We began 2024 in a very different place—investors had expected slow growth, or like me, a recession. The Bloomberg consensus estimate for US gross domestic product (GDP) growth was about 1 percent. We expected federal spending would decline following the pandemic response stimulus, while 2022-2023’s steep interest rate hikes were still percolating through the economy, and high overall price levels were expected to crimp consumer spending. As it happened, consumer spending remained strong, fiscal spending didn’t fully unwind, and the economy proved to be more resistant to interest rate hikes than expected. The economy turned in a solid record in 2024, growing 2.8 percent. The S&P 500 Index returned 25.0% last year, further propelled by expectations for interest rate cuts and optimism about artificial intelligence (AI). Interest rate expectations were realized, with the Fed cutting rates a full percentage point despite continued economic strength.
Investors are more optimistic now. Tax cuts and deregulation could extend the economic expansion. The same Bloomberg survey forecasts 2.1% real GDP growth for 2025. S&P 500 constituent earnings are expected to grow 14.5% this year and 13.5% next. Unemployment has been ticking up ever so slowly, although, at 4.1%, it remains low by historical standards. Moderating employment may actually be a positive in the eyes of the Fed, as it is likely to help depress inflation. Wage inflation, +3.9% year-over-year in the most recent report, is probably higher than the Fed is comfortable with. Fed members may still cut rates another half percentage point in 2025 if inflation continues to trend lower.
Trump Policies and the Economy
While many investors are optimistic that the economy will stay strong, others are concerned that Trump administration tariff and immigration/deportation policies will hurt the economy. Although US President Donald Trump has honed his political craftsmanship, he still revels in strategic ambiguity. His policy proposals are far-reaching, but it’s unclear how far he will take them, how other branches of government will respond to them, and how impactful they will be when put into practice. Congress may help codify Trump’s intentions or it may get mired in internal debate, with some members prioritizing fiscal restraint. Republicans’ majority in the US House of Representatives is particularly narrow. Given the likelihood of legislative and legal hurdles, some of Trump’s policies may not be implemented until 2026 or later, if at all.
Investors also seem to be anticipating more inflation, at least in part due to Trump’s tariff and immigration policies. The Personal Consumption Expenditure (PCE) price index rose 2.6% year-over-year while the core PCE price index, which excludes food and energy prices, rose 2.8 percent. The timing of newer inflationary pressures is uncertain, as a great many things about Trump’s policy platform are still unclear. Reducing the number of immigrants in this country might shrink the workforce enough to increase wage pressures over time, with an outsized effect on the agricultural, construction, food service, and hospitality industries. The buildout of artificial intelligence (AI) data centers is likely to exacerbate our need for energy resources, but by improving productivity, AI may also partially offset inflationary pressures.
Tariffs will increase prices—we’ll see if the prices of goods rise enough to impact consumers’ overall cost of living, and for how long. Trump may be using tariffs to negotiate other policy objectives, only to set them aside once he has won concessions from counterparties. On the other hand, if tariffs are systematically imposed with a goal of compelling manufacturers to bring production facilities back to the US, the rush to rebuild with accompanying supply constraints could be powerful enough to stoke inflation over a multiyear period. Some counterparties are knuckling down with retaliatory tariffs. Insofar as tariffs are taxes, they generally tend to slow economic growth.
The mere continuation of current income tax rates is unlikely to be stimulative, although letting them expire and return to higher levels could be contractionary. Tariffs will raise tax revenue, allowing for some cuts elsewhere, but high current deficits give Congress little room to introduce new stimulative measures.
The Trump administration will also look to deregulation to further stimulate growth. Banks are likely to see less burdensome oversight. Beyond that, it’s not clear what these deregulatory measures would entail. As Bill Darling and I imply in the Page One article, there’s only so much deregulation the federal government can do. State and local authorities, and the courts, can also tie up business interests. If Trump proves to be more pragmatic than some of his rhetoric suggests, the stock market could benefit as fears are assuaged. We should get a much better sense in the coming months of how much of Trump’s posturing is bluster. As we better understand his operating style, uncertainty will abate.
The Case for Austerity
The total federal debt burden outstanding is now $35.5 trillion, or 118.5% of GDP.[1] With federal budget deficits running 5%-7% of GDP (6.6% in 2024), and interest rates in the 4% range, the total debt burden continues to rise at an unsustainable rate. Few expect annual deficits to shrink any time soon (see Figures 1 and 2). The Congressional Budget Office (CBO) projections do not take into account any extension of the Tax Cuts & Jobs Act of 2017 or any other changes to the tax code. There is no definitive limit on how high the debt burden can rise, but if our governing bodies do not make the hard decisions necessary to curb its expansion, Treasury bond investors will doubt our ability to repay them. Our financial challenges will become more acute with some combination of prohibitively high interest rates and inflation, depending on how the Federal Reserve responds to the fiscal negligence. The US Treasury might continue to shift more of its debt to short-term issuances, where rates are effectively set by the Federal Reserve.
