2025 Outlook: Will the Fed Cause a Recession?

By: Brian Seay, CFA

Is inflation on the rise again? According to the Federal Reserve it may be.

Will we have a recession in 2025….or ever?

Are stocks overvalued after 2 years of strong returns?

Will the largest technology stocks just keep rolling or is it time for other areas of the market to play a bigger role?

What about bonds? Why bother with bonds if they have such low returns?

These are just a few of the questions investors are asking as we head into 2025. I covered all of these topics in more in our 2025 outlook. Watch the video below or listen to the audio only version anywhere you listen to podcasts.

Transcript:

Hello and welcome to the 2025 Outlook from Capital Stewards. Is inflation on the rise again? According to the Federal Reserve it may be. Will we ever have another recession? Are stocks overvalued after 2 years of really strong returns? Will largest technology stocks just keep rolling or is it time for other areas of the market to play a bigger role? What about bonds? Why bother with bonds if they have such low returns? These are just a few of the questions investors are asking as we head into 2025. In this episode I will share my view on where the economy and investment markets are headed in 2025.

As always, these outlook episodes are longer, so I know you will want to listen to the whole thing, but in case you’re looking for something specific, check the notes and you can skip ahead to the different topics I discuss. There’s lots of charts in this episode, so if you’re listening to the podcast version, consider watching on YouTube so that you can see the charts. Alright – let’s dive into the economy and markets as we move into 2025.

Let’s start with what’s happened so far this year. On the chart you can see the S&P 500 stock index in the red line. It’s now up more than 24% for the year, only to be outdone by Gold, which is up more than 27% since January. Real estate had moved higher throughout much of the year on expectations of lower rates, but the Fed’s reduced expectation for future rate cuts killed most REITS in mid-December. Now real estate is up more marginally for the year. Bonds are now only slightly positive for the year as rates rose after the most recent Fed meeting.

This year has been good, but most of our clients, and most investors in general, have long-term goals that extend far beyond 2024.  The most important factor in investing success is choosing the right assets and sticking with them long-term. You can see over the last 28 years, the S&P 500 is averaging 9.7% per year in returns. Stocks produce the highest return over long periods of time, even when you consider the recessions that happened in 2001, 2007 and Covid in 2020. Gold returns just over 7.0% annually, Bonds just over 4%, all outpacing inflation, even after the recent run-up in inflation, at 2.5%.

When we zoom in and look at the past decade, The S&P 500 has returned more than 13% each year on average, Gold around 8%, Real Estate has averaged 5.5% and Bonds are actually the laggard averaging only 1.4%. You can see the draw-down in Bond performance as rates rose after Covid.

When you think about the 28 year and 10 year history, you would be a very happy investor today if you invested at the peak of markets before the global financial crisis or right before Covid. We will take about the current state of the U.S. economy and markets in a minute – but investing solely based on whether we will or will not have a recession or whether stocks are overpriced and in a bubble is a bad idea. We talked in the last episode about the accuracy – or lack thereof - of these kinds of forecasts. Most Wall Street shops through stock market returns would be much weaker this year and liked other assets. Stock valuations were high coming into 2024 and many expected a pullback, now the S&P 500 is more than 25% higher. Selling your stocks based on a forecast would have led to really bad results. Recessions and market drawdowns don’t feel good, I’ve lived through a few myself, but building a portfolio you can stick with through the hard times is the best way to achieve long-term compound returns. So regardless of the rest of this outlook, think about your portfolio and other assets and whether you feel comfortable regardless of the environment – good or bad - going forward. If you have concerns, then it’s probably time to seek out professional advice.

2025 has been a good year for most investors, especially those with large equity portfolios. However, going forward I think returns will be harder to generate and my view is that the economy is continuing to slow down, contrary to the Fed, which apparently believes we are speeding back up. More on the Fed in a few minutes. Let’s look at some real data on the economy. Once we have a good feel for where the economy is at, we can discuss various asset classes that we can use to build investment portfolios.

