January 7, 2025
Shortly after the Fed removed some uncertainty in the market by beginning to lower interest rates in September, it was the electorate’s turn to provide some added clarity. The GOP’s clean sweep of the White House, Senate, and House of Representatives in November cleared the path to push through President-elect Trump’s economic agenda this year, which is expected to include a combination of tariffs, tax cuts, and deregulation to boost domestic growth.
The markets rallied in the immediate aftermath of the election results, with the Standard & Poor’s 500 Index closing above the 6,000 mark for the first time. Areas of the market that were viewed as early beneficiaries of reduced regulation, such as banks, certain energy companies, and cryptocurrency-related stocks, did particularly well. At the same time, government contractors slumped, as the leaders of the newly established Department of Government Efficiency (DOGE) began outlining their goals of cutting as much as $500 billion in wasteful spending.
Exhibit A: Total Returns by Asset Class
Source: Bloomberg, Fiduciary Trust Company. Indices: Cash: Bloomberg Barclays 1-3M Treasury Note, High-Yield: Bloomberg Barclays US Corp HY, Corporate Debt: Bloomberg Barclays US Corporate, U.S. Large and Mid Cap: Russell 1000, U.S. Small Cap: Russell 2000, Dev. Int’l: MSCI EAFE, Emerg. Mkts: MSCI EM, Municipal Bonds: Bloomberg Quality Intermediate Muni. Data as of December 31, 2024.
Investors quickly realized, however, how fleeting clarity can be. Within days of the GOP victory, investors began wondering whether potential inflationary pressures associated with higher tariffs and lower taxes might cause the Fed to moderate the pace of its rate cuts. The post-election rally stalled going into the Fed’s final meeting of the year in December. Although the Fed chose to cut rates another 25 basis points, its financial projections and Fed Chair Jerome Powell’s comments only served to exacerbate investors’ fear of an abbreviated rate cutting cycle. The market went from pricing three rate cuts in 2025 prior to the meeting to just one rate cut after the meeting. The S&P 500 had its second worst day of the year while small cap stocks, which are more interest rate sensitive, suffered their worst single day decline of the year.
The Known Knowns
The up-and-down reaction to the election reaffirmed how difficult it is to predict what’s in store for the market. The potential impacts of policy prescriptions are particularly hard to gauge because, in addition to the effects of unintended consequences, it’s never assured that what lawmakers propose will materialize in the exact form they initially intended.
Still, there are some things we know will occur at the start of this year. Among them:
More fiscal stimulus is on the way. Long before the election, it was clear that no matter which party won the White House the federal government would need to run large fiscal deficits, as nearly three quarters of federal spending goes toward mandatory entitlement programs along with interest payments on the debt.1 Those programs will almost certainly increase in size given the country’s growing and aging population. Indeed, the 2025 budget that the Biden Administration proposed calls for a modest 1% increase in base funding for discretionary spending.2 This was guided by the Fiscal Responsibility Act of 2023, enacted as part of the 2023 debt ceiling debate, which caps growth in discretionary spending in FY2024 and FY2025. Yet despite these restrictions, mandatory spending on Social Security, Medicare, Medicaid, other entitlement programs and interest payments are expected to climb 6% to $5.3 trillion this year.3 Part of this increase is due to rising healthcare costs and shifting demographics. This mandatory spending represents enormous fiscal stimulus that will provide a tailwind to the economy near term and offer support for risk assets.
Exhibit B: U.S. Federal Debt Interest Expense Relative to GDP
Source: Bloomberg, Bureau of Economic Analysis (BEA), Fiduciary Trust Company. Data as of December 31, 2024.
Exhibit C: U.S. Federal Spending by Category
Source: Bloomberg, Congression Budget Office (CBO), Fiduciary Trust Company. Other Spending includes Income Security and Veterans Benefits and Services. Data as of December 31, 2024.
Portions of the Tax Cuts and Jobs Act of 2017 (TCJA) may be extended. With the GOP in control of both the Senate and the House, many elements of the TCJA, passed during President Trump’s first term, may be extended in some form. This includes maintaining the top personal income tax rate at 37% instead of reverting back to 39.6%, as well as maintaining the higher lifetime exclusion for estate and gift taxes. This year, the exclusion stands at $13.99 million per person. In 2026, however, it is set to return to the pre-TCJA schedule, which would be just over $7 million per individual, if provisions are not extended.
