The S&P 500 Index closed 2024 with back-to-back annual returns exceeding 20%. While we think investors will have something to cheer about in 2025, we anticipate more muted gains compared to recent years. The economic backdrop remains favorable, with solid growth, a resilient labor market, and a healthy consumer, which should be supportive of equity markets. Potential tailwinds brought about by the new administration are expected to include the extension of the 2017 tax cuts, deregulation, increased mergers and acquisitions activity, and continued investment in Artificial Intelligence (AI). However, headwinds remain, including elevated equity valuations and the prospect of stubborn inflation. While the outlook remains positive, policy uncertainty and market volatility reinforce the need to prioritize quality investments and diversification.
Tariffs and immigration policy may pose challenges to the Federal Reserve's (Fed) inflation objectives, raising questions about whether the Fed will be able to cut rates this year. While inflation showed good progress in 2024, it began to stall toward the end of the year. How the new administration implements these new policies will be key. More moderate tariff and immigration controls could be absorbed by the economy and markets with limited disruption. However, higher tariffs applied broadly across multiple countries could elevate prices for U.S. consumers, creating an inflationary headwind. Similarly, stricter immigration policies that result in a large backfill of jobs could tighten the labor market, driving higher wage growth and adding to inflationary pressures. The Fed will closely monitor how these policies unfold, likely adopting a "wait and see" approach. Our current assumption is that the new administration will engage in a moderate version of these policies, with limited impact on inflation. Under these conditions, we believe the Fed will lower interest rates this year, though this outlook remains contingent on actual policies enacted.
U.S. equities remain our highest conviction recommendation, driven by several key factors. Economic growth in the U.S. is forecasted to outpace that of other developed markets this year, providing a strong foundation for U.S. equity returns. We expect AI will be a transformative, multi-decade theme and that U.S. leadership in the AI space will benefit domestic equity markets. Over time, we expect the beneficiaries of AI to shift from a concentrated group of enablers and providers to a broader range of users leveraging AI to boost productivity and profitability. Meanwhile, the continued strength of the U.S. dollar is likely to have a negative impact on international investments when converted to U.S. dollars. Lastly, a higher dollar may act as a headwind to emerging market economies, which would face rising debt service costs, due to significant dollar-denominated liabilities.
In terms of fixed income, we believe the asset class continues to play a vital role in meeting income needs and providing diversification benefits for balanced investors. With yields near decade-highs, fixed income offers a compelling case for investors despite the potential for policy uncertainty. In this environment, the short-to-intermediate part of the yield curve presents attractive opportunities, with Treasury yields exceeding 4%. Adding exposure to short-term credit, agency mortgage-backed securities, and municipal bonds can create a high-quality, diversified fixed income portfolio, yielding mid-single digits. While we expect the Fed to adopt a gradual approach to monetary policy, inflation could remain elevated due to government policy and the need for increased Treasury issuance, which may keep longer-term yields relatively range-bound, even in the event of rate cuts. For longer-term investors, short-to-intermediate maturity fixed income portfolios can deliver solid yields and returns, making them an attractive option in today's market.
In conclusion, we expect a solid year for investors, with low- to mid-single-digit returns in fixed income and slightly higher equity returns. The economy is on stable footing, and the potential for interest rate cuts may serve as a catalyst for markets. Currently, we maintain a modest overweight to equities and a modest underweight to fixed income. Within equities, we have a preference for U.S. over international markets. In fixed income, we favor the short-to-intermediate part of the curve, with exposure to Treasuries and high-quality credit. Given the policy uncertainty this year, it is important for investors to prioritize quality and stay diversified to help mitigate potential market volatility. Finally, a systematic investing plan, which involves consistent contributions on a regular basis, can help mitigate the impact of market fluctuations and capitalize on dollar-cost averaging.
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