You can see on the first chart, the economy is moving along nicely. Real GDP is growing 2.7-2.8% a year. That’s consistent with the economic growth we saw before the Covid recession. You see the covid recession in 2020, the a big spike in GDP growth, the red line. The came with a big spike in inflation, the green line, and then the Fed raised interest rates to cool off the economy. Growth and inflation have come down meaningfully from their post-covid highs, but the big question markets are grappling with is why the funds rate, which is still relatively high at 4.5% hasn’t brought growth and inflation down even closer to the 2% target. Now when we think about keeping GDP high, the largest contributor to GDP growth is consumption in the U.S. That’s all of us going out and buying things. And the U.S. consumer tends to be really good a spending… unless they lose their job. So lets look at the jobs market.

This is where I see the potential for problems as we move further into this cycle in 2025. You notice on the page that the Jobs market is essentially “in-balance,” meaning that the number of Job openings only slightly exceeds the number of unemployed people looking for jobs. The number of job openings has steadily moved lower over the past 2 years. Firms filled their backlog from Covid and higher rates have constrained further employment growth in most areas of the economy. Until recently, the unemployment rate was relatively flat, but now, as workers lose their jobs, it is becoming increasingly harder to find new ones.

We looked at this last quarter. On the left, you can see the 3 month average of nonfarm payrolls, the green line, moving steadily lower in 2023 and 2024. The labor force, which is the total number of people that are working and want to work, is more volatile, but that has also been moving lower. On the right, I simply subtract additions to the labor force from the change in non-farm payrolls. Essentially, are we creating enough jobs every month to support the people that we know are looking for work. Anything over 0 is good, anything negative is a problem if we stay there too long.

For now, that number has remained positive, but again, the trend is lower. Outside the headline stats, the duration of unemployment is moving up, recruiting intensity is lower, the number of people leaving their jobs is lower, and wage growth is slowing back to where it was pre-covid. Layoffs have also been fairly well contained so far, but they have normalized. Meaning any growth in the number of layoffs from here is going to drive unemployment higher as those workers are not able to easily find a new job.

Is the labor market about to fall off a proverbial cliff on its own? No. But if the Fed continues to hold rates high, all of those statistics are not going to magically turn around. The labor market will continue to weaken, eventually causing consumer to spend less, which causes companies to earn less and kicks off a self-reinforcing cycle of lower earnings, more layoffs, which leads to lower earnings and a recession. I think the risk of a recession from a policy error next year from the Fed is higher than at any point in this cycle. So far, I’ve been bullish on the economy and markets, but there is a now a real chance we see a significant deterioration in the labor market next year that cause growth to stall out.

The other side, of course, is inflation. That’s obviously the concern for the Fed and why they may choose to keep rates higher. You can see in the chart the PCE indexes have moved significantly lower from their peaks post covid. If you look at the core number especially, you see the downward momentum stalling out a bit in the 4th quarter of this year. No doubt spooking the Fed. However, when we look under the covers, we see an inflation environment that should continue to weaken over the next year.

The market is expecting a 0.12% print for core PCE later this month. That runs about 1.44% on an annualized basis. The main component of the last 8 tenths of 1% on core inflation – what would get us back to the Fed 2% target – is housing inflation. It operates with a lag and we use Owners Equivalent Rent to measure the “inflation” felt by homeowners. Has your mortgage payment gone up over the last 3 years? Mine hasn’t. But my “owner’s equivalent rent” has gone up because my home would be more expensive to rent if it was on the market. So, while it will take some time for the government statistics to bare out what’s happening in the marketplace, I think it’s fair to say that real-world Core PCE inflation is running somewhere very close to the Fed’s 2% target. For even more evidence, you can look at the Harmonized CPI, which is running at 2.3% over the last 12 month. This is the CPI measure they use in Europe – and most every other developed country in the world. It does not use Owners Equivalent Rent to capture housing costs, so I think it’s a fair measure of what’s happening in the   

Whether you believe real-time inflation is running at 2.8% – or closer to 2% - it’s certainly not accelerating and not high. Over the last few months, progress on inflation moving lower has stalled out a bit after what has been a big move down over the course of the year. I would expect that move to continue into the 1st quarter of 2025. Economists can argue to the tenth of 1% about the inflation stats, but from an investment standpoint, my view is that inflation continues to move slowly lower and is not a major concern for the economy.