While the TCJA permanently reduced the top corporate tax rate from 35% to 21%, several corporate deductions enacted by the law are set to expire. For example, the ability for small businesses formed as LLCs, partnerships, and sole proprietorships to claim a deduction for qualified business income will sunset at the end of this year unless Congress acts. The bonus depreciation that allowed businesses to immediately write off 100% of the cost of eligible property has already begun to phase out. The write-off was reduced to 80% in 2023, 60% in 2024, and 40% this year. Unless Congress enacts a new law, the percentage will continue to decrease by 20 points annually until it falls to 0% in 2027.
Prior to the election, we believed this market slightly favored small stocks. If Congress extends supportive tax policies included in the original TCJA, this could be another reason to tilt toward smaller companies, which tend to be bigger taxpayers relative to large multinationals.
The debt ceiling returns. While some investors have expressed concern that new tax cuts could trigger a debt crisis, we’re confident that this won’t come to pass in the near or intermediate term. Why? The debt ceiling, which was temporarily suspended as part of the Fiscal Responsibility Act, was automatically reinstated on Jan. 2.
Once confirmed, President Trump’s Treasury Secretary must begin relying on existing cash on hand to continue paying the federal government’s bills. We view this as highly stimulative in the near term, as drawing on existing cash in the Treasury General Account pushes liquidity into the economy. The reinstatement of the debt ceiling will restrict the issuance of new Treasury debt in the short term. That should help keep a cap on interest rates at the long end of the curve, reaffirming what we mentioned last quarter — that this is an appropriate time to extend duration in fixed income. However, we are underweight fixed income overall because as we mentioned previously, we believe ongoing economic growth will be even more positive for risk assets like stocks.
The Known Unknowns: Key Themes for 2025
As the new year begins to unfold, there are several themes we will be watching out for.
Chief among them is regulations. President-elect Trump has promised fewer regulations across a number of industries from energy to autos to tech. The financial sector may be one of the first areas to see an immediate impact.
Under the Biden Administration, the Federal Deposit Insurance Corp. (FDIC) and the Federal Reserve have been advocating for the so-called Basel III Endgame proposals, which seek to shore up the banking system by increasing capital requirements at large U.S. banks. Those efforts are likely to be delayed or suspended under the incoming Trump Administration. Already, long-time FDIC Chairman Martin Gruenberg, a proponent of greater capital requirements for banks who also disfavored bank merger activity, announced plans to resign ahead of Trump’s January 20th inauguration.
Bank stocks were one of the strongest performers in the weeks following the election on the prospect of less stringent regulations, as fewer capital requirements mean they can potentially lend more and earn more. Many of our clients’ portfolios are overweight financials, specifically bank stocks, in anticipation of an easier regulatory environment and greater merger activity going forward. While bank stocks gave up more than half of their gains following the Fed’s December meeting, we believe the market’s initial reaction following the election was correct.
The impact of deregulation in other industries, however, may be harder to predict. One example is the auto industry, where the Trump administration could roll back Biden-era regulations on emissions and end tax credits that were part of a push toward faster adoption of electric vehicles. However, sorting out the winners and losers of such efforts may be complicated by Trump’s threats to impose tariffs on imports from Mexico and Canada that, when combined, account for more than half of all parts supplied to U.S. automakers.4
Tariffs are among the biggest question marks at the start of Trump’s second term. Investors want to know: Will Trump actually impose all the tariffs he championed during the campaign? A recent survey by Reuters found that economists are expecting nearly a 40% tariff on imports from China to be imposed early this year. This could have the potential to reduce China’s GDP by up to 1 percentage point.5
It’s difficult to tell how those tariffs will ultimately impact the U.S. economy, as much depends on how China and other trading partners choose to respond. By some estimates, though, blanket tariffs on imports could amount to a one-time 2% increase in inflation thanks to the higher cost of imported goods. Trump’s proposed immigration policies are another wildcard that could be inflationary in the near term. Some FOMC members likely started to incorporate the potential impact of both policies in their inflation forecasts. We believe that the policies ultimately implemented won’t be as extreme as what President-elect Trump has floated, and the market is likely mispricing the number of rate cuts coming in 2025.
Productivity is another factor the markets will be monitoring. Currently, economists believe there is a 27% probability of a recession occurring within the next 12 months, according to the Blue Chip Economic Indicators survey by Wolters Kluwer.6 We’re more bullish on the economy than that. Why?
It is partly due to fiscal and monetary policy. With deficit spending continuing to provide fiscal stimulus at the same time the Federal Reserve has begun its first easing cycle since the global pandemic, it’s hard to see the economy contracting in 2025. Part of our optimism is also due to the staggering level of investment being made in artificial intelligence, which could provide a much-needed boost to productivity growth.
In our last quarter Market Outlook, we discussed how the mania surrounding artificial intelligence (AI) is one reason why the shares of the Magnificent 7 — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla — have accounted for the vast majority of the market’s gains since the start of 2023. This is not just an investment craze. Morgan Stanley recently forecast that just four companies — Amazon, Alphabet, Meta, and Microsoft — will collectively invest more than $300 billion this year and more than $335 billion next year in capital expenditures for generative AI and other large language models.7
In many ways, this environment resembles the late 1990s — not in terms of market conditions but related to the capex spending spree. Even as the stock market suffered a setback in 2000, the investments that companies made then in developing the Internet created a significant productivity boom in the economy that played out throughout the subsequent decade.
Exhibit D: U.S. Productivity Change in Nonfarm Business Sector
Source: U.S. Bureau of Labor Statistics, Fiduciary Trust Company. Data as of November 7, 2024.
We prefer to see increases in economic growth come from productivity gains as opposed to stimulus, as the former produces increases in wealth and incomes without increasing broad inflation. This gives us more conviction in our view that today’s economic backdrop resembles a 1994-95 style soft landing is still intact.
Finally, there is a $7 trillion wildcard to consider. Another reason for cautious optimism is the $7 trillion currently sitting on the sidelines in money market funds in the U.S. This is a disproportionate sum relative to GDP and how much investors in other countries are holding in these funds.
Money market funds is an intriguing asset class that sits in a grey zone outside of the banking system. As the Fed continues to cut rates, lowering the payouts offered by such funds, investors utilizing these vehicles have a couple of choices: they can redeem their shares and temporarily park the money in the banking system where it can fund more lending in the economy.
Alternatively, investors can choose to direct those proceeds into risk assets like stocks, which can fuel demand in equity and fixed income markets.
Right now, investors seem satisfied to keep their powder dry by keeping cash in money market funds. But as they become increasingly motivated to make a move, either through fear or greed, that capital could have a profound impact on the markets this year.
Implications for 2025 Investment Strategy
Investors have enjoyed two straight years of strong market returns, and as we mentioned previously, we believe stocks are poised for a solid start to 2025. While the S&P 500’s lofty valuation may be unnerving, several macro and technical tailwinds, including the debt ceiling, deregulation, and a likely winding down of the Federal Reserve’s Quantitative Tightening program should provide support for further gains. Technical factors and fundamentals tend to have a greater influence on markets than valuations in the short term. Investors in search of more reasonable valuations need look no further than small cap stocks and non-US equities where multiples remain in line with historical averages.
The uncertainty surrounding President Trump’s tariff policy poses a risk, but the performance of Chinese equities and the dollar since the election suggests the market has already priced in some increase in tariffs. Should the proposals prove to have been negotiating tactics rather than actual policy, markets could get another boost. Within fixed income, further Fed rate cuts mean investors won’t earn the 5% on cash that they have recently enjoyed, and select areas in credit markets still offer high single-digit yields. While it is still early days, artificial intelligence has the potential to meaningfully boost the economy in the coming years. This is provided the large capital expenditures in this area materialize into productivity gains.
We will continue to monitor and evaluate these and other forces shaping the economy and markets, and work to position client portfolios to mitigate risk while capturing upside opportunities. Please reach out to your Fiduciary investment officer with any questions.
Exhibit E: Fiduciary Trust Asset Class Perspectives
Note: These forward-looking statements are as of January 3, 2025, and based on judgements and assumptions that change over time.
