In my Strategy 2024 blog entitled “Powell Pivot: What Could Go Wrong or Right?”, I suggested global financial markets had entered a cyclical sweet spot. Specifically, the combination of steady (if uneven) global growth, declining inflation, and easing monetary conditions pointed to higher equity market valuations. Indeed, even my bullish S&P 500 projection of 5,800 proved too conservative.

As we gaze into 2025, the same bullish conditions would appear to be still in place. Despite his pessimistic campaign rhetoric, President-elect Trump once again inherits (as he did in 2017) a steadily growing economy, inflation falling towards its 2% target, and a Federal Reserve poised to lower interest rates. The big question is whether the incoming Administration’s plan to impose tariffs, to expand fiscal policy, to deregulate, and to deport millions of undocumented immigrants will upset or reenforce the favourable market conditions.

Typically, I dislike when analysts outline multiple market scenarios — I prefer to convince readers of the wisdom of my base case. In the coming period, however, the range of possible policy outcomes is wider than at any time I can recall. Therefore, investors need to contemplate a variety of possibilities. The bull case involves a trade policy combining threats with market-opening negotiations, supply-side deregulation boosting Amercian productivity and long-term economic growth, and fiscal consolidation with spending cuts offsetting promised lower taxes. The other extreme features the outbreak of a full-blown global trade war, higher inflation, confrontation with the Federal Reserve, and bond market scepticism about the unstable path of US fiscal policy (as UK Prime Minister Liz Truss experienced).

For now, both markets and I are working under the assumption the President-elect’s bark is worse than his bite, as it was during his first term. Admittedly, it’s impossible to maintain this view with complete confidence. All US presidents begin their terms believing they possess a popular mandate for their agenda. However, events often derail such plans.

Overall, I expect market returns will be modest in 2025; for instance, my S&P 500 target is 6,250. However, with such a broad range of plausible outcomes, greater market volatility appears assured. Therefore, while the current bullish mood may continue into the New Year, I anticipate a meaningful (up to 10%) correction at some stage (perhaps during the first 100 days of the Administration). Indeed, investors may need to question the consensus “Trump trades”, e.g. overweight risky assets, the US market, and the US dollar, as well as underweight duration and European and Emerging market equities.

Bark or Bite: It’s Inflation, Stupid!

In my humble opinion, the key determinant of the US election outcome (as well as in the UK, France, Germany, Italy, etc) was the recent experience with higher inflation. With US price growth now moderating, I hope any prospect of a renewed bout of inflation would temper the timing and extent of implementation of the incoming Administration’s promised economic plans.

Fiscal Policy: Unstable Debt Dynamics

One would think the precarious state of US public finances, which has deteriorating signficantly since Mr. Trump first took office, should limit the new Administration’s budgetary options. Indeed, the budget deficit stands at 7.5% of GDP compared to 4.5% in 2017. Likewise, the government debt/GDP ratio is now 100% (125% by some definitions) versus 80% of GDP earlier. And, the CBO projects public sector liabilities to increase to 125% by 2035.

Nevertheless, I expect Mr. Trump will extend the TCJA tax cuts due to expire next year. If the President-elect implements all his fiscal pledges, the highly-respected CRFB suggests annual deficits could increase to 9-10% of GDP, and boost the debt ratio to 143% of GDP during the next decade (Chart above). In a fully employed economy, this fiscal stimulus would stoke inflation, and put the Administration and Federal Reserve on a collision course.

Newly-appointed Treasury Secretary Scott Bessent would like to reduce the deficit to 3% of GDP, which would stabilise (but not reduce) the spiraling debt ratio. As discussed in my earlier article “Election 2024: What They’re Not Telling Us”, an adjustment of this scale would require both changes to entitlement programs and draconian cuts in government programs popular with Trump’s political base (nor does the new President have a mandate for such measures). Likely, Elon Musk will suggest that improved government efficiency will solve the problem, but that’s implausible. Unless budget cuts totalling $5 trillion accompany the the TCJA extension, the bond market may revolt. Moreover, the Trump-Musk-Bessent billionaires’ bromance may begin to break down as fiscal reality sets in. (Also, I’ll be curious whether Messrs Trump and Musk fall out over the need for electric vehicles).

Trade Policy: Bark or Bite

During his first term, fortunately, Donald Trump’s trade policy involved more bark than bite. To be sure, 25% tariffs were imposed on Chinese imports, and the USA left the Transpacific Partnerhip. But, the USMCA was merely a needed update of NAFTA, and measures against Europe and others were modest. Trump 2.0, however, appears set to be more aggressive. It’s never quite clear what the objects are: to reduce the world-wide US trade deficit and external debt (won’t happen), to cut bilateral shortfalls with individual countries (achievable), to improve US exporters’ access to foreign markets (hopefully), or to pursue other non-trade geo-political objectives (understandable), e.g. curbing China’s regional aspirations in Asia or securing Mexican cooperation on immigration and drug trafficking.

The Chart above identifies prime targets, e.g. countries with large bilateral surpluses and where US exports have the most restricted access (the export/import ratio is below the overall US average). China and Mexico are most vulnerable. Canada and the European Union enjoy large surpluses, but US access to these markets is not particularly hindered. In the EU case, Germany, Italy, and Ireland account for the bulk of the bilateral imbalance. US exporters encounter significant barriers to Asian markets — note Vietnam.

What are the implications? First of all, tariffs will never remedy the US trade deficit and rising external indebtedness. The Chart above illustrates that while China tariffs have reduced the US-China imbalance, Americans just bought stuff elsewhere, and deficits with other countries (and overall) have increased (see my blog Election 2024: International Trade Policy for a detailed discussion).

If the Trump Administration fulfills its promise to impose tariffs of 60%, 25%, and 20% on China, Mexico/Canada, and the rest of the world respectively, the USA will suffer a one-time inflation increase of about 4%. Likewise, GDP would be reduced by 1-1.5% over the next couple of years. To be sure, consumers suffer from higher prices. In addition, manufacturers (the supposed beneficiaries of protectionism) are also harmed by higher costs for intermediate inputs provided through foreign supply chains. The consequences will be greater if trading partners retaliate, and they will eventually.

Given the political consequences of higher inflation, I suspect President Trump’s bark will be worse than his bite again. Nevertheless, planned levies on China and Mexico will go ahead, and the impact on US inflation may be limited to 1-2%. On the other hand, if Mr. Trump succeeds in using tariff threats to negotiation greater American access to foreign markets, this outcome would support the bull market case.

Immigration: Demographics Remain a GDP Headwind

To be sure, Mr. Trump plans to deliver on his pledge for the “biggest mass deportation ever”. Again, we will only learn about the scale and timing later. But, size matters to the economic consequences. At present, it’s estimate that more than 11 million undocumented migrants reside in the United States, which represents 6.5% of the US labour force (and 33% of the foreign-born labour force). Of course, deportation at this scale would lead to a deep economic downturn. Previously, the largest US expulsion was 1.3 million under President Eisenhower. Alternatively, if illegal immigrants with criminal records are targeted, ICE estimates this group totals 450,000 or so (which represents only 1% of the foreign-born US population).

My base case is the deportations may exceed the earlier record (allowing Mr. Trump to assert its “the biggest ever”). Historically, however, net immigration averaged about 1 million per year. Overall, therefore, I would anticipate a net immigration decline of only about 500,000 in the period ahead.

Deportations of this scale would not have serious inflation or GDP costs: perhaps shaving 0.25% off GDP and adding a similar amount to consmuer prices. However, larger expulsions would have a more meaningful impact on wages and prices, especially amongst low-income US citizens. Given the aging (and slow-growing) native-born US population, immigration reform is needed to prevent stagnant labour supply from becoming a serious economic headwind (as in many European countries). Indeed, the Chart above illustrates that foreign-born workers have accounted for the entire expansion of the US labour force since the Covid pandemic.

US Market Implications: Clash With the Fed?

• During Mr. Trump’s first term, US equity markets were very cheap relative to bonds (Chart above). Thus, stocks benefited both from earnings growth and PE multiple expansion. However, equity earnings yields are now similar to fixed income rates, e.g. stocks no longer offer relative value. Further market advances, therefore, will rely either upon EPS growth or lower bond yields. GDP should remain healthy in H1 2025 before slowing into 2026 prior to mid-term elections, as the consequences of tariffs and deportations take hold. I expect EPS to increase 15% and 10% in 2025 and 2026 respectively.
• Meanwhile, however, I expect bond yields will rise, not fall in 2025 (see Forecast table for explicit projections). As Trump’s trade, immigration, and fiscal plans will all add to inflation (hopefully more modestly than some fear), I expect some EPS multiple contraction in the coming period. Therefore, I expect modest returns with an S&P 500 target of 6,250.
• Federal Reserve policy will be reactive, not proactive. At least two additional rate cuts are likely in H1 2025. However, if inflation concerns build, the pace of Fed easing will slow by mid-2025. The terminal Fed funds rate is likely to be closer to 4% (roughly in line with current market pricing) rather than the Fed’s earlier projection of 2.9%.
• Undoubtedly, the Fed’s policy will displease Mr. Trump. At some point, I anticipate the US bond market will challenge the President’s pro-growth agenda, with 10-year yields spiking temporarily towards 5%.
• There’s a strong (and understandable) consensus for US dollar appreciation, as the US economy outperforms other countries and trading partners seek to offset the adverse consequences of tariffs. However, the greenback is now quite overvalued (next Chart). And, if the market begins to question the sustainability and efficacy of American fiscal and trade policies, the US currency may suffer. As a weaker dollar would support growth, I don’t think President Trump would mind.
• If deregulation (along with AI, innovation, etc) succeeds in boosting US productivity, I’ll become even more bullish. After languishing following the Global Financial Crisis, American efficiency does appear to be reviving in recent years.

China: Having a Draghi Moment?

At the height of the Euro Crisis in 2012, ECB President Mario Draghi pledged “to do whatever it takes” to counter the region’s deflationary spiral. Do China’s more assertive policy decisions reveal a similar commitment? Will the recent measures remedy the nation’s deflationary conditions, and attract investors back into relatively cheap Chinese equities? And, what will be the impact of higher US tariffs on Chinese exports?

As welcome and appropriate as the recent actions are, they will not quickly remedy China’s deflationary pressures. First of all, China is only in the early stage of addressing its huge surge in corporate sector debt; indeed, the debt ratio is still rising (Chart above). Deleveraging of this scale will take several years. Likewise, oversupply in the property market remains enormous, and will require a multi-year adjustment, especially as housing demand will remain weak (next Chart).

What’s missing are measures to boost local consumer expenditures. President Xi appears to have abandoned the earlier goal of rebalancing the economy towards services and household spending. Indeed, after years of success, there has been little progress in expanding tertiary (service) activity since the pandemic (next Chart).

Unfortunately, the surge in Chinese liabilities has not been limited to private businesses. Public sector debt, likewise, is rising on an unsustainable trajectory (next Chart). Consequently, the goverment does not have the “fiscal space” to support household spending, unless President Xi shifts priorities away from supporting struggling SOEs.

What about the American tariffs? Surprisingly, Chinese exports coped remarkably well following the imposition of levies in Trump’s first term. To be sure, sales to the USA suffered, but China successfully redirected trade and supply chains with Asian trading partners and Mexico (next Chart). Intra-Asian sales have expanded 63% since 2018 (some of these goods have been re-exported to the USA).

Inevitably, however, the imposition of 60% tariffs on exports to the USA will take a heavier toll; reducing GDP growth by 1-1.5%. Therefore, additional policy stimulus will be required to prevent GDP growth from slipping to 3%. With limited fiscal policy options, the burden will continue to fall on the PBOC. I expect interest rates to decline up to another 150bp. Meanwhile, to offset the impact of US tariffs, the RMB may depreciate 10-15%; provided market stability can be maintained.

Emerging Markets: Be Selective

Not surprisingly, the consensus view is to avoid Emerging Markets. Indeed, the prospect of a strong US dollar, smaller-than-expected Fed rate cuts, and the possibility of higher tariffs is an unenviable combination for export-oriented EMs. To be sure, foreign sales to the USA represent an especially large share of GDP for Mexico, Vietnam, and several Asian nations. Indeed, the hit to Mexican GDP could be 4-5% (Chart above).

However, Asian countries have implemented various strategies to successfully cope with the 2018 tariffs on China (see Chart in the China section above). For instance, Vietnam (especially), Thailand, Malaysia, Taiwan, and India increased sales to the USA at China’s expense. Meanwhile, Indonesia, Vietnam, and China were able to expand intra-Asia regional trading links. India also boosted sales to Europe. I expect US tariff hikes in Asia will be modest (some may escape all altogether), and all with achieve another competitive windfall versus China.

In addition, inflation in most Asian countries is low, and government deficits and debt levels are less elevated than in the developed markets. Therefore, policymakers have more options to ease monetary and fiscal conditions should economic activity falter. Likewise, I expect Asian (and other EM) central banks will not resist some FX depreciation to offset the tariff impact.

FX risks are greatest in China, Mexico, Thailand, Philippines, and Taiwan (all currencies are overvalued, see Chart above). Indeed, while EM are vulnerable, I believe there are selected opportunities. Focus on countries with large domestic markets, scope to cut interest rates and boost government spending, and the ability to manage the complicated global environment, e.g. Indonesia, India, Korea, Thailand, and Malaysia. Avoid China, Taiwan, Mexico, Brazil, and Vietnam (a former favourite, but may be a Trump target). Meanwhile, overweight Japan modestly.

Europe: Can Discount Narrow Finally?

To be sure, European markets are cheap both compared to their own history (next Chart) and relative to the US market (Chart above). But, will the valuation discount finally narrow? We’ve been waiting a long time.

It remains difficult to get excited about Europe’s economic outlook. In addition to numerous structural headwinds, the possibility of a 20% tariff hike would slice about 0.5% from GDP growth (see my blog for a discussion of the urgent need for reform “Can Europe Surprise? Only with Reforms”). To be sure, European GDP growth will lag the USA again in 2025.

Therefore, what’s the case for European markets? First of all, it’s possible tariff hikes may be fairly limited again. To be sure, Europe enjoys a fairly large and expanding trade surplus with America. However, the imbalance is largely with Germany, Italy, Ireland, and Switzerland. Germany and European automakers may be the biggest targets.

In addition, Eurozone inflation is again lower than in the USA (Chart above). And, the prospect of further declines in price growth is far more secure than in America. Therefore, the scope to reduce interest rates is more substantial and more clear. In addition, fiscal metrics — government debt and deficits — in many European countries are healthier than in the USA. Thus, the prospect for European bond market outperformance is likely. And, without getting over-excited, European GDP may produce an upside surprise in 2025. Unlike the insatiable American consumer’s post-Covid spending spree, European households have been stockpiling savings (next Chart). Should confidence improve, Europe’s consumers could enjoy life a bit more.

Therefore, I advocate a modest overweight in European equities and bonds. Focus on the UK (very small bilateral trade imbalance with USA), Spain, Italy, and Scandinavia. More cautious on Germany, France, and Switzerland.

Forecast Summary 2025