For their part, I’m not sure what got into the Fed this month. Even with very slightly higher expectations for growth and lower expectations for unemployment in 2025 – they now see significant inflation upside risks? Yes, September and October were higher from an inflation perspective, but the November PCE is likely to be equally soft. Either they simply needed to justify a way to slow down the pace of rate cutting – which in my view was unnecessary – no one expected them to cut every meeting until they hit neutral. The market already expected the pace of cuts to slow OR they are attempting to price in the impact of immigration and tariff policy – which we will discuss in a minute – but is its far from certain that either of those Trump policies will drive materially higher inflation across the economy.

I agree with Chairman Powell that the economy is currently in a “good place” – but it is continuing to slow down. Not speed up. I’ve seen NO forecast of next year’s GDP that is higher than this years. The expectation is for positive growth, but slowing growth. Eventually, if the Fed does not get rates down, they will be the cause of the next recession. I think one of the major risks going into next year is that the Fed is late cutting rates because of the vagaries of the inflation data and as a result, drives the economy into a recession.

The market is currently pricing in 2 cuts – with a 1 or no cut “whisper” number on the street. I think we will continue to see interest rate volatility as the market sorts itself out. Over the course of 2024, the market expected 6 cuts, then no rate cuts, then 5, now we know the answer and we got 4. My view is next year we will get 4 rate cuts, so another 1% to bring the funds rate down to 3.5%, then I think we may be close to neutral.

One aspect that I think is also making it harder to judge the strength of the economy is the wealth effect. The wealth effect occurs when consumers determine their spending based on their assets levels instead of their income. As the stock market and home prices go up, consumers feel better off and tend to spend more. This is especially true for baby boomers in retirement and high-income consumers. You can see in the chart, equity holdings have gone from 30 to 45 trillion in the last 4 years.

I think there is a scenario in 2025 where unemployment moves meaningfully higher, but spending and GDP growth stay flattish as the baby boomers keep spending. Then the Fed will have real quandary on their hands. They should lower rates to increase employment, but they may be doing so without being in a recession.

Before we move on to asset classes, perhaps a word on potential policies from the incoming Trump administration. I did a full episode on various proposed economic policies during the campaign season earlier in the fall. In short, wide-spread tariffs are not good economic policy. Each tariff drives up the price of an imported good and all of the evidence shows that the end consumer ends up paying for the tariff through higher prices. The challenge with forecasting policy is whether President Trump really intends to placed tariffs on every imported good or every imported good from a particular country like China. That unquestionably would raise prices in the near term. However, in the past, Trump tended to talk big and then implement much smaller Tariffs to accomplish other geo-strategic goals. Not all tariffs are bad, for example, to prevent a country from dumping goods on the U.S. economy at below market prices subsidized by a foreign government. So if the tariffs are more limited, the impact is likely to be more negligible. The impact of immigration policy is similar. If Trump rounded up every illegal immigrant in the country, we would have immediate labor shortages, inflation and lower GDP. In reality, the Trump administration will likely reduce new immigration and increase deportations marginally. That may not be as inflationary as soon, including members of the Fed, apparently assume. So I think its really important to not get ahead of what we know and bake in unlikely policy choices into our 2025 outlook. I also think there are a number of folks in the investment and economics industry that frankly don’t like President Trump very much – and they let their opinion cloud their professional judgement. Anyone definitively making the case that his policy will be inflationary at this point is over their skis, there simply isn’t enough information to judge it either way. I try to keep my political views out of forecasting work and make data – centric investment decisions. I think the investment industry writ large would be well served to do the same – ok I’ll get off my soapbox now.  

So there are other economic topics we could cover, but I think inflation and the employment situation are the major parts of the risk and opportunity set for 2025. In summary, my view is that the economy is growing, but slowly, in-line with the slow growth we saw prior to Covid. I expect that to continue next year, albeit as rates move lower with an even weaker labor market. The risk to the economy is that the Fed overstays its welcome on higher rates and drives the economy from slow growth into no growth or negative growth. The room for error is certainly much lower now than it was in 2023 or 2024.

