Q1 2025 Economic and Financial Market Outlook

By Peter R. Phillips, CFA®, CAIA®
Senior Vice President and Chief Investment Officer
Washington Trust Wealth Management

Two years of better-than-expected economic growth have kept unemployment levels low, consumer spending high, and investors optimistic. The start of a Fed easing cycle and a new presidential administration have sustained bullish sentiment on the economy and financial markets.

2024 Recap: The Economy Continues to Outpace Expectations

The U.S. economy continued to outperform expectations in 2024, though progress on inflation stalled. GDP growth for 2024 is estimated at 2.7%, well above the initial forecast of 1.2% at the start of the year.ⁱ The Federal Reserve began an easing cycle but raised its inflation expectations, indicating that rate cuts in this cycle are likely to be more modest than previously anticipated. 

Meanwhile, the incoming Trump administration is expected to implement policies that support economic growth, which in turn may increase inflationary pressures. Consensus estimates project U.S. GDP growth at 2.2% in 2025, indicating continued solid economic momentum.

Equity Markets

Equity markets remained strong, with the S&P 500 delivering a 2.4% total return in Q4 2024 and an impressive 25.0% for the full year. The robust economy supported corporate earnings, and the start of a Fed easing cycle kept investors optimistic and bullish. Late in the year, the presidential election results and expectations for pro-growth and deregulation policies further propelled stock market gains. Large-cap growth stocks, particularly the "Magnificent Seven" (Apple, Nvidia, Microsoft, Alphabet, Amazon, Tesla, and Meta), continue to be key drivers to both earnings growth and price performance.

Fixed Income Market

The fixed-income market faced headwinds late in 2024. The Bloomberg U.S. Aggregate Bond Index returned -3.1% in Q3 and 1.3% year-to-date as stalled improvement in inflation, reduced expectations for Fed rate cuts, and the Trump election pushed yields sharply higher in Q4, negatively impacting fixed income market returns. Two- and ten-year U.S. Treasury yields rose by 60 and 78 basis points, respectively, during the quarter.

The start of a Fed easing cycle and a new presidential administration have sustained bullish sentiment on the economy and financial markets.

Economic Growth: Will 2025 Bring Another Year of Better Than Expected Growth?

Real GDP growth for 2024 is expected to be near 2.7%, up from an initial estimate of 1.2% at the year’s start. Similarly, 2023 saw GDP growth of 2.9%, well above the 0.3% expectation at the beginning of that year.  We start 2025 with a consensus expectation of 2.2% GDP growth. Will growth once again surprise to the upside?

Labor Market

Payroll growth remains robust, with the economy adding 2.2 million jobs in 2024 on top of the 3.0 million created in 2023. Although job growth has slowed, the average monthly increase of 170,000 jobs in Q4 2024 is solid, particularly given that 29.1 million jobs have been added since April 2020, surpassing pandemic-related losses by 7.2 million. Job openings of 8.1 million compared to 6.9 million unemployed workers, indicate the potential for continued growth into 2025.

Despite solid employment growth, the unemployment rate rose from a low of 3.4% in March 2023 (and a 3.8% rate at the beginning of the year) to 4.1% in December 2024, with a peak of 4.2% in July. This increase briefly triggered the “Sahm Rule,” which signals the early-stages recession of when the three-month moving average of unemployment rises 0.5 percentage points or more above its 12-month low.ⁱⁱ The signal appeared in late summer but has since improved slightly. 

Consumer Spending

A stable labor market along with gains in the equity and real estate markets supports personal income and consumer spending. Personal income grew at a respectable 5.3% annual rate (year over year as of November 2024). Despite still relatively high inflation levels, real (adjusted for inflation) hourly earnings (as of November) and real (adjusted for inflation) disposable personal income (as of November) are both still positive at 1.2% and 3.1%, respectively.  While these rates have decelerated compared to last year, stable labor market conditions are expected to sustain income growth. 

In addition, two consecutive years of 20%+ stock market gains and a 50% rise in housing prices since 2019 have bolstered household wealth and spending sentiment. 

Personal consumption expenditures grew at a 5.5% annual rate as of November 2024, with inflation-adjusted growth at 2.9%. 

(Note: Personal consumption expenditures are typically the largest component of GDP growth.)

Government Spending 

Government spending continued to support the economy, with the federal budget deficit rising to $1.8 trillion (6.4% of GDP) in fiscal 2024, up from $1.7 trillion (6.3% of GDP) in 2023.  Similar spending levels are expected in 2025.ⁱⁱⁱ The incoming administration’s Department of Government Efficiency (DOGE) has pledged significant spending cuts—ranging from $500 billion to $2 trillion—but even the more modest $500 billion reduction appears to pose a significant challenge. 

Fed Support

The Fed has shown a willingness to support the economy, reducing the federal funds target rate by 100 basis points to 4.25%-4.50% since September 2024. Initial projections suggested aggressive rate cuts through 2025, but strong labor markets and persistently high inflation have tempered expectations. Markets now anticipate only 50 basis points of additional cuts in 2025, bringing the target rate to 3.75%-4.00%. Further cuts are likely if economic growth falters or inflation subsides.

We are optimistic that the economy will avoid recession in 2025; however, it is not without some uncertainty.

2025 Outlook: Positive Economic Momentum Likely to Continue

We are optimistic that the economy will avoid recession in 2025; however, it is not without some uncertainty.

No recession remains the base case, but risks are present. The base case for 2025 does not include a recession, though risks are evident. The FactSet consensus estimate for real U.S. GDP growth in 2025 is 2.2%. While this marks a slowdown compared to the past three years, it remains relatively strong. For the 10- and 20-year periods prior to COVID, the median annual GDP growth rate was 2.5%.

Despite challenges, the U.S. economy continues to demonstrate resilience, leading to a more optimistic outlook. However, some tangible risks must be monitored. 

Higher For Longer Interest Rates

The Federal Reserve is expected to remain accommodative, though rates are unlikely to fall as quickly or as significantly as initially projected. The federal funds rate remains at a 15+ year high and borrowing costs across the economy are also near 10-15+ year highs, which could negatively impact consumer and business spending. Historically, past cycles of Fed rate increases have often led to economic slowdowns or recessions.

Other Economic Indicators Suggestion Caution

Various economic indicators warrant caution. While traditional indicators of slowdowns and recessions have been less predictive recently, several measures suggest a cautious outlook is warranted. 

The Leading Economic Index (LEI). The Leading Economic Index (LEI), which includes ten components from financial, labor, manufacturing, consumer, and housing markets, rose in November 2024 for the first time since February 2022. However, it remains near levels signaling a slowdown or recession.^iv

The Institute for Supply Management (ISM). The ISM manufacturing index indicates slight contraction in activity and has signaled a slower growth environment since October 2022. On a positive note, the new orders component of the index has recently improved, and the services component has consistently signaled expansion for some time. 

Consumer Confidence. Consumer confidence levels, particularly the future expectations component