Disruptive Forces

Despite incessant political, geopolitical, and financial chatter, 2024 turned out to be another record-setting year on Wall Street. Buoyed by a resilient U.S. economy and more accommodative Federal Reserve, investors propelled the S&P 500 stock index to 57 record closes. Improved corporate earnings and a series of interest rate cuts further boosted market confidence.

For the second consecutive year, U.S. stocks delivered banner returns. As in 2023, the A.I.-powered “Magnificent Seven” (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla) led the charge. However, market strength broadened after mid-year as earnings improved across other sectors, prompting investors to tack into previously unloved areas. According to FactSet Research, analysts expect corporate earnings to continue to accelerate in 2025.

Phoenix rising

If the current soft-landing scenario endures, it would mark one of the rare occasions in the last 60 years that the Fed had raised rates to combat inflation without triggering a recession. Economists typically expect a “long and variable lag“ of 12 to 18 months before monetary policy shifts are felt. Yet, nearly three years since the Fed’s initial rate hike, like the mythical Phoenix, the U.S economy keeps regenerating and sustaining itself.

After growing 2.5% in 2022 and 2.9% in 2023, gross domestic product likely closed out 2024 at a 2.5%-3% pace. What the recessionistas missed: the unusually strong position of both corporate and consumer sectors heading into the Fed‘s tightening cycle.

The U.S. economy proved less sensitive to the Fed’s interest rate hikes this time, in part because borrowers had previously secured rock-bottom rates on much of their debt. Approximately 95% of U.S. home mortgages are fixed-rate, with the average borrower locked into a 4% rate, despite new loans being financed at 7%. Similarly, fixed-rate debt dominates most corporate borrowing, much of it refinanced during the pandemic. Net interest payments as a share of operating income has actually dropped as corporate America benefits from higher rates on cash and short-term investments.

Aggressive fiscal policy also provided crucial support. Pandemic-era relief bolstered consumer savings by over $2 trillion. While that windfall has been spent, household balance sheets remain in excellent shape. In addition, legislation like the CHIPS Act, the Inflation Reduction Act, and the Infrastructure Act spurred manufacturing and construction spending. So as the Fed applied monetary brakes, fiscal policy pressed the accelerator.

Pivot time

In September, the Fed pivoted towards easier monetary policy, culminating in rate cuts. In November, the American electorate also pivoted, ushering in a red sweep — a changing of the guard on Pennsylvania Avenue and narrow Republican majorities in both houses of the 119th Congress.

Equity markets initially rallied after election day, with investors embracing the pro-business and pro-growth aspects of the incoming administration’s agenda. In contrast, the bond market reacted with caution, focusing instead on the prospects for higher budget deficits and inflation. Since November 5th, the 10-year Treasury yield has risen by half a percentage point.

Clearly, the new regime’s overarching theme is the disruption of the status quo. While premature to really assess the potential economic and financial market impact of the policies of Trump 2.0, the election brought three primary areas into focus: immigration, tariffs, and taxes. The stated policy goals on those fronts involve curbs on immigration, higher tariffs on imported goods, and lower taxes for individuals and corporations.

Immigration: Finding the balance

Controlling the flow of undocumented immigrants has bedeviled one administration after another. However, over the last several years, migrants and asylum seekers have surged across the southern border. As of December 2023, the immigration court backlog had reached 3 million pending cases, up 1 million from 2022.

While most immigrants are likely law-abiding, simply searching for better opportunities, the influx has increasingly strained the social and financial resources of many state and local governments. In fact, the bond rating agency, S&P Global has warned that some cities could see their credit ratings downgraded due to budget pressures.

Rightly or wrongly, this surge of illegal immigrants has helped ease U.S. labor market tightness. And from a longer-term perspective, immigration will continue to be critical to augment our slow-growing domestic workforce and boost potential economic growth. But currently, the system is broken.