Lets talk through how this economic backdrop sets up for the stock market, bond market, real estate and a few other areas as we move into the new year.

I start with stocks because equity exposure generally forms the bulk of portfolios aimed at long-term growth. When we think about portfolio construction, the major question is really how much stock exposure should we have? Equities, both public and private, provide the bulk of portfolio growth over the long-term. After that important question is answered, you can fill in the rest with diversifying assets.

On the stock market, this year was a banner year if you owned something close the equity indexes. You can see the S&P 500 is now up something like 25% for the year. The growth has been highly concentrated in the “Magnificent 7” – which are a few very large technology companies that are involved in the production and AI related chips and cloud infrastructure. Think names like Nvidia, Google, Microsoft etc. The average company has done ok as well – the return of the “average” S&P 500 company is up almost 12% - which is in-line with long-term historical averages. So its been either a very good or a good year across the board. The challenge with all of that outperformance, especially from the large tech stocks, is valuation. The market is currently trading about 22x next years earnings. Historical averages are closer to 18x. That means investors are paying a premium to own the future earnings of companies next year. This year, the S&P 500 grew earnings about 12%, that means about half of the return can be attributed to earnings growth and the remainder is expanding multiple, or increasing the price investors are willing to pay. This often gets referred to as “animal spirits” driving the market, as if that is a real thing. There are no spirits placing trades, just people that are buying either too high or too low. I prefer to find real answers to what’s driving the market and not just rely on the “animal spirits.” In this case, it seems to be 50% increased earnings and 50% optimism about the future that drove the market higher.

For 2025, the analyst consensus is for another 15% earnings growth. That’s roughly $275 per share for the S&P 500 index. 15% would be a fairly optimistic scenario, analysts typically overshoot. But it that turned out to be true, and earnings were $275 and the S&P were priced at 22 times earnings, the index would be worth 6,050. Which is a whole 2% more than its worth today. It wouldn’t surprise me if we closed the year close to that number. So that means earnings have to exceed those estimates in 2025 and continue to grow in 2026 for us to have significant stock market returns. Those same analysts expect the economy to continue to slow next year. Not having a recession, but slow..

You have likely heard about forecasts for modest growth over the next decade. Goldman Sachs famously put out a 3% growth estimate for stocks over the long-term. That’s based on the high valuation we see today. Valuation is a terrible market timing tool because stocks can continue to be over-priced for a long time, but valuation is the best predictor 10-year stock market returns. The market is overvalued by every reasonable metric, however, I urge a little caution for those that want to jump off the cliff and sell everything. Yes multiples are comparable to 1999/2000, but I don’t think we are in a full on “bubble” in the stock market yet. The reason is that the companies with those high valuation have grown earnings and cash flows tremendously over the past few years. This is not all “optimism” about the future, some of that has translated into cold hard cash. The market doesn’t usually correct “just because.” It’s more likely we continue to see positive returns, albeit at a lower rate, until something comes along to change the course of the market…perhaps like a few bad unemployment prints like I discussed earlier.

So I’m having trouble making the math work for another booming year in the stock market in 2025. I think we are more likely to see lots of volatility as the economic story plays out and optimism fades. Perhaps we end the year with positive returns, but 7-8% feels more appropriate. My view is that earnings end up growing far less than analysts expect and the multiple on the market does not continue to increase, so only modest upside in the stock market from here. I also think that means being very careful about big overweight to technology stocks. They will likely continue to lead the way from an earnings perspective, but when the growth scare comes, investors will sell what they own. We saw that back in August of this year. And what investors own is tech stocks, so my view is they carry a lot of risk going into 2025 and investors should look for a more balanced approach to their portfolio. I don’t think smaller companies or value will outperform with growth continuing to decelerate, but I do think the gap between tech and the rest of the market will continue to narrow moving forward and the non-Mag 7 universe provides a better risk/reward trade-off going forward.

So if equities are less attractive than they have been the last few years. What other assets can help diversify the risk if something happens to stocks? Remember, equities, both public and private, drive most portfolio growth. So the purpose of other assets is to diversify the risk of major equity declines.

