2025 Outlook: A Matter of Perspective

Jen Blaha: Hi, I'm Jen Blaha, director on the Investment Analytics team, and welcome to SpringTalk. Today, we have a special edition of our podcast: our Allview Outlook Face-Off. Joining me today are Allspring's very own Danny Sarnowski, senior portfolio specialist for the Plus Fixed Income team, and Ozo Jaculewicz, senior portfolio specialist for the Growth Equity team. We'll be talking about our predictions for the markets and beyond for 2025. Thank you both for being here today.

Ozo Jaculewicz: It's great to be here, Jen.

Danny Sarnowski: Thanks for having me.

Jen: Yeah, looking forward to hearing your insights and your crystal ball for 2025.

Ozo: Nice outfit, Danny.

Jen: Yeah, you guys look great today. You didn't give me the memo. So, let's jump right in because we have a bunch to go over today. So, for 2024, no shortage of headlines, but let's focus on some of the headlines over the past month or so. In November, we saw a Republican sweep in the U.S. elections and markets rallied right after that. And while they pared back a little bit, November ended up being the best month for the S&P 500 in over a year. So, I'm wondering what is your thought for the incoming administration and their impact on some of the financial markets for 2025?

Ozo: I'll take a first stab at that, Jen. Well, there is some excitement. There's sort of like this initial almost sugar high. Business confidence is up. Consumer sentiment is up. There's a sense that the new administration may sort of juice the economy. And we're expecting some more animal spirits, especially with corporate activity—M&A, IPO markets, just a little more risk-taking in the environment. We have to also remember, though, that there may be a little bit of a hangover from a sugar high. There's a price tag to tax cuts or deregulation. And I think the market is very soon, if not already, anticipating that some of these policies could be inflationary. We have not declared victory on bringing inflation down. And so, if there are things like tariffs on imported goods or curbing on immigration, remember the labor market is critical to inflation. We've had a very tight labor market for a few years. Now, it's just starting to thaw out a little bit. That's given the Fed (Federal Reserve) a little room to cut rates. But if potentially new policies make the labor market tight again, immigration is a really important industry for labor, particularly in construction, hospitality, restaurants, food processing. These are big industries. If we have tighter labor markets, more wage inflation that sort of rekindles back, well, now the Fed and interest rates may be sort of on hold in terms of coming down.

Danny: I like your term sugar high and then that crash afterwards. And not to be a doom-and-gloom fixed income person at the table, but I do think markets have obviously reacted very strongly to the election outcome and really sort of juiced and built in and priced in a lot of good news. But this may be somewhat a function of buying the rumor and someday selling the news because we have to eventually parse campaign rhetoric to what actually becomes proposed policy and then what and how much of that policy can actually be implemented and what the impacts of those are. But I think markets have moved pretty quickly to price in a lot of that good news. And if you get things that fall short of that or if we think we're going down one path and suddenly take a turn, you could get some volatility back in the markets, both in the equities and the fixed income world.

Jen: Our team also monitors a bunch of market risk concerns. And one of those is surrounding the U.S. government debt, which is at $36 trillion now at this point. And while we haven't quite seen the full scope of the new administration's fiscal policy, it does make me question where the Fed is going here. We saw two rate cuts this year. So, Danny, what are you thinking in terms of rate cuts? We have one more meeting in 2024 and then for the upcoming year, how many rate cuts are you predicting?

Danny: That's an important question to markets and to a lot of investors. And the first total cop-out answer I'll give you is that the Fed is data-dependent. And I think they continue to hammer that point home. They are not on a set-it-and-forget-it, preordained path. We're not just cruising along to their estimate of the neutral rate that we last saw in the previous dot plot. In fact, we'll get an updated dot plot here in December and it would not surprise us to see some cuts priced in for 2025, but maybe that neutral rate also coming up even further. And so, the idea from our team is that the Fed is likely and they're biased toward wanting to cut, wanting to make rates less restrictive, not ease policy and be stimulative, but just take that edge off while recognizing that they probably don't need to cut as much as they thought they would have needed to, based on the data in the past. So, the data will tell them how much they can cut, when and if they can cut. We do expect that we'll get a cut, whether it's in December or January. We think we'll get another 25 basis points. Likely hear some rhetoric from the Fed’s pledging to be data-dependent and that they're okay cutting, maybe taking a pause, cutting, taking a pause. And again, painting this picture for markets that please don't just straight-line what you think is going to happen and make some big, bold presumption because we're going to take it as it comes. So, we do think that rates on the front end are going to continue to drift lower over 2025. But we're not headed, we don't think, to 2.5% or even 3.0% like we might have a year or more ago.

