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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence of Ideas from Confluence Investment Management focusing one that may one that may slow during the year. In its report, Confluence discusses the reasons behind this prediction and ways investors can prepare. Confluence Chief Market Strategist, Patrick Fearon- Hernandez, joins us today to summarize the 2025 outlook. We are recording this in mid December 2024. Patrick, you've titled your report a year of political and policy change.
Phil Adler:Are you looking for inflationary pressures to accelerate because of new policies coming out of Washington?
Patrick Fearon-Hernandez:Well, hi, Phil. Thanks for having me on the program. I think you're right to mention the title of our 2025 outlook, a a year of political and policy change, because we think the changes, because of the 2024 election, will have the dominant influence on the economy and markets in the new year. However, the economic and financial trends that we foresee aren't just the inflation related factors that everyone else seems to to be talking about. In broad terms, the landscape we see leading up to and after inauguration day includes an economy that continues to grow but with some loss of momentum.
Patrick Fearon-Hernandez:Because of that slowdown in economic momentum, we see a Federal Reserve that cuts interest rates helping send funds flowing into stocks. However, we also see sticky price inflation stemming from both current factors, such as today's labor market tightness, as well as potential impacts from Trump policies like tariffs and migrant deportations. That sticky inflation means the Fed probably won't cut interest rates as fast or as far as some investors currently expect.
Phil Adler:Patrick, do you think forward momentum might sustain the economy for a while until or if inflationary pressures build from present levels?
Patrick Fearon-Hernandez:Yes. We do judge that the economy is in a virtuous cycle in which increased spending sparks continued job creation and wage gains, which in turn leads to more spending. The consumer sector is the main driver of growth right now, and that's where most of the momentum is. In any case, that continued growth and demand coupled with some resource shortages has the potential to keep price pressure high and could even lead to a reacceleration of inflation in the coming year.
Phil Adler:I remember the title of last year's report was the slow bicycle economy, and the theme was that when economic activity doesn't have much momentum, it's more susceptible to a shock. Now clearly, the economy, at least by some measures, performed well in 2024 and withstood various global geopolitical shocks quite well. Is our luck running out?
Patrick Fearon-Hernandez:Well, I would put it this way. Gradually moderating activity is a risk since slower growth makes the economy more vulnerable to a shock, such as a geopolitical crisis that undermines confidence. But in 2025, that suggests the Fed is likely to cut interest rates a bit more. That's important because as investors have become optimistic about deregulation and tax policy under the incoming Trump administration, they've gotten very bullish on stocks. If a gently moderating economy really does prompt the Fed to cut interest rates a bit more, we think it would add to the stock euphoria we're already seeing and drive valuations higher.
Phil Adler:I'm curious about the stock market's impact on the economy. After all, household wealth has climbed to a record on higher stock values. What happens if the market suddenly does retreat sharply from near record territory? Could that alone be enough to crush consumer confidence and and cut spending?
Patrick Fearon-Hernandez:Yeah. In theory, that could happen. But to reiterate, in an environment in which the economy continues to grow, the Fed cuts interest rates a bit more, and the Trump administration delivers on at least some of its promises regarding deregulation and taxes, then the wealth effect from rising stock prices would likely help reinforce the rise in consumer spending that's driving economic growth these days.
Phil Adler:Patrick, how do you rate the possibility of a recession in 2025? What signals are your favorite economic reports currently sending?
Patrick Fearon-Hernandez:Well, we feel comfortable that the US economy can keep growing in 2025 with no recession. The momentum that we see today, especially in the consumer sector, gives us a lot of comfort. And on top of that, there's still a lot of fiscal stimulus, primarily in the form of Social Security and Medicare benefits going to the retired along with big interest payments by the federal government. These trends are visible in the quarterly report on gross domestic product and the monthly data on personal income and spending, treasury spending, the Chicago Fed's National Activity Index, and the like. Importantly, data such as the quarterly and monthly figures on consumer debt levels, corporate inventories, and the like suggest that we don't have some of the big economic imbalances that kicked us into recession in the past.
Patrick Fearon-Hernandez:Overall, as of right now, it looks like the economy is in a good position to keep growing in the coming year.
