of inflation at current levels. The long-term terminal rate of interest of R* is a vital driver of equity market valuations which, unsurprisingly in the period post the meeting, saw a downward readjustment in valuation (PE) levels investors were prepared to pay. Looking into 2025, it is not just the Fed who will be monitoring incoming data closely and no doubt markets will react swiftly to economic data points, but in recent years have tended to at times wrongly extrapolate the most recently published numbers.
The American economy has outstripped European countries (except Ireland) in terms of economic growth since the start of the new Millennium. American society seems to embrace personal ambition, together with a willingness to innovate, and is a society that rewards and confers recognition on those who take a risk and does not stigmatise failure.
Multinational US businesses are building the world of tomorrow and continue to create new wealth. In Europe, there remains a high emphasis on regulation writing, which some controversially argue exacerbates wealth inequality and has helped fuel support for populist parties seen in elections in Italy, Germany, France, and the Netherlands. In the UK, the Reform Party seems to be developing as the coming force even before potential financing by Musk. The dynamism of American society has been reflected in the success of many of its leading companies, now global leaders, where scale and networking effects have helped preserve super normal profit margins which look extremely unlikely to mean revert in the future outside of regulative constraints. The lack of dynamism in European economic policy making suggests that, if tariffs are imposed by the Trump regime, it will be the region most vulnerable to a negative economic shock.
China
After the very sharp rally in China equities in the final two weeks of September and early part of October, unsurprisingly, there was a consolidation phase with markets drifting back awaiting more tangible evidence of fiscal measures to improve the economy and stabilise the property market. The delay in announcing more concrete stimulus measures might well be a desire by China to hold some stimulus measures back until the impact of Trump tariffs becomes clear. China continues to have financial fire power with the ability to raise the fiscal deficit to around 4% of GDP and issue more government bonds. Tier 1 cities have much less excess supply than lower Tier cities where problems may well persist for many years with the worst areas of excess supply in locations where prospects for jobs growth are poor. In China, consumption growth remains tepid, and signs of economic recovery are needed to deliver on forecast earnings numbers. The success story within the Chinese economy in recent years has been its export growth, although there are fears that this could weaken or even contract next year as a result of Trump tariffs.
China’s recent annual economic conference saw the government shift emphasis away from investing in technology and industry to supporting domestic demand, with party leaders speaking of the need for vigorous efforts to boost consumption and domestic demand, with funding provided by expanding the country’s budget deficit. While Xi has not given up on his longer-term economic and strategic objectives, there is a realisation that baseline economic growth is necessary to ensure this broader national rejuvenation agenda remains intact, with a need to deliver increased living standards as a trade-off for a lack of political freedoms, the CCPs traditional pact with the people. Details of measures are only likely to be released at China’s annual meeting of its rubber stamp parliament in March, by which time clarity on Trump’s tariff and economic policies is likely to have emerged.
China’s potential remains in that households have some of the world’s highest saving rate, partly due to the lack of healthcare and pension supports in later life. The country needs to make largescale commitments to these areas to give households the confidence to consume today rather than save for the future. Before a significant continuation of the Chinese market rally, investors will want to see promises of stimulus turned into concrete policy proposals which can underpin earnings projections for future years for Chinese corporates.
India
In contrast to China’s woes, India has enjoyed a strong run in its stock market over the past two years, as investors latched on to the strong economic growth narrative, while also looking for an alternative to China with India offering investors a large liquid and deep market. In recent months, some of the shine has come off Indian equities as a spate of weaker data and persistent inflation has caused some investors to question the economic fundamentals.
Many investors however continue to believe that this will be India’s decade, benefitting from an economic boom led by offshoring, manufacturing, green energy, and advanced digital infrastructure. India has undoubtedly seen a loss of momentum in its growth rate but some of the slowdown may relate to a post-election low in government spending and severe monsoon rains. The central bank has also prudently begun a crackdown on unsecured bank lending which has reduced the availability of easy credit and is best seen as a pre-emptive measure to prevent a credit bubble, rather than looking to prick an established one.
On the positive side, India is continuing to see signs of an investment cycle, with aggregate corporate demand for loans and capex growing. Steel and cement continue to see broadly positive trends, and, unlike many countries, demographics are positive with a population which is around 1.3bn and growing by 2% p.a. with as a result 25-30m people entering the workforce each year looking for jobs. The government is aware it needs to provide employment opportunities, and this has the potential to drive growth over the next five years.