Ozo: Yeah, I would agree. I mean, we're obviously on the equity side. So, we'll leave it to the experts to try to predict the Fed. But this idea of maybe inflation being a little bit stickier than people think or expectations. And it's interesting how often the fed fund futures market seems off. Like it wasn't that long ago, I think, the market was pricing in almost 8 or 10 cuts in 2025. And then, within a month now, the futures market’s pricing in 4 or 5 cuts. And it might go down again. I think the more salient part of what you asked, Jen, was the debt picture. When you think beyond the next 6 to 12 months, we do have to sort of realize that these really high debt levels that we have now in the United States and most Western nations does ultimately constrict growth. Servicing our debt in the United States is now a huge line item on the budget. It's larger than military spending and expected to grow, so that's usually not the most productive use of our investment capital or our tax base. And so, we've been talking to clients for quite a long time about these three D’s: debt, demographics, and disruption. These, we believe, are structural forces that will influence stock market behavior and prices for many years to come, once we sort of move past the election euphoria that's happening right now.

Jen: And I think with this new administration coming in, what we're going to see in terms of tariffs and deregulation is also going to play into some of the inflation numbers. So, in July, we saw the start of a new regime basically for inflation—some of the lowest levels we saw since 2021. And really, it's been kind of sticky since then—hasn't really moved all that much. Considering some of these new policies coming in with the new administration, what are you seeing for inflation? I mean, I hear you on the rates, but do you see inflation being stickier?

Danny: I always get these questions. Please, take the inflation question. OK. So, we do think that inflation is likely to remain stickier, stubborn, slightly above the Fed's preferred 2% target. But the Fed is also telling us that they understand that this is a long game. Markets and all of us want inflation solved. We want to sort of wrap this all up and go back to sleep and they're telling us this could take a year or two years to sort of eventually get down to 2%. So, I don't think they're going to panic if inflation sort of ticks up a little bit, if it stays stubborn, based on base effects and year-over-year measurements. You get some higher inflation. Certainly, the impact of immigration change, trade policies, all these things could have an impact on inflation and on growth and the consumption side of things, of course. But if it stays a little bit higher, we don't think the Fed will panic and they'll take that as a sign that something's wrong. I think they're going to try and read through. And we do think over time they will be successful in getting inflation closer to the 2% target. But we would expect in 2025, the first half in particular, we'd expect to see things sort of hang in this higher, sticky, stubborn area for a while.

Jen: Yeah, absolutely. So, we've talked about interest rates and inflation. So, what are some fixed income opportunities, should those rates continue to stay a bit higher for longer?

Danny: Yeah. Well, rates staying elevated, I certainly understand, would be challenging for people, if you're looking to buy a house or buy a new car or take out any sort of credit. But for investors, that's a fairly good outcome, actually. We're sitting at the spot where the dollars of yield available from the public global fixed income markets is the highest it's ever been. This is a fertile time for fixed income investors to put money to work. The challenge is the forest says fixed income is broadly attractive because of that level of income. When you zoom in and try and find the individual trees to invest in, valuations are pretty tough for a lot of sectors. And so, we think this is that time where investors want to take advantage of the opportunities in fixed income but not take for granted that you can just allocate to something—deep credit, long credit—where valuations have really kind of gotten ahead of themselves and priced in a lot of good news already. So, we think investors should be focused on things like spreading some of their positioning across the curve. So, rather than moving from one spot to another with this hope that we'll get a big move in rates because the Fed is moving or for some other factor, but instead building some resiliency across the curve and having a few positions, we think, will help diversify some of that risk and provide a really attractive level of income across the curve and across the portfolio, but then also focusing on not taking for granted that spreads are tight and they'll stay tight. So, we want to focus on having lots of flexibility and lots of optionality in the portfolio and meaningfully taking advantage of what's available in fixed income. So, higher rates, that'd be ...

Jen: Not a problem.

Danny: Not a problem for us.

Jen: Got it, got it. All right. So, Ozo, let's turn to equity opportunities. In 2024, the AI boom really sent the market rallying for that first half of the year. Do you see that continuing into 2025, or how are you feeling about the overall S&P 500? You bullish? Bearish?

