The stock market enjoyed favorable momentum and easier financial conditions for the majority of 2024. Stock market performance was led by large-cap growth companies predominantly in the technology and communications services sectors, and most major asset categories posted positive returns.
The US remained in a firm expansion, driven by solid consumer spending. Earnings trends improved, and profit margins ticked up. Although the labor market softened, recession risk appeared low.
Globally, a monetary easing trend picked up steam in the second half of 2024. Most major economies remained in expansion amid improved global financial conditions and stable employment dynamics, despite some weakness in manufacturing.
So what lies ahead for 2025?
The biggest concern for asset markets might be complacency. It’s hard to consider the US stock market inexpensive, which raises the question of how much of the potentially good news is already reflected in asset prices. For example, S&P 500® earnings growth expectations for 2025 stood at more than 15% near the end of 2024. Also, the stock market has experienced a lengthy period of benign volatility since the last major market disruption in early 2020.
Overall, the near-term macro backdrop does not suggest major troubles ahead. The US economy is in a solid expansion, and the US Federal Reserve is easing monetary policy. That said, many of the biggest changes in asset prices tend to be driven by surprises.
The following are some of the biggest potential surprises we’re watching heading into 2025.
1. Inflation may not decline
US inflation has slowed meaningfully since the 2022 peak of 9%. This “disinflation” means prices have risen at a slower pace—not that they are coming down.
Disinflation has been a key trend supporting asset prices in the last 2 years. Market indicators for inflation in 2025 bounced around in recent months but often reflected an expectation of a continued drop in inflation. This view is echoed by the Fed, which (in line with the markets) is expected to make additional rate cuts in 2025.
However, core inflation (excluding food and energy) for both the Consumer Price Index (CPI) and Personal Consumption Expenditures Index (PCE) remain around 3% and stopped falling in the second half of 2024.1 Labor markets have cooled but are still relatively tight, keeping wage growth elevated. Solid employment conditions continue to support the US consumer, as does a record level of wealth. As a result, the economic expansion continues, and services- and housing-related inflation remains elevated.
Without a bigger economic slowdown, it’s not clear where the impetus for softer inflation will emerge. If the Trump administration follows through with campaign proposals to dramatically increase tariff rates on China and the rest of the world, additional inflation pressures would be likely as at least some of the higher cost of imports would be passed along to US consumers.
Moreover, our long-term outlook suggests the backdrop is less conducive for a return to stable, low inflation than during the past 2 decades. Deglobalization and trade-policy pressures are widespread, disrupting supply chains, and will generate less disinflation in manufactured goods. Meanwhile, climate and geopolitical destruction are pushing up rebuilding costs, and aging demographics are restricting labor supply and contributing to higher employment costs. Consumers may be noticing these trends, as their long-term inflation expectations remain at the high end of their range over the past 2 decades despite the recent drop in inflation.
2. The fiscal policy debate could matter to the markets in 2025
US government debt relative to gross domestic product (GDP) tripled in the past 2 decades, and the 2024 fiscal deficit is near 7% of GDP, which is the highest ever experienced during a peacetime, non-pandemic expansion. To date, financial markets have expressed indifference to the deteriorating fiscal trajectory, largely because interest rates have remained low, keeping debt service manageable.
The situation could be different in 2025. The government’s net interest outlays are already at their highest level in decades, are larger than total defense expenditures, and are poised to increase further—even if interest rates don’t rise. The Congressional Budget Office’s (CBO) base case for the next decade is for publicly held debt to rise to a record 122% of GDP. For debt-to-GDP to stay at current levels, interest rates would need to average 1% over the next decade (and we see this as unlikely). We believe that the path of debt-to-GDP is likely higher than CBO forecasts, and we estimate an upper-bound scenario based on the experience of how countries like the US with aging demographics tend to face acute fiscal pressures.
Additionally, the CBO projection assumes increased revenues starting in 2026 after the expiration of the 2017 personal income tax cuts. However, an incoming Republican-led White House and Congress appear to place a high priority on extending these tax cuts, which would add $4.6 trillion to the debt outlook over the next decade. Campaign proposals from President-elect Trump included many additional tax cuts as well.