Figure 1
Source: St. Louis Federal Reserve, Congressional Budget Office, Bloomberg
Figure 2
Source: St. Louis Federal Reserve
Interest Rates and the Dollar
The S&P 500 Index did fairly well over Trump’s last tenure, returning +21.8% in 2017, -4.4% in 2018, +31.5% in 2019, and +18.4% in 2020, despite, or because of, the Covid-19 pandemic. With many investors anticipating that Trump’s policies will accelerate growth, both the US dollar and long-term interest rates have risen (bond prices have declined) since the 2024 election. Investors responded similarly after his 2016 election into his first inauguration. The dollar subsequently softened in 2017 as the global economy strengthened and as the market came to terms with the realities of getting the first Trump administration’s agenda passed.
US Treasury yields stayed up through 2018 as the Fed was in the midst of a rate-hiking cycle. The economy was finally strong enough to handle interest rate hikes. But while absorbing 2.25 percentage points of interest rate hikes, GDP growth was not observably different from prior years, with the possible exception of 2018 when the Tax Cuts and Jobs Act was implemented. When the Fed cut rates in 2019, concerns about tariffs and an escalating trade war were among its reasons. The fact that Treasury yields fell in 2019 suggests bond investors were not particularly worried about how Trump’s tax cuts were impacting the fiscal deficit.
In contrast with Trump’s first presidential term, however, the Fed appears to be in the middle of a rate-cutting cycle, having cut rates by a full percentage point in the back half of 2024. Fed members felt that lower rates would better position monetary policy to balance the risk of inflation reigniting with the risk of an economic slowdown. However, even as the Fed was cutting rates in the latter part of 2024, a number of economic statistics came in stronger than expected, prompting it to signal fewer rate cuts going forward. Short-term interest rates were likely to stay higher for longer than previously expected, and longer-term rates rose.
After bottoming out in mid-September, the US 10-year Treasury yield rose 0.95 percentage points to end the year at 4.57 percent. The rise in long-term yields could mean bond investors are expecting any or all of the following: stronger economic growth than previously expected, stronger inflation, or the government having greater difficulty repaying its burgeoning debt. Concerns about the Fed’s independence may further be playing into long-term rates, as Trump gets to appoint a new Fed chairperson in 2026.
The Fed believes its short-term rates are restrictive, but clearly rates haven’t been all that restrictive considering the economy has continued to grow at a healthy pace and long-term rates have risen. Despite the federal funds rate being higher than it has been since the Great Financial Crisis of 2008-2009, it’s below its average over a longer span of history. Whether or not short-term rates are restrictive, rising long-term rates are likely to slow incremental demand for housing, capital goods, and investment. Higher rates may further change how Congress and the administration think about running large fiscal deficits. Insofar as higher rates slow the economy, they will also slow inflation. Long-term rates themselves may then ease from higher levels as both economic strength and inflationary pressures dissipate.
This time around, the dollar may stay relatively strong, supported by high interest rates, tariffs, and the relative strength of the US economy. By making imports cheaper, the dollar could be strong enough to offset price increases generated by import tariffs. However, the strong US dollar is also pressuring earnings growth for multinational companies and exporters. But by the same token, these dynamics could work in reverse if economic growth were to broaden around the globe: a softening dollar and declining interest rates might provide a boost to earnings. Both the dollar and rates will continue to fluctuate in a range, hopefully stabilizing growth, although it may be hard to predict the amplitude of their swings (see Figure 3).
Figure 3
Source: St. Louis Federal Reserve, FactSet
Magnificent Seven
With the so-called Magnificent Seven[2] accounting for more than 30% of the weighting in the S&P 500, idiosyncratic factors can affect the broader market. Company-specific risks such as antitrust regulation might further affect the bellwether index’s returns. The Magnificent Seven are all tied to the AI investment theme in some way, with Nvidia the arms dealer of AI semiconductors. We are believers that AI will bring about substantial technological advances, much in the way the internet has. The technology will develop over a decade or more, and it will have its share of misuses, wrong turns, setbacks, and regulations along the way. As such, we expect AI stocks are likely to be buffeted by swings in sentiment along a generally advancing trajectory.
The US Department of Justice is suing to break up Alphabet, and suing to force Apple to open its devices to services offered by competitors. Microsoft is under antitrust investigation, not for the first time. Nvidia is facing restrictions on the export of AI chips to foreign countries. It is unclear if the Trump administration will continue these efforts or develop new lines of attack against big tech. Other countries are in various stages of implementing similar measures. How these matters develop will affect the share prices of the Magnificent Seven, and therefore the S&P 500 Index. But while the Magnificent Seven will be buffeted by stock-specific factors, we are hopeful that other companies can benefit from the economic opportunities available to them, allowing for broader participation in the stock market’s advance.
A Focus on the Long Term
It’s still a time to exercise overall caution while looking for opportunities to add great companies to client portfolios. The stock market is likely to be more volatile than in the recent past. The president enjoys posting on social media and teasing at policy changes. Considering the extraordinary amount of power and influence enjoyed by the president, the markets will likely be more responsive to possible changes in policy. Specific Trump policies may drive the market up and down, while the general uncertainty over policy, if it persists, could itself limit business managers’ confidence to invest. The market may be on a roller coaster until it gains comfort with the overall tenor of the administration, while investor sentiment will continue to swing between fear and greed. Intelligent cases can be made for whether inflation or a recession presents the greater risk.
We’re staying focused on the long term. We believe Woodstock’s clients are well positioned to take advantage of the market’s long-term advancement by simply riding out its ups and downs. Stocks generally rise over the long term, even if the manner in which they get there is unpredictable.
Adrian G. Davis, CFA — President