For all the concern about a recession in 2024, the U.S. economy proved robust and will enter 2025 in generally good health, boasting a 2.8% gross domestic product (GDP) for the third quarter of 2024 accompanied with recent economic data that has exceeded expectations.

Looking ahead, there are good reasons to believe robust growth can continue. Interest rates are likely to fall further over time, and we are encouraged by rising productivity insofar as it can be a significant contributor to long-term economic growth.¹ Furthermore, the vast resources companies have poured into developing artificial intelligence (AI) applications could boost productivity further, possibly creating a noticeable impact as early as next year. And while many of incoming President Donald Trump’s economic policies are yet to be clarified, his election and the Republican Party’s newfound control of Congress is widely viewed by markets to be positive for economic growth.

To be sure, economic data occasionally flashed warning signs throughout 2024, and still does. Also, the incoming administration comes with a great deal of policy uncertainty that could significantly impact inflation and thus interest rates. A more protectionist trade policy is likely to be inflationary as tariffs are implemented, while Trump’s immigration policies have the potential to shock the labor market. For example, a sudden drop in the supply of labor could both slow the economy and put upward pressure on wages, risking higher inflation and slower cuts to interest rates.

But our base remains that the U.S. economy is sufficiently robust and diversified to withstand uncertainty and can, with time and a little help from the U.S. Federal Reserve (Fed) if needed, adapt to even dramatic policy changes. As such, we expect financial markets in 2025 are more likely to be volatile but ultimately positive, then to see a sustained reversal in stocks or a surge in bond yields.

Has the U.S. economy become recession resistant?

Recessions in the U.S. have become increasingly less frequent and more moderate. The short-lived dip from the 2020 global pandemic aside, the last time the U.S. had a recession was more than 15 years ago, following the 2008 Global Financial Crisis (GFC). In the last 40 years, the U.S. has only had three recessions, and only one of those (the post-GFC recession) lasted more than a year. Compared to the prior 40-year period, when there were eight recessions, the declining volatility in the business cycle is remarkable.²

The causes of this evolution are neither obvious nor a complete mystery. First, the Fed has become increasingly more willing to support the economy in times of weakness through lower interest rates and, more recently, through quantitative easing (directly injecting cash through the purchase of bonds). Additionally, central bank policy has matured significantly as financial markets have become more sophisticated and technology has improved the availability and analysis of economic data. While it can be difficult to imagine a time before real-time data and the personal computer, it wasn’t that long ago. For example, Federal Reserve historian Alan Meltzer noted in his paper that in the 1960s and 1970s, the Fed “made no effort to clarify such basic issues such as the causes of inflation” while “several of its members doubted it was worth the effort.”³

A structural decline in inflation from its dizzying heights in the 1980s also helped stabilize the business cycle by relieving pressure on the Fed to consistently “over-tighten,” intentionally or accidentally causing a recession in its multi-decade effort to drive inflation back down to more normal levels. Additionally, there has been a steady transition in the labor market from manufacturing to health care and education—two sectors which tend to grow more consistently across the business cycle—as well as shift from private to public sector jobs, which tend to be less cyclical.  

While other factors have surely played a role, the U.S. economy has become less volatile, and recessions have become rarer. While we are not suggesting this is a permanent shift or that the U.S. is now immune to a recession—particularly from exogenous shocks—an increasing resistance to recession may help explain why so many predictions for a recession in 2024 were wrong.

Our guardedly optimistic outlook for stocks

The primary drivers of the S&P 500^® Index’s gains in 2024 were the very large mega-cap stocks. There is little debate these stocks are now expensive as their price-to-earnings (PE) ratios are well above their long-term averages. However, valuation looks more reasonable when looking at the enormous amount of cash they generate. While rich valuations may signal justifiable caution for longer-term returns, it does not mean they cannot rally further into 2025. Valuations can stay expensive and get more expensive without implying that a price correction is imminent. However, we do think these companies and others investing in AI need to show a continued path to higher earnings, specifically the monetization of their enormous capital expenditures in AI. 

In our view, stocks more broadly can rally further in 2025 as long as we see a cyclical upturn in economic growth. Alternatively, continued gains in productivity (such as from AI) could also fuel earnings growth, as could efficiency or productivity gains from the new administration’s regulatory, trade or tax policies. Management in financial and industrial sectors already have started to believe policy changes can increase earnings, while small business sentiment has picked up in hopes of lower taxes and de-regulation. But we do believe the market—broadly speaking—will need to see or reasonably expect higher earnings growth to justify further gains.

While we remain optimistic, we maintain a more cautious stance and expect periods of high volatility. A healthy correction, even in the near term, cannot be ruled out. The S&P 500 Index has risen steadily since October 2023, without a significant or lasting correction, and forecasters are nearly unanimous in their optimism for 2025. With all this enthusiasm, markets could be easily disappointed.  

Bottom line: Remain moderately overweight large- and mid-cap stocks, neutral small-cap stocks

The insistent importance of inflation

The Fed has been very successful in bringing inflation closer to its target level, driving the Consumer Price Index (CPI) down from its high near 9% to 2.6% and the Core Personal Consumption (PCE) Price Index down to 2.8% as of the latest data available in early December. But both measures remain above the Fed’s long-term average target of 2%, and the most recent data suggests the downward trend in inflation could be stalling. Service price inflation, in particular, has been notably sticky as demand for services remains strong in areas like air travel and dining, while the estimated cost of home ownership remains high.

More recently, inflation expectations have risen on expectations of stronger growth and potentially inflationary policies from the incoming administration. While we agree the new government will enact more pro-growth policies, and some of the stated goals are likely to be inflationary, there is a high level of uncertainty around which policies will become law, and how different their final form may be from their recent pronouncements.