Markets may react unfavorably if the incoming government takes steps that exacerbate the fiscal outlook, potentially placing upward pressure on bond yields and stock market volatility.
3. Long-term market interest rates may not fall
What happens if the Fed eases policy but long-term market interest rates do not fall?
Yields on 10-year Treasurys dropped to 3.6%, down from an April high of 4.7% just before the first Fed rate cut in mid-September. This move was likely attributed to expectations for the Fed’s shift to easing, bolstered by softer employment data during the summer months. Bond yields then inflected higher after the Fed’s first cut, implying the market’s anticipation of Fed cuts had gotten ahead of itself.
The Fed is expected to ease policy provided it believes rates are above its estimate of the neutral rate. But how many rate cuts—and whether it’s more than is already priced into longer-term bond yields—remains a key question for 2025. If US economic strength, inflation, and the fiscal debate surprise markets in a way that puts upward pressure on rates, then additional Fed easing may not be able to push longer-term rates lower in 2025.
We believe the fair value of 10-year Treasury yields roughly equals the long-term potential nominal GDP growth rate, which, as the chart below shows, we estimate to average 4.4% over the next 20 years. This rough proxy suggests current yields are near their fair long-term valuations. Yields could rise above fair value due to either a growth or inflation surprise to the upside and/or high deficits that would increase the supply of bonds relative to demand for fixed income securities. If yields fall significantly in 2025, it likely would be due to a weaker-than-expected US economy and rising recession fears.
4. Emerging-market stocks could give US stocks a run for their money
US large caps outperformed their non-US counterparts in 2024 and have surpassed international stocks by more than 7% per year over the past decade. Investors have recognized that the US has had a stronger and more resilient economy than most other developed countries, and that its return on equity has been far superior due to its more shareholder-friendly corporate management, the high levels of profitability by several large, dominant technology and communications companies, and most recently the boom in artificial intelligence (AI). The incoming Trump administration may raise challenges for other countries, including higher tariffs and more uncertain foreign policy. Some investors may think it’s time to give up on global diversification.
We are not in that camp. The world backdrop may well be messy and volatile in 2025, but outperformance by emerging markets and perhaps other non-US stocks could happen without a reversal in positive US trends. It could potentially combine relative international improvement with a conclusion by more investors that stock valuations already reflect a good portion of the good-news expectations for US stocks.
Our estimates conclude that US stocks should sell at a 20% to 40% valuation premium with non-US developed-market and emerging-market stocks over the long term. This is far out of line with the current valuation gap of 70%.
Catalysts for non-US stocks in 2025 may include better corporate earnings momentum (which we’re currently seeing in emerging markets), a Chinese stimulus policy response that surpasses expectations (which could happen in response to higher US tariffs), and a global economic acceleration on the back of central bank easing. Even if none of these events occur, there are significant country, industry, and security-specific opportunities to globally diversify a portfolio.
5. Asset returns might be below average
We’ve seen strong gains among most major asset classes in recent years. Global stocks have thus far generated strong double-digit returns, with US large-cap stocks possibly surpassing 20% gains for the second year in a row.
With so much good news baked into consensus expectations—a US soft landing, double-digit earnings growth, US deregulation and potential tax cuts, global disinflation, and central bank monetary easing—many of these events may happen, and the market still might not outpace investor expectations.
High valuations set a high bar for any outsized gains in asset prices in the shorter term and tend to restrain the outlook for long-term return expectations. We have just lived through a 20-year period in which US stocks outpaced investment-grade bonds by nearly 7% per year. This has been well above the 5% average over the past century. As the chart below shows, our forecast is for US stocks to outpace bonds by a much narrower amount in the coming 2 decades.
Conclusion
Surprises are always possible, and they may be more impactful given the near-term strength of both the economy and the markets.
Longer term, we believe a healthy amount of portfolio diversification may help investors navigate a world in which upside surprises in fundamental trends may be more difficult to find.