Despite headline economic data showing a slowdown, fund managers visiting corporates on the ground report more confidence and optimism, with many businesses showing strong entrepreneurial qualities and increasingly a desire and ability to go global. Many Indian companies have been successful domestically in what is a large market and now have the vision and confidence to look overseas. Operating in a country with a large domestic market provides strong tailwinds and manufacturing in India remains very cost competitive against western multinationals. While bank restraint regarding unsecured lending has been viewed as a short-term negative, it will prevent a significant deterioration in credit quality, and the banking sector in India remains well placed with NPLs low. While India, like all economies, is potentially vulnerable to Trump tariffs, the country generally operates in areas which are politically insensitive rather than in tech hardware. India continues to have the potential to be one of the world’s best secular growth stories over the next decade due to the long-term growth potential of the Indian consumer, an under-penetration story in many industries/sectors, which should allow well run businesses to successfully compound high c.a.g.r. rates over many years. There are concerns about market valuations, but the depth of the market means there remain stock picking opportunities, especially for investors prepared to take a longer-term view on a market which has rarely looked cheap compared to its Asian or emerging market peers.
Latin America
The biggest disappointment for emerging markets in 2024 has been Latin America with most countries seeing their currencies fall significantly against the US$. Latin America is a region which has not delivered economic growth in recent years and investors are becoming evermore cautious on the prospects for this changing. Incomes are stagnating and the region is suffering from outward migration, with investors further concerned by the electoral success of the populist left in the region’s top five markets. As a result, Latin America has delivered the worst stock returns of any region this year. Latin America has fallen behind emerging peers in Asia and Eastern Europe when looking at per capita GDP growth and seems to be experiencing another lost decade. Nations which have either moved to or reinforced leftist governments in recent elections include Brazil, Mexico, Columbia, Chile and Peru where incomes remain around a quarter of that of the US on average and have gained no ground over the past 10 or even 50 years.
Deficits in countries such as Mexico and Brazil have increased significantly, hampering the fight against inflation which has resulted in rates being kept higher for longer. Shifting spending priorities from investment to social welfare and the increase in the minimum wage by 145% adjusted for inflation, while socially popular, has made Mexico less competitive and per capita GDP growth has fallen to around zero. Brazil has benefitted from a booming agricultural sector, but the high levels of social spending have resulted in a ballooning deficit, persistently high inflation and a rapidly depreciating currency, limiting scope for future interest rate cuts and Brazil has been forced to raise rates in 2024.
In contrast, the one economy which has not taken a leftist route in recent elections has been Argentina which has now seen a strong rebound in its currency post the election of right-wing reformist Javier Milei who has slashed bureaucracy and subsidies, fired civil servants, and turned a deficit into a surplus. Monthly inflation has fallen from 26% to below 4% and the stock market has now seen a strong revival.
Markets have entered 2025 with much higher levels of uncertainty than 12 months ago and a much wider range of outcomes are now possible. This is not a scenario to make firm forecasts or predictions. The election of a mercurial president whose pre-election economic promises outlined what can only be described as a huge economic experiment may or may not be implemented, with all that implies for financial markets and the real economy. A return to using tariffs as a major source of revenue would take economic policy back 100 years, but it is unclear whether this is merely a negotiating tactic to deal with issues such as immigration, opioid production, defence spending and trade deficits, or whether Trump really believes that trade allows other countries to rob from the US.
The Fed, in its latest SEP has not only become a little more concerned about the stickiness of inflation and the speed at which it will fall to its 2% target level, but Fed members have indicated a much wider range of possible outcomes.
US fiscal policy is likely to remain loose, which is a positive for growth for an economy already outperforming the rest of the developed world. This suggests the US currency will maintain its strength, and the interest rate gap with the rest of the developed world will either be maintained or widened. In this scenario, the Dollar is likely to stay strong or get even stronger, and this is not a positive backdrop for emerging market assets. For the US, tighter than expected monetary policy could be outweighed by the positive support to growth from loose fiscal policy together with tax cuts and deregulation, and while it is likely that markets will be more volatile and give investors a bumpier ride, with continued strong earnings growth and no obvious catalyst for a significant market de-rating, on balance, the US is likely to deliver gains to investors next year.
The impact of Trump tariffs is extremely hard to predict in terms of how many nations will be targeted. China is now a much less significant exporter to the US than before the first Trump trade wars started in 2018, and economies such as Mexico and Vietnam are much more exposed to a negative impact from across-the-board tariffs than China as major exporters to the US. For those who believe global trade has lifted all boats, the anti-globalisation agenda seen across many countries, not just the US, will pose concerns. Both politics and geopolitics will continue to wield much higher influence on markets than was the case a decade ago. Events in France and Germany have led some investors to wonder whether these countries are becoming ungovernable with both nations seeing a rise of far-right populism. Geopolitical tensions remain, namely the Middle East post the revolution in Syria, Israel’s measures against Iranian proxy allies, the potential or not for a resolution of the conflict in Ukraine and China’s policies, not just towards Taiwan but across the whole of the South China Seas.
