For next year, 2025, global economic growth and falling interest rates will provide a good base for equity markets. Equity returns will be driven by earnings growth, as valuation levels are elevated relative to history. Global economic growth masks the continued divergence between economies and industrial decline. The US continues to grow at a brisk pace of over 2%, while Europe remains stagnant with growth again below 1%. China is keeping the wheels of its economy turning through stimulus measures. The economic divergence is reflected in interest rates, as the gap between US and European rates continues to widen. The expensive dollar continues to strengthen on the back of Donald Trump's policies. The main themes that will move markets are Trump's trade war and possible peace in Ukraine.
Global economy growing at a healthy pace and rates are falling
Next year the global economy will continue to grow at a good pace and inflation will fall. But economies are diverging. The US will grow at a brisk pace of over 2% a year, but Europe will again grow at less than 1%. China will maintain a growth rate of over 4% with the help of stimulus measures.
The US Federal Reserve (Fed) will continue to cut interest rates, but they will hold at 4%, a higher level than previously thought. This is due to the economic policies of President-elect Donald Trump, who aims to boost economic growth and inflation through tax cuts and deregulation. US economic growth is likely to exceed 2%.
Europe should be coming out of hibernation, but it isn’t. Economic growth risks staying below 1%. But inflation continues to fall. Therefore, the European Central Bank (ECB) is continuing to cut interest rates and, in the face of a pending trade war, may even accelerate the pace of cutting. According to market forecasts, the key policy rate will be below 2% in a year's time. A potential boost to the economy would be an end to the war in Ukraine, which would boost consumer and business sentiment. European households have significant excess savings that could boost economic growth, as has happened in the US.
China has revived its economy since the property bubble burst. China has been able to keep growth above 4% despite the reluctance of the Chinese to join the consumer spending spree. But Trump's new term means another trade war is coming. China has already budgeted some of its stimulus for next year with the trade war in mind.
China has also been rerouting its exports to the US through other countries, and as a result China's share of US goods imports has fallen from almost 22% to around 14% since the last trade war. China's economy is more driven by domestic demand anyway. The trade war is a drag on growth, but it doesn’t bring a threat of recession for China.
US equities are the best performers
Next year, the equity market will continue to rise, driven by earnings growth. Returns will be lower than this year because valuation multiples will not increase next year. Equity markets will be supported by strong economic growth and falling interest rates.
US equities will again be the top performers, while Europe and emerging markets will underperform. US equities are supported by strong corporate earnings growth of just over 10%, in line with economic growth of around two and a half percent. US equity valuations are high at the index level, but in line with the past five years and far from the levels of the IT bubble.
European corporate earnings growth risks falling below 5% as economic growth remains below 1%. Without economic growth there is no profit growth. It is also important to understand that the European economy would suffer from a trade war even if it was not a major player. A trade war is poison for investment, and the deterioration in sentiment means that industrial orders would be postponed. This is what happened in the trade war of 2018, when European growth stalled even though the trade war was between China and the US.
Market concentration does not depress returns, but increases volatility
The concentration of the US stock market worries many investors. The seven largest companies account for more than 30% of the market value of the S&P 500 index. Equity strategists at investment bank Goldman Sachs believe that this concentration will reduce returns on the S&P 500 from 7% to just 3% over the next decade. They are mistaken.
Let's consider this thought experiment: Large companies are broken up into smaller ones. Google is split into Chrome, Android, YouTube, GCP and Waymo. Meta becomes Facebook, WhatsApp, Instagram and Metaverse. We can go on like this until the seven largest companies become thirty smaller companies, thereby reducing the concentration of the S&P 500. If we follow Goldman's thinking, returns should rise from three percent to at least seven percent.
But has anything really changed in terms of returns? No, since the concentration of the stock market does not affect returns. But it does affect stock market volatility. It is also worth noting that many European stock markets are now more concentrated than the S&P 500. Historically, the Finnish stock market was the most extreme, where Nokia once accounted for more than 70% of the market.
Good and bad peace
Trump could also be positive for European equity markets. An end to the war in Ukraine would not only boost equities, it would also boost European consumption and hence economic growth. The economic bonus would be geopolitically a small consolation. If Trump were to end the military aid and insist that Ukraine accepts a peace deal, it would set a bad precedent for Europe. Especially for other border countries like Finland.
Emerging market returns are being weighed down by the rising dollar and Trump's trade policies. In particular, China's stock market rally could be stalled by a trade war. Other emerging markets and Europe will suffer more from the effects on sentiment from the trade war than from the tariffs itself.
Valuations are stretched in the US and in line with history in both Europe and emerging markets. Valuations have risen further this year, but this is unlikely to happen next year, so returns will depend on earnings growth.
Trump has said he wants to weaken the dollar, but it is likely that his trade policies will lead to a stronger dollar.
Economies diverging - rates will too
Interest rates are diverging as economies diverge. In the US, the Fed will cut rates less than originally expected, while the ECB may cut rates more than expected. These expect central bank actions will cause US short rates to rise and European short rates to fall.
Longer maturity rates are generally driven by expectations of economic growth and inflation. Higher economic growth and inflation expectations in the US mean that US long rates will remain higher than in Europe, where economic growth is not expected to accelerate.
Historically, fixed income markets can be disrupted by excessive debt. Under former US President Bill Clinton, for example, the ten-year rate rose by around three percentage points between 1993 and 1994. Another more dramatic example was the resignation of UK Prime Minister Liz Truss in October 2022, due to the bond market's reaction to a lax budget.
In 2023, the US budget deficit was 6.3% and public debt was 120% of GDP. As a result of Trump's economic policies, the budget deficit could be closer to 10%, depending on how many of his campaign promises are fulfilled. Nevertheless, a bond market rebellion is a possible scenario, but an unlikely one. There are at least two reasons for this. The US is richer than ever and there are few alternatives. The US economy is growing fast and net assets are at an all-time high. However, the bond market is driven by the probability of repayment, not the amount of debt per se. Alternative markets such as Germany, the UK, France and Japan are growing more slowly and are not as wealthy. Nor are they military superpowers sheltered across the ocean.
Thoughts on allocation
Equities will outperform fixed income next year. US stocks will outperform European and emerging market equities. Corporate bonds will outperform government bonds and high yield corporate bonds will outperform investment grade corporate bonds.
Equity returns will lag this year’s returns due to high valuation multiples. Returns therefore depend on earnings growth. The excess return on corporate bonds over government bonds will also be lower because credit spreads are narrower.
Next year will be more volatile than this year. The source of turbulence will be Trump's actions, with a trade war being the main source of uncertainty. The trade war in 2018 led to a correction of almost twenty percent in equity markets. Equities eventually corrected in six months. The trade war has also had a negative impact on sentiment, which put a significant dent in European economic growth. The trade war will come early in the year, but this time it will not come as a surprise.
European equities would benefit from an end to the war in Ukraine. A forced peace would of course set a bad geopolitical precedent, especially for border countries like Finland.
After Trump
The last time Trump won the election, the market initially rallied in the first six months. Tax cuts and deregulation fattened corporate profits and boosted economic growth, but the rally fizzled out when the trade war broke out, especially in Europe and emerging markets. This time around, both the good and the bad Trump will be back from the start.
A key investment guideline for the Trump era could be that Trump's desire to boost the US at the expense of other countries will apply to markets. US equities should be overweight relative to the rest of the world and the dollar overweight relative to other currencies. The dollar can also protect portfolios in the face of market downturns. Trump's policies will be particularly supportive of US financial and energy companies, which will benefit from deregulation.
If Trump's actions hit the rest of the world's equities or currencies too hard, this could be a good time to buy them at low valuations if one has a longer investment horizon. At the moment, European and emerging markets are more in line than cheap. Certain companies and sectors, such as semiconductors and pharmaceuticals, may also become attractively cheap.
Is it too early to speculate on what will happen after Trump? He will not be allowed a third term. But lobbyists have signalled that his family and interests are to the Republicans what the Kennedys were to the Democrats in their day. Trump has succeeded in changing the face of the Republican Party. His spirit may be with us for a long time to come.