Phil Adler:Well, to summarize then, what are positives for the economy right now?
Patrick Fearon-Hernandez:Well, what we like is the continued growth momentum with gradual moderation, which the Fed is responding to with gradual interest rate cuts. And we also like the way that the demand for labor remains healthy with businesses creating new jobs and boosting pay rates. Since debt is still manageable in the private sector, that's allowing households and businesses to increase their spending, leading to further growth.
Phil Adler:And on the other side, what are key reasons to perhaps worry?
Patrick Fearon-Hernandez:Well, as we discussed earlier, the economy is susceptible to a shock even if it's still growing. The key risks, we think, include a geopolitical shock that undermines confidence, such as a further outbreak of violence in the Middle East or perhaps hostilities in the Asia Pacific region. Alternatively, keeping with our theme of political and policy changes in 2025, we see some risk from the possibility of disruptive new policy changes by the new administration. While the likelihood of deregulation and extending the 2017 tax cuts would probably be positive, proposals such as high tariffs and mass migrant deportations could be disruptive. If the new administration signals it's prepared to allow the federal budget deficit to blow out, that could also potentially spark a sell off in the bond market, which would drive up interest rates and weigh heavily on the stock market.
Phil Adler:Let's look, Patrick, at your outlook for various asset classes, and and let's begin with bonds. What's your overall assessment?
Patrick Fearon-Hernandez:Well, if we're right that residual inflation pressures will prevent the Fed from cutting interest rates much further, it would imply that bond prices may be range bound near current levels throughout the new year. Indeed, our bond model suggests that the yield on the benchmark 10 year treasury note may be little changed from where it is right now, which would imply that the total return from that instrument may be its current yield. Investment grade corporate spreads are a bit tight to treasuries right now. So if the economy unexpectedly shows signs of faltering, they could potentially be repriced and return something a bit below their current yields. Junk bond spreads are more decidedly tight, so they would potentially be at greater risk of repricing if the economy fares worse than we expect.
Phil Adler:Within the bond class, where is the best landing place for new money and why?
Patrick Fearon-Hernandez:Well, the yield curve is pretty flat these days, and we think it's likely to stay roughly that way in the coming year. Therefore, you're not going to be well compensated by moving out the maturity scale. Therefore, we prefer short duration fixed income with perhaps a slight preference for treasuries over corporates because of today's tight spreads.
Phil Adler:Turning to stocks, Patrick. Everybody's aware of the stock market's recent records. Do you have a 2025 target for the S and P 500?
Patrick Fearon-Hernandez:Yes. We are optimistic on US stocks in 2025. Based on our modeling, our base case expectation is for the S and P 500 stock price index to rise roughly in line with projected earnings growth, up about 10% for the year, and that would put it at 6,735 with a range of 6,500 to 6,800. However, our modeling also suggests there's a notable upside to valuations in 2025 based on factors such as the continued economic growth, good earnings margins, modest interest rate cuts, and the potential for those rate cuts to prompt investors to shift some of their money market holdings into stocks. To take advantage of the deregulation and low taxes under the Trump administration.
Patrick Fearon-Hernandez:Under our best case scenario, the PE ratio on the S and P 500 could therefore increase from about 25 x today to perhaps as much as 30 x at the end of 2025.
Phil Adler:Is your target for the S and P 500 more likely at mid year, or or is this an an end of year calculation?
Patrick Fearon-Hernandez:Our approach is to project a number at the end of the year. So that's what that figure represents.
Phil Adler:Much of the gains this year have been due to relatively few stocks. Is this likely to change in 2025?
Patrick Fearon-Hernandez:Let's put it this way. If we're right about continued or even increasing stock euphoria in 2025, the asset classes that have been outperforming in 2024 could well continue to outperform in the new year. That would bode well for large cap growth stocks, for example, while we could see small caps and value continue to lag. All the same, because of the recent outperformance elsewhere, we still think the better buys will be in small caps and value. So we think most investors will want to keep diversified into those areas.
Phil Adler:Consumer discretionary has had a good run lately as well as technology, of course. Where are the best sector opportunities right now?