Tariffs: No free lunch

Trade policy remains fluid, but during his campaign Trump floated a blanket tariff of 10% to 20% on all U.S. imports with additional levies of up to 60% on Chinese goods. Taken at face value, Trump’s proposals would lift the average U.S. tariff rate to the highest level in over 100 years and above the levels from the 1930 Smoot-Hawley Tariff Act.

And to be clear, neither the Chinese government nor Chinese exporters, for example, would be on the hook for these tariffs. Rather, U.S. companies seeking to import goods from China would have to pay more (to the U.S. government) to bring them in. These higher prices will have to be absorbed somewhere along the supply chain. Higher tariffs also present risks to large U.S. exporters due to the prospect of retaliation from trading partners.

Trade wars create uncertainty, clouding the business outlook, so firms slow both capital spending and hiring. Although more limited in scope, the 2018-2019 trade spat under Trump 1.0 pressured economic activity and stock prices. The S&P 500 sold off by almost 20% in 2018, before recovering to close out that year with a 6% drop.

Perhaps much of the banter around trade policy is a negotiating tactic, aimed at squeezing out various concessions. Nevertheless, a new tariff regime seems likely this year for two reasons. First, the executive branch has the authority to unilaterally enact tariffs without any input from Congress. Second, potential federal government revenues from such tariffs would be meaningful and viewed by the administration and Congressional Republicans as a source of funds to partially offset tax cuts.

Fiscal Policy: Cut and spend

Under Trump, fiscal policy seems likely to become more expansive, leading to larger budget deficits, aggravating the national debt. Among other things, the president-elect proposes to extend the expiring Tax Cuts and Jobs Act (TCJA); exempt Social Security income, tips, and overtime pay from income taxes; lower the corporate tax rate to 15%; and restore the deduction for state and local taxes.

Even after assuming sizable revenue from broad-based tariffs, the non-partisan Committee for a Responsible Federal Budget estimates that the new administration’s tax and spending policies could add $7.75 trillion to the debt level over the next decade. Standing at nearly $36 trillion, federal debt has more than doubled over the last ten years.

Due to the combination of higher rates and larger debt levels, the government’s debt-servicing costs have skyrocketed. Net interest payments surged 34% in fiscal 2024 and actually exceeded defense spending. Currently, the U.S. government is spending $3 billion per day on interest expense or $1 trillion on an annual basis.

DOGE-ball

A new presidential advisory commission will be coming to the rescue. An Elon Musk brainchild, the Department of Government Efficiency (DOGE) aims to root out inefficiencies and cut government spending. While the cause certainly has merits, the group’s claims seem unrealistic. Musk initially signaled that his posse would identify $2 trillion of government spending to cut. By mid-January, he had backtracked to $1 trillion.

Either way, the math cannot be reconciled with political realities. Total government outlays totaled $6.8 trillion in 2024. Mandatory spending alone (including entitlements such as Social Security and Medicare) gobbled up almost all government revenues while accounting for more than 60% of expenditures. After taking interest payments and defense off the table, only $800 billion of outlays remain. How much wasteful non-defense discretionary spending is realistically available to slash?

Higher for longer

Trump’s policy initiatives should prove a key driver of financial markets this year as investors continue to debate whether their cumulative impact is likely to be inflationary or deflationary, a tailwind or headwind for growth. On balance, the admintstration‘s policies suggest a mixed outlook for growth with upward pressure on inflation and interest rates.

Ultimately, the 10-year Treasury will be the best financial barometer of the new administration’s policies. If the benefits from deregulation and tax cuts outweigh the inflationary impacts of tariffs, a shrinking labor supply, and widening budget deficits, the yield may well stay in the range of 4.5% to 5.0%. But if the 10-year yield rises meaningfully above 5% and remains there, the bond market will be signaling more inflation ahead, imperiling the economy.

Most investors entered 2025 in a bullish mood, embracing the view that disruptive forces will lead to positive outcomes. However, because current valuations are elevated, we anticipate greater volatility this year and potentially larger drawdowns than experienced in 2023 and 2024.

-Christopher J. Singleton, CFA, Managing Director

January 15, 2025