Let’s start with bonds and interest rates. One major question for markets is where long-term interest rates will end up. The 10 year treasury rate is used as a benchmark for business financing, mortgages and many other things across the economy. I’ve used these charts in the last few outlooks, but my view is that the right answer for long-term rates is somewhere between what we saw in the strong economy of the 1990s and the very low rate experience of financial repression from the financial crisis through 2019. You can see on the chart, the 10-year rate averaged about 3.6% leading up to the financial crisis. Assuming inflation moves back close to the Fed 2% target, which is our base case, then that leaves the 10 year between 5.5% and 6%. However, I don’t think all of the deflationary forces from the post GFC era are completely dead. We have already seen good prices return to deflationary prints. During the post-GFC era, the 10 year treasury only traded about 1.2% over the Core PCE. That would leave the 10 year trading from 3.2 to 3.7%. So my view has been the right answer for rates is in between those two realities, pre-financial crisis and post financial crisis. That leaves us close to where we are, a range between 4.25% and 4.75% on the 10 year on average. As we move into next year, my view is a slowing economy should drive rates towards the lower end of that range, perhaps even back below 4%. Generally, investing is about managing risks. So I’m comfortable adding longer term bonds to portfolios in a world where falling inflation, lower rates from the Fed and a slowing economy should keep rates from rising significantly from here. Even if rates don’t fall much, investors can clip their coupon and earn returns from 4.5% to 5.5% without taking much risk. You can see Long-Term bonds 4.6%. My view continues to be bond investors should own very short-term bonds and cash and long-term bonds. You can see on the chart that intermediate bonds suffer when we have a flat yield curve. They don’t pay as much interest as cash and don’t have the same upside if rates fall as long-term bonds. So think about a bond “barbell” if you will with cash and longer term bonds. Returns will be in the low single digits if the economy continues to hum along – and that’s ok – because remember that the purpose of this part of your portfolio is diversification. If the economy and markets remain strong, your equity portfolio will drive returns. Bonds and other assets are there for the times when stocks falter. Also, remember that the bond market is broad, so consider corporate bonds, high yield and international bonds as well for 2025. Spreads on investment grade and higher yield bonds are very narrow, meaning the extra yield investors earn over treasuries for taking the corporate credit risk is low, but spreads can and will likely remain very low unless we have a recession. So the extra yield can still provide positive extra return for investors willing to look beyond treasury bonds. It’s not all about rates and cash vs. treasuries. If you can earn 5-6% without taking on a ton of credit risk, that is an attractive proposition for most investors.

What about other assets outside of bonds? Let’s start with Gold – which is coming off a really strong year in 2024.

Gold should be one of the few diversifying assets if we do see inflation move higher. Gold was one of the top returning asset classes in 2024. That was driven by above average central bank demand for gold and some investor demand on lower rate expectations. Going forward, If the path of future rate decreases is slower, than will keep a lid on returns, I wouldn’t expect the kind of double digit returns we saw this year again. But central bank demand remains strong. Central bank buying has decelerated from last year by about 10%, but is still above the averages we saw over the past decade. Global Central Banks tend to add about 500 tons of gold each year, and in 2022 and 2023 they added over 1,000. This year they are on track to buy over 900 tons of gold, so still strong. I would expect central bank buying to continue to put upward pressure on gold prices going forward. Gold should act as a diversifier in portfolios if inflation returns unexpectedly or if we have a recession and rates move materially lower.

Let’s look at real estate, both residential and commercial. On the residential side, national home prices are up about 4% over the past year. That is very market dependent, some markets are closer to flat while others are still seeing upward pressure on prices. Obviously higher mortgage rates have slowed down transaction volumes as folks are locked in to their existing very low rate mortgage. From a homeowner standpoint, I don’t see mortgage rates going all the way back down to the 3-4% levels we saw in the late 2010s. I think they will continue to drift down from today’s elevated levels, perhaps into the 5% range, but that should be viewed as a “good” mortgage rate going forward. Prices continue to go up, so if you are in a location for an extended period, it may pay off to buy a house vs. waiting for a better rate. You will need to adjust your affordability expectations accordingly. For residential investors, I think higher rates do make longer term rentals more attractive vs. the short-term rental market (AirBnB, VRBO etc.). With rates this high, most of the deals I see don’t cash flow, meaning its hard to find a property that you can buy with a high interest rate mortgage, pay for the marketing and operating costs and break even at year-end. So I think the focus for new money should be elsewhere. Speaking of elsewhere, commercial I think is potentially a more attractive option.