The bond market’s reaction to higher inflation expectations has been to price in fewer interest rate cuts in the year ahead. While we agree there will likely be less need for lower interest rates, we also believe the Fed would like to return rates to a more “neutral” (neither stimulative nor restrictive) level estimated around 3.5%, as the data allows. Like the rest of us, the Fed will probably need more clarity on the new administration’s economic policies and will closely monitor the path of reported inflation. But we have little doubt that inflation data is likely to be less encouraging than it has been if only because history shows us the last final mile is the hardest to complete.

Bottom line: We expect inflation will remain contained, if a bit higher than the Fed’s target rate, but the risk is clearly to higher inflation. The Fed will continue cutting rates, but slowly and moderately.

The implications for bonds

Stronger growth and a risk of higher inflation is not an ideal environment for bonds. But, shorter-dated Treasuries should follow the Fed funds rate lower, and we expect longer-dated Treasuries are likely to remain within a range. Worrying inflation data, inflationary policies or higher budget deficits (requiring increased borrowing and thus greater Treasury supply) will push yields higher, while the attractiveness of high yields will encourage more demand. In 2024, benchmark 10-year Treasuries traded in a range just over 100 basis points (reaching a high of 4.71% and a low of 3.62%), and we currently expect 2025 will see a somewhat narrower and higher range.

We continue to see current yields—between 4% and 4.5% for bond maturities between 2 and 30 years—as attractive for long-term, buy-and-hold strategies. Furthermore, given the propensity of Treasury bonds to rally (for yields to fall and prices to rise) when equity markets receive a negative shock, their value as a diversifying asset in uncertain times should not be underestimated.

The credit markets, which includes corporate bonds, municipal bonds, mortgages and other asset-backed securities, are generally trading at rich valuations (aka spreads—the extra yield offered above similar maturity Treasury bonds). But given our generally positive outlook for the economy in 2025, and credit’s attractive absolute yields, we find it difficult to justify underweighting these markets.

Despite their tight spreads, investment-grade corporate bond yields are significantly higher than they have been over most of the last 15 years, while corporate balance sheets are generally healthy and should improve with economic growth. In the municipal bond market, high-quality credits offer tax-free yields in the 5-6% range, which we believe are compelling even if tax rates fall in the years ahead. Finally, securitized credit, such as residential mortgages or collateralized loan obligations (CLOs) offer similarly compelling yields, with A-rated CLOs currently offering yields around 2.0% above cash rates.

Bottom line: Another year of volatility in Treasuries, but their attractive yields and diversification value keep them a core holding in a diversified portfolio. Modestly overweight credit risk, favoring high-quality corporates and securitized products.

What are the biggest risks?

The health of the U.S. consumer: Consumption comprises around two-thirds of GDP and thus is a critical factor for any growth forecast. Consumer spending has been resilient, supporting by a relatively strong jobs market. But it has also been bifurcated, with the upper income segments spending strongly on services, travel and experience, while the lower income segment is more stretched. A September Gallop poll⁴ showed 52% of Americans felt their finances were worse than four years ago, and the Conference Board’s Consumer Confidence Index^® (CCI) in November confirmed that consumers “overwhelmingly selected higher prices as their top concern.”⁵ As such, high prices of goods and services are still a headwind for the aggregate consumer, and should inflation tick up, the headwind will get stronger. While employment (a necessary condition for healthy consumption) has recently softened, the economy is adding jobs and the unemployment rate remains relatively low.

Bottom line, we don’t see a lot of risk that consumption will falter significantly. However, given that there is some risk (particularly in the lower-income segments of the population), and its importance to growth should not be underestimated, we are keeping a close eye on consumption trends.

Inflation: If inflation falls faster than expected it could be a substantial boon to both stocks and bonds. But if it rises significantly higher than current expectations, it could derail both stocks and bonds as interest rates would rise. We believe inflation will remain contained, but stronger growth and more stimulative fiscal policies—both of which are likely—have the potential to reverse the hard-fought decline in inflation and create more macroeconomic uncertainty.

Geopolitics: There remains a great deal of uncertainty in the Ukraine/Russia conflict and in the Middle East, while a new U.S. administration is likely to pursue new or as yet unknown foreign policy goals, creating further uncertainty as we enter 2025. On the one hand, the Trump administration seems likely to pursue a negotiated settlement between Ukraine and Russia, but it also has indicated its intent to increase pressure on Iran and be more aggressive with China. And in areas the U.S. is less involved in, such as the stability of the French government or an attempt at martial law in South Korea, uncertainty has been rising. While we do not expect any of these situations to have significant and lasting effects on U.S. financial markets, they warrant careful monitoring.

Bottom line: Watch consumption and inflation closely and be mindful that geopolitical surprises could have a sudden (though likely temporary) impact on markets.

Stay (cautiously) invested

While there are many potential headwinds, we expect 2025 will confirm that the economy had a soft landing in 2024 and should see sustained and possibly accelerating growth in the year ahead. There are risks to this view, foremost of which is the lack of clarity about the incoming administration’s domestic and foreign policies.

But in our approach to investment management, we believe the prudent response to these concerns is not to withdraw from the markets, but to remember that having a diversified and actively managed portfolio is necessary to withstand periods of uncertainty and ensure participation when markets are strong. We generally favor, over the long-term, a strategic bias to being overweight equities relative to bonds as we believe that investors are rewarded in the long run for the additional volatility stocks generate. But looking into 2025, we continue to favor a more modest overweight, as the number of uncertainties remains high.