Ozo: Well, my mentor taught me, probably 20 years ago, a saying that's always stayed with me. And it is that capital flows where it's treated the best. So, think about capital in the sense of almost like a migration of birds. Birds, when they migrate, seek warmth, safety from predators, and food. And global capital flows are kind of similar. And that's part of the reason why we have $6.5 trillion right now sitting in money market funds because all those flocks of birds went to yields of 4% or 5%-plus. Within equities, the birds have flocked to the Mag 7 and AI beneficiaries partially because of exciting fundamental growth but also partially because these stocks are pretty defensive in some ways. They have a fortress of their balance sheets. And there's been so much uncertainty in the world, it's been a place to have a certain amount of safety as well. Some people call those companies like digital gold. It really is starting to feel like the birds are flying a little different direction. We're starting to see capital broaden out. We're starting to see parts of the market that were unloved or kind of left behind within equities perk up. Some of that has to do with the Trump trade, the excitement around new policies. But I think it's going to be longer lasting. If you told me, you give me the Mag 7 or the 493 left in the S&P 500, I'll take the 493. I think you're going to see earnings growth really start to catch up from some of those other stocks. And you may see some beneficiaries within the market of new policies that are coming. So, I would say there are zones that are crowded with a lot of birds. But watch for the birds to start to fly in different directions and reward investors who maybe are going against the grain.

Jen: Really hoping this doesn't turn into a Hitchcock movie with the birds. Yes, I definitely see some opportunities with AI expansion to other industries, as well. I think that we'll probably see that. And right now, U.S. valuations are so high. And some of that Mag 7 is really looking expensive relative to the rest of the U.S. market even and then abroad. So, I think that we could see some normalization in some of those valuations. And I agree, looking down cap might be a good place to start, as well as abroad. A lot of these emerging market companies are part of that supply chain to these AI companies. And so, I think there could be some opportunities.

Ozo: The birds could make it across the pond. They can fly.

Jen: They can, they can. They don't only go south.

Ozo: Exactly.

Jen: Yeah, that's great. So, Danny, are you seeing global opportunities, or how are you thinking about that?

Danny: Yeah. I mean, we think that investors should take a global view. I mean, not to stretch the metaphor here, but we don't want to put all our eggs in one basket.

Jen: Are we talking more birds?

Danny: More birds. We know it's not just the American eagle, right? There are other opportunities to take advantage of fixed income around the world. But I do think that new policies from the new administration, trade impacts, all of that needs to be considered and will have some impact on valuations. But when we look at things in credit, for example, today and you're looking at credit spreads for things like U.S. investment grade, U.S. high yield credit, the credit spread, the compensation we get for taking that risk, is at the lowest point it's been in 20 years, like the zero percentile. Whereas in Europe, whether it's in investment grade or high yield, you're in the mid to high 20s. So, it's not amazing and it's below average, but it's not at zero. And so, the opportunity here to carve off some of your allocation from the U.S., find good opportunities in European or other markets, whether it's developed or emerging, we think there's an opportunity there to further the diversification and to find good opportunities. And we have to remember, we all think and get asked about and write about and talk about what's happening here at home—our Fed, our CPI, our economy—but we're not alone in going through what we're going through. Most other economies on Earth have just had their central banks work harder than they've ever worked to combat the worst inflation they had in four decades or longer. So, we’re in good company and that should provide more opportunities for investors to put money to work. And some of that capital, some of those birds, will find another spot to go as opposed to one roost, one place, all in the U.S.

Jen: All right. So, let's move out of equity and fixed income. Let's go to the beyond area of cryptocurrency. I'm very curious to get your thoughts on that. I was reading an article recently where $1.1 trillion have gone into crypto ETFs since the election. Pretty astonishing there. So, what are your thoughts about crypto? Anybody want to take that?

Danny: Well, it's certainly had a very strong return since the election. And of course, some of that is just the fact that there's an expectation for maybe either less onerous or different regulatory regimes, the fact that the incoming administration seems very supportive of crypto.

Jen: They seem very pro.

Danny: Very pro, very pro. So, I think that there's a reason for some enthusiasm. But I would, in my heart of hearts, think markets may have gotten a bit carried away in the last couple weeks. But actually, you said something earlier. You said digital gold. So, I think at some point there is a use for things like bitcoin to serve as that digital gold, that store of value beyond whatever your native currency is. So, there's an opportunity for it to add value as part of an overall investment strategy for investors. But this idea that we all just pile into crypto because it just goes up all the time? I mean, I feel like this is one of those things that at some point you look back on the timeline and think, right there. That was a problem. We all should have noticed right then and there. That's what it feels like. Maybe I'm wrong and maybe bitcoin will be at $300,000 in a couple of months. I don’t know.

Jen: I kind of thought that a few years ago, though. Every year I tell myself, no, no. It’s too good to be true. But it continues to excel. And I think now that the retail investors have that accessibility to buy those ETFs rather than actually invest in the currencies themselves it's not surprising that we're seeing that people want to participate in that.