The commercial real estate market is a tail of two halves. Commercial office properties continue to struggle as demand for office space was dramatically reduced post Covid. Despite what you see in the news about return to office programs, offices are operating at about 54% of their occupancy levels according to Kastle systems, which tracks card swipe data for office workers. The result is that companies are reducing their space when leases come up for renewal and office properties are struggling. Other parts of the real estate market, retail, industrial, multi-family apartment housing are doing ok. If you look at default rates, they are a long way from 2008 levels. I expect defaults will rise as the extend and pretend party – where owners extend unprofitable deals hoping for lower rates before their financing comes due – I expect as some of those deals come up to the market in 2025 and 2026 – we will see higher defaults. But that can be attractive if you have new capital to deploy to buy those properties on sale. IF you could buy a newly launched fund that was buying properties valued based on today’s interest rates, with today’s debt levels, and with today’s occupancy levels, that maty represent an attractive opportunity to buy properties at relatively low values. The challenge is that many REITS, public and private, are perpetual in nature. So in addition to their ability to acquire properties at today’s good values, you are also buying shares in their prior holdings which may drag on performance for a while. So I think there may be a buying opportunity emerging in some spaces, but I wouldn’t blindly assume all real estate funds will benefit equally. You need to find a fund that is raising fresh capital and buying at today’s good prices. Also, if you can stick several hundred thousand into a private real estate fund, you can likely buy a small local property on your own. You may be better off buying your own properties – in your local community – than investing through a larger fund.

Lastly, a word on Crypto. I get more and more questions about crypto, especially as ETFs roll out that can be purchased in standard brokerage accounts. When anyone asks about crypto, I usually ask they why they want to own it and whether or not the trade with margin – which are borrowed funds – today. The reason I ask that question is because Crypto is a risk asset. In fact, it’s a magnifier of risk. If you look at the chart, you see that Bitcoin prices in the Red line almost do the opposite thing as inflation in the green line. They are negatively correlated. Bitcoin has a strong positive correlation with – you guessed it – the tripled leveraged ETF that tracks the Nasdaq tech stock index. That means gains and losses are magnified 3x what they would have otherwise been on a given day. So, if you want to own crypto, which I’m not for or against, I think about it like any other asset, you have the have the right strategy in mind. Crypto behaves like venture capital esq commodity, not a “safe haven for if the world goes to hell and a handbasket.” So as long as you allocate to crypto like you allocate to venture capital, which is essentially money you can afford to lose completely, then have at it. Just keep in mind what crypto is – and is not – and don’t expect it to be a safehaven when the world comes crashing down, there is very little evidence that it will behave that way.

Alright, as usual, I try to sum all of my thinking up into a few bullets for investors.

First, my view is that the economy is not going into an imminent recession in the first quarter of next year, but that it is weaker than many investors – including the Fed – believe. For that reason I expect rates to fall moderately from here and for stocks to have positive, but significantly lower returns next year than this year. That means looking at other assets in your portfolio like bonds and real estate for potential gains – and as a risk management tool - in addition to stock returns. I always recommend creating a long-term portfolio that you can stick with, so this is not a recommendation to time the market and sell all of your equities. However, I would consider rebalancing back to your equity target if this year’s gains have made your tech exposure outsized. I would also consider buying bonds with excess cash, rates are still very high, but my view is that the risk of rates moving much higher from here is limited, so now is the right time in this economic cycle to extend bond maturities and lock-in higher rates for several years.

As always, if you have any questions, feel free to reach out anytime, I’m always happy to discuss how to apply this thinking to your specific situation.