Equity markets have also seen extreme levels of concentration, and in the US, a number of small cap rallies, including in the aftermath of Trump’s election, have proved to be a false dawn, and the returns of the Magnificent Seven significantly outstripped the other 493 members of the S&P 500 during 2024 as they had in 2023 although for different stock specific reasons in the case of Tesla. The AI theme has benefitted some other names outside of the Magnificent Seven, including Broadcom and Palantir which both saw huge gains in the fourth quarter.
Going into next year investors can feel more relaxed about the possibility of a recession during 2025 with fears of banking blow ups at the US regional level dissipating. Commercial real estate, while producing sluggish returns, no longer seems in crisis, and markets have shrugged off the effects of quantitative tightening. In 2024, US markets saw returns driven by both low double-digit earnings growth and further multiple expansion with corporate margins remaining strong (plus a small element from dividends). While it will be hard for margins to improve much further, there seems little reason to expect a marked deterioration in profitability at US corporates with revenue growth remaining positive. Markets are trading on relatively high valuations, especially in the US, but this alone is rarely a trigger for a significant market correction or a guide to returns over the next 12 months.
The US benchmark index, the S&P 500 continues to be dominated by businesses in the technology sector boosted by AI spending with, as a result, earnings growth which should continue to impress. Even as the likely re-rating story comes to an end, partly due to the change of policy stance towards rapid rate cuts by the Fed, positive earnings growth should ensure support for the market. Outside of the US, the European economies, especially at the core, look more vulnerable to weaker than expected economic numbers and there remains a continued threat of further pressure from competitively priced China exports now having to be diverted from the US. Europe’s manufacturing sector does not look flexible or dynamic enough to respond to the threats from China and the region continues to see downside risks to its economic prospects.
China itself is suffering from the long, drawn-out effects of the bursting of a property bubble, which history suggests always takes many years to work through. Like most economies, suffering from a slump in its property market, the major excess inventory in China remains in lower Tier cities where economic growth and employment prospects are less strong.
China remains better placed than other emerging market economies to further stimulate growth and does have firepower to respond to Trump tariffs if imposed. Its competitiveness in high quality, high value add manufacturing is demonstrated by the strength of its exports, so growth in China looks unlikely to collapse. Even after the late September/early October rally, valuations, if earnings estimates are met, do not look stretched, although investors will wait for further clarification of economic support measures which are only likely to be forthcoming at the meeting of the Chinese Parliament in March when the authorities will have had a chance to view Trump’s policies in action.
Markets have had some level of reset following the Fed meeting, but if rates are likely to continue, on a downward trend, even if at a slower rate, there should remain a broadly positive backdrop for financial assets at a time when short-term recession fears have in the main dissipated. The mercurial nature of the US President and the possibility of policy shocks, negative and positive, (including a swift resolution to the war in Ukraine) means volatility is likely to be higher than last year in both directions. Overall, the prospects for bond markets are more muted than for equities and credit spreads have shrunk to extremely tight levels, meaning spread tightening is unlikely to be a driver of investor returns. The yield pickup from high yield bonds has also shrunk and this sector would be extremely vulnerable to an economic downturn if it did occur. The impact of Maximum Trump if it occurred quickly would be a shock to financial markets and likely result in a sharp setback. The consensus view is that the ‘adults in the room’ in the Trump administration will want to avoid disorderly chaos in financial markets although a policy of escalate to de-escalate does seem a preferred course of action by incoming Treasury Secretary Scott Bessent.
At a time of significant policy uncertainty and market noise, investors need to try to step back from emotion and focus on the three key drivers of returns. The first of these is fundamentals where the US economy appears better placed than other developed countries, suggesting US exceptionalism, certainly in terms of relative growth rates, will continue. This argues both for a strong Dollar and a generally supportive background for earnings growth globally as many non-US multinationals will benefit from a stronger US currency when reporting earnings. The economy in China appears to have bottomed and this also places a floor under global economic growth. Uncertainties over economic policies of the new Trump administration could see strong market reaction to policy announcement, but even these when they come may have uncertain economic implications. Some economists argue tariffs would have a greater impact on economic growth (negative) than their expected impact on inflation (especially in the US). Valuations alone, while looking somewhat stretched in the US, are not typically a catalyst for a significant market correction and the gap between the US and the rest of the world in part reflects the stronger economic fundamentals of the US economy and the high degree of innovation in the economy which are likely to be further boosted by Trump’s ‘America First’ agenda and deregulation. If tariffs did hit global economic growth, the US market would likely suffer less than other regions such as Europe. Cheaper markets such as China and the UK have the potential to react positively if news turns out to be less bad (rather than necessarily good) than investors currently fear, with current expectations muted and these markets remain under owned.
Turning to investor sentiment, indicators here do not display the typical exuberance of a bubble. The American Association of Individual Investors survey is high but not at a peak and has moved sideways for the past 12 months. On the other hand, the Conference Board’s Consumer Confidence Survey sees respondents optimistic that stocks will continue to rise. Overall, investor sentiment levels do not signify excessive bullishness on markets.
Investors need to make some assumptions about Trump policies as an immediate move to maximum tariffs with no scope for negotiations would provide a shock to the global economy estimated of at least a 2% reduction in economic growth over the next couple of years, but this is not the central case scenario as most senior members of the incoming administration recognise disorderly markets would not be helpful to the long term strategy of ‘Making America Great Again’. Policies will transfer growth from other regions to the US and the currency markets have quickly recognised this. Tariffs, if imposed, are likely to be less inflationary than originally feared in the US due to the strength of the Dollar. Prospects for US equities look positive, supported by strong company earnings, although the gains of last year look unlikely to be repeated as further multiple expansion at a time when rapid rate cuts are off the table looks improbable. The Fed, faced with uncertainty, is likely to proceed with caution.
European equities are trading at a significant valuation discount to the US but have less earnings certainty outside of businesses benefitting from a stronger US$. Political uncertainty in Germany and France will continue to make domestic economic recovery slow, although the German market benefited from leading components of the Dax not being reliant on domestic growth to outperform most other European markets. Gains were driven by software giant SAP, defence stock Rheinmetall, industrial conglomerate Siemens, Siemens Energy, Deutsche Telecom, and insurers Allianz and Munich Re. A positive for European markets, though not the currency, is the scope for rate cuts (consensus view four) with the ECB more confident about hitting its 2% inflation target in 2025 than most central banks.
Within emerging markets, the positive long-term story for India remains intact and while valuations appear expensive in the short-term, this is a market which has rarely traded on cheap valuations in the past decade due to the strong growth runway. Economic recovery in China is likely to remain a longer-term story with the likelihood of a rapid rebound in growth constrained by the deflationary effects of the unwinding of a property bubble. However, valuations remain modest, and many companies have strong entrepreneurial management, are extremely cost competitive, innovative and ambitious. If clearly defined proposals to support the consumer to emerge, there remains scope for another sharp move upwards. Within the Asean region, Indonesia remains a strong, longer-term story with favourable demographics and strong natural resources. Latin America continues to suffer from self-inflicted problems and will need policy changes to deliver on the regions potential. Mexico awaits Trump’s moves on tariffs, while Brazil needs to rectify its poor fiscal position to see confidence return to its currency and allow rates to be cut from extremely high real (post inflation) levels. A strong US$ and higher Treasury yields have proved a headwind to the region in the past and Trump policies have not helped prospects for recovery in the developing world’s stock markets, although valuations to a large part now reflect this.
Trump’s proclaimed attitude to immigration and tariffs with their influence on interest rates are not bond market friendly and the fiscal deficit, unless Musk and DOGE enjoy unexpected success, looks likely to grow further. This is unlikely to promote a crisis in the short term, especially if US growth remains resilient, but has the potential to be an issue further down the line. Credit spreads have tightened to such a degree that they offer little value to investors. Investors will need to watch if the so-called bond vigilantes force up 10-year Treasury yields, although this is less likely if the views of Bessant prevail.
For longer-term investors, risk assets such as equities remain the best home for those wishing to grow long-term wealth above the rate of inflation, providing there is an acceptance that markets do not move up in a straight line for ever. In the short term, the markets view of Trump policies post inauguration will drive returns in the first quarter and the Fed reset on rates means a further upward rerating in equity markets looks unlikely in 2025 and it will be down to corporate earnings to drive returns. Significant policy moves would require investors to react rapidly and be prepared to be more dynamic in their approach, with recognition that this is never easy to achieve in practice. With the Fed still in a rate cutting cycle, albeit a more muted one, equities still have the potential to deliver positive returns in 2025 although it is likely to be at times a bumpy ride.
Graham O’Neill, Investment Consultant
RSMR provides impartial, qualitative, forward-looking research for advice businesses.
Click here to head to the RSMR blog for market updates and a whole host of informative, up-to-the-minute content.
Click here to sign up to RSMR research where you can access RSMR fund ratings, fund profiles, factsheets, insights, market updates and event information.
This information is for UK Professional Advisers only and should not be given to retail clients.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Rayner Spencer Mills Research Limited is a limited company registered in England and Wales under Company Registration Number 5227656. Registered office: Number 20, Ryefield Business Park, Belton Road, Silsden, BD20 0EE. RSMR is a registered trademark.