U.S. Equities: A Mixed Bag of Opportunity and Risk

U.S. Equities: A Mixed Bag of Opportunity and Risk

2025 returns look positive, but may be subject to potentially significant shifts in the macro backdrop.

As we look ahead to 2025, several key factors will shape the U.S. investment landscape, particularly considering recent political developments and economic indicators. The reduction in political uncertainty, especially following the convincing outcome of the U.S. presidential election, is expected to drive positive year-end returns that could spill into the new year. Furthermore, the perceived shift towards a more business-friendly administration has sparked optimism in U.S. equity markets, with the S&P 500 Index surging to new all-time highs, led by small caps and financials.

Resilient economic growth data and more expected rate cuts by the U.S. Federal Reserve (Fed) further contribute to the healthy near-term outlook for U.S. stocks. Real GDP grew by 2.8% annualized in the third quarter, with solid contributions from consumer spending, business fixed investment and government spending (particularly on national defence). The Atlanta Federal Reserve’s GDPNow tool shows expansion slowing just a little in Q4, with the disinflation trend remaining intact. Meanwhile, the latest Federal Open Market Committee update suggested further rate cuts are likely forthcoming, but that their pace and timing were dependent on incoming data. Fed Chair Jerome Powell also outlined that interim data have been stronger than expected in the aggregate and downside risks have diminished.

We see several areas of opportunity in this evolving climate:

Small caps: Small-cap stocks are poised for the potential of significant gain even after, in the wake ofthe election, notching their largest weekly gain since the COVID-19 pandemic. The Russell 2000 index is expected to continue outperforming. Small caps typically thrive in environments where the Fed cuts rates, and with moderating inflation and easing financial conditions, we believe this sector is well-positioned for growth.

Financials: Post-election, we saw a massive rally in financials, likely tied to anticipated de-regulation. The outlook for corporate mergers and acquisitions (M&A) and initial public offerings (IPO) activity is optimistic, as policy uncertainty is expected to decrease. The incoming administration may adopt a more lenient regulatory approach, enhancing CEO confidence, which is crucial for M&A engagement. Additionally, IPO activity is anticipated to recover, reflecting a more favorable macro environment.

Industrials: The industrial sector is poised for significant growth, particularly as domestic manufacturing gains momentum amid potential tariff increases. Key trends such as re-shoring and deglobalization, the transformation of data centres driven by generative AI, and the modernization of the grid for sustainability are all contributing factors. Additionally, the U.S. has seen substantial underinvestment in its fixed asset base since China joined the WTO in 2000. Together, these elements create a perfect storm of opportunities for the industrial sector to excel.

Technology, communication services and biotech: Companies in these sectors maybenefit from increased investment and consumer spending. The focus on software and biotech also presents substantial opportunities, as these areas are expected to see robust growth driven by innovation and demand.

Modernization of defence spending: Trump’s focus on the military is expected to continue, requiring funding. Despite prior promises to cut the Department of Defense budget, his first budget in FY2018 saw the largest procurement increase since 9/11. On the other hand, efficiency pushes on government spending, like those suggested by Elon Musk, could disrupt norms. In that world, companies tied to modernization spending may benefit, with Bank of America (BofA) Global Research predicting a 10% compound annual growth rate (CAGR) in defence budgets through 2027.

Of course, opportunities rarely if ever come without risks, and we see several potential challenges on the horizon. One is interest rate sensitivity. The recent climb in U.S. 10-year Treasury yields from 3.62% to 4.42% underscores the need for vigilance as the Fed continues to navigate its monetary policy. A sharp increase in yields could dampen stock price rallies. Historically, significant rises in yields have correlated with declines in U.S. equity prices.

Another area of concern is that Trump’s promised tariff regime will create a downside risk to corporate earnings. According to Goldman Sachs, the new administration might implement an average 20-percentage-point increase in tariffs on imports from China, with a 40% chance of a 10%-20% blanket tariff, which Trump proposed during the campaign. While companies managed to pass tariff costs on to consumers during the 2018-2019 trade conflict, this could change. Tariffs may still lower earnings due to reduced consumer spending, retaliatory tariffs on U.S. exports, and heightened uncertainty.

Meanwhile, pressures may build in the U.S. housing market. If interest rates rise, that could hinder a rebound in 2025. While the Trump administration may implement supply-side solutions to improve housing affordability, the overall impact of tariffs on homebuilders remains uncertain. Some companies seem well-positioned to potentially benefit from policies favouring higher-income buyers, but the broader market may still struggle.

Finally, the Republicans’ electoral victory casts renewable energy policy into uncertainty. The  Republican sweep could jeopardize tax credits associated with President Joe Biden’s Inflation Reduction Act, leading to downgrades in clean energy stocks. The outlook for onshore and offshore wind projects may also become less favorable, impacting companies reliant on these sectors.

In short, the 2025 outlook for U.S. equities presents a mixed bag of opportunities and challenges that are subject to potentially significant shifts in the macro backdrop as the year progresses. The reduction in political uncertainty and anticipated economic growth provide a solid foundation for stock market gains, particularly in small caps, financials and industrials. However, potentially higher interest rates, risks to earnings from tariffs, and housing market challenges mean that caution may be warranted. In our view, investors should remain agile, focusing on sectors poised for growth while being mindful of the broader economic landscape and the possibility that market leaders can quickly become laggards and vice versa in the current environment.