Ozo: It feels similar to other disruptive technologies. Security prices often get ahead of themselves with excitement and euphoria and that's a little bit maybe what's happening with cryptocurrency. But the underlying technology of digital currencies, similar to even AI, the economy has different layers to be impacted by change and by technology. And usually, it takes time for innovation and technology to work its way through those layers. Some things, like fashion, move really fast and that's what cryptocurrencies feel like at the moment. They're sort of in vogue. But the underlying technology can take years, if not decades, to ultimately play out and have a huge impact on an economy. And that's probably the case with cryptocurrencies. They're here to stay. As is AI and all the other innovations that have come along that have changed our lives—I believe this is another one.

Jen: All right. So, let's get to the heart of the matter. For 2025, what is the asset class that you see being the best performer? I don't think your cryptocurrency. I don't think you're going all in there.

Danny: Well, I would say cryptocurrency has a chance because I agree with Ozo that I think this is somewhat euphoria, some markets getting ahead of themselves. But the returns can be very strong if that momentum continues. So, I think it would be cryptocurrency or equities. I mean, I do think that this will be a great year for equities. And fixed income will do its job in the portfolio—add ballast, add income.

Ozo: I think bonds are up like 2% since our last prediction and stocks are up like 26%, so it's good to see you come around. 2,000 basis points of outperformance and he's on our team. I like it.

Danny: Finally on board.

Ozo: Well, no surprise. I am excited about the opportunities in equities this year. And I think this is where things are really starting to line up for, again, this broadening-out theme where earnings growth for small- and mid-cap stocks is starting to close the gap relative to large caps. Relative valuations of small caps, not as cheap as they were 6 or 12 months ago. There's been a catchup trade in the last 6 months, but still pretty attractive on a historical basis. You have an administration that may juice the economy a little bit in the short term. You have a Fed who may be cutting rates. We may be in a little bit of a different rate regime period. And it's starting to feel like maybe the CPI print from July could be that date that we look back to say the mood of the market changed. It was so narrowly focused on 7 or 10 stocks that made the benchmark so concentrated. We may look back at the middle of 2024 to be the time that that started to shift. I think it's still early days. I think small- to mid-cap stocks will benefit from these tailwinds. And what's interesting is that there's a lot of security selection opportunities as you go down cap. If you focus on quality, on companies that have strong balance sheets, that don't have a ton of leverage, that have positive earnings growth and positive revisions, right now, we are getting paid for those fundamental results, which is so exciting. I saw a chart recently that showed that the explanation of stock prices being driven by earnings results is at a 20-year high right now. There's high dispersion within equities. The tailwinds are there. So, the setup is just really favorable, I believe, for small- and mid-cap stocks. So, I'm going to go with the Russell Midcap Index as the top-performing index for 2025.

Jen: All right.
Ozo: I want to play off one thing you said, Jen, which I think is really on target. AI has been this huge theme and a lot of capital and birds have flown into the AI trade.

Jen: Back to the birds.

Danny: I’m done with birds. I’m done with birds. I’m sorry.

Ozo: We will go through a pause. We will have a period of time where there needs to be a payback on those investments and there will be an implementation phase and it could be multiyear. So, our team has been hunting for beneficiaries outside of technology and semiconductor chips that are going to benefit from this new AI type of technology. But there could be a bumpy road if spending on AI sort of plateaus a little bit. You could see real volatility in some of the crowded stocks in particular. So, we're excited about AI, but let's also be a little bit sober. Realize this is a multiyear trend, look for beneficiaries that are not as sort of right in the zeitgeist of the trade of the last year or two. So, I think you were spot on.

Jen: Well, outside of that, what sectors are you kind of thinking are going to benefit from that AI expansion?

Ozo: Industrials, for sure. There's been some really exciting opportunities within industrials. There have been some tailwinds from reshoring and bringing manufacturing back in the U.S. and the Chips Act, etc. But within industrials, there are also companies that are using AI just to be more efficient in their delivery or even the energy sector is going to unlock new sources of energy. I think it's in consumer, it's in industrials, a little bit in energy, and it'll be a multiyear theme.

Jen: Yeah.

Ozo: What about fixed income? How does AI ...?

Danny: It's not dissimilar. I mean, it's all those same trends. It's all those same themes. And there are going to be winners and losers and there are going to be industries that kind of get on the right side of this transition that take advantage of it, that exploit it.

Ozo: The right side of change. Yes, Danny.

Danny: That free up cash flow for themselves, pay off debt, are mindful of their balance sheet and their future. And those are the names where we would want to take a position, but make sure we're getting paid to take that position, as always.

Ozo: Exactly.

Jen: Well, thank you both for your insights today. It's been really interesting to hear how you're looking at the world for 2025 and beyond.

Ozo: It was fun. Thank you, Jen.

Danny: Yeah, thanks for having us.

Jen: And to our audience, thank you for joining us on SpringTalk.