Patrick Fearon-Hernandez:Well, we don't get into a detailed analysis of all the various stock sectors in our outlook. But if we're right that large cap growth will continue to outperform, we could also see continued strong performance in the recently strong sectors like technology and consumer discretionary. The very biggest of such stocks such as the Magnificent Seven may slow a bit, but it wouldn't be surprising if investors keep bidding up the stocks in the broader sector.
Phil Adler:Are mid caps still a good place to be?
Patrick Fearon-Hernandez:We think they can be. After all, since they haven't performed as strongly as large caps recently, there are probably much better buys in the mid cap space. With their lower valuations, the mid caps are probably also relatively less at risk of a steep correction than the large caps. For now, the momentum is most obvious in the large caps, but mid caps may be more attractive on longer term risk adjusted
Phil Adler:Patrick, Confluence has identified in some of your recent reports that there are opportunities in foreign markets for defense related companies. But how about non US equities overall?
Patrick Fearon-Hernandez:Well, outside the defense sector, we think foreign stocks will continue to be challenged. With the US' relatively strong economic growth, rising financial markets, and safe haven status, we expect to see continued strong capital flows into the US, which will likely drive up the value of the dollar. As we've noted many times before, foreign stocks usually struggle when the dollar is strong and or rising, and that's the environment that we would expect in 2025. And on top of that, if the new Trump administration really does implement big import tariffs, a lot of foreign producers are likely to face reduced business and lower profits.
Phil Adler:Is the value of the dollar the key metric to watch as we assess foreign markets?
Patrick Fearon-Hernandez:Yes. In 2025, we think you wanna closely watch the value of the dollar along with the new administration's decisions on tariffs.
Phil Adler:Turning to commodities, slowing economic growth in China has had an impact on oil prices. Do you expect this to continue?
Patrick Fearon-Hernandez:Yes. We think so. As we've noted in many of our publications, the Chinese economy has hit some big structural headwinds including weak consumer demand, excess capacity and high debt, poor demographics, the disincentives that come with the Communist party's intrusions into the marketplace, and of course, the trade, capital, and technology de decoupling by the West. On top of that, the government is ideologically opposed to big powerful stimulus programs that would boost consumer spending and faster growth. As a result, China simply won't be the engine of world economic growth that it once was.
Patrick Fearon-Hernandez:Overall world demand will rise more slowly than in the past, and that will hold down prices for all kinds of commodities, at least in the near term.
Phil Adler:Where are the best opportunities then in commodities?
Patrick Fearon-Hernandez:Well, in commodities, we continue to favor precious metals and uranium, both of which are likely to benefit from today's geopolitical tensions. Over the longer term, we also like energy and other mineral commodities in part due to weak investment in recent years. However, we probably need to see a resurgence in global demand before those commodity prices start to do substantially better.
Phil Adler:Well, Patrick, as as we sum up, I can only imagine how difficult the predicting game is. You have predicted moderating economic growth with a fairly low risk of recession, and confluence asset allocation models across the risk spectrum are attuned to this outlook. Can you identify as we move into 2025 key economic reports and likely policy developments that you are watching especially closely for signs of deviation from this outlook?
Patrick Fearon-Hernandez:Well, in the US, the key economic reports to watch are probably the ones related to the labor market, such as the monthly change in non farm payrolls and the weekly data on initial jobless claims, which is a proxy for layoffs. If those indicators continue to moderate but don't show job losses, it would suggest the economy is evolving as we anticipated. The key policy developments to watch would include the pace of the Fed's interest rate cuts and the tax and spending policies put into place by the new Trump administration. If the Fed doesn't stop cutting rates too soon and if the budget deficit doesn't blow out too much, the economy can keep growing and more money market funds will likely flow into the stock market giving it a boost. If we see all these things happening, we think investors could see pretty good returns in 2025.
Phil Adler:Thank you, Patrick. Listeners can read detailed explanations and view charts of economic data that build a case for Confluence recommendations by accessing the Confluence Investment Management webpage. That's confluenceim.com. Look for links to the Confluence of ideas report titled Outlook 2025, a year of political and policy change. Geopolitical events can disrupt markets and you can gain an understanding of what to watch out for by reading the confluence 2025 geopolitical outlook also by accessing the confluence web page.
Phil Adler:Today's discussion is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll. I'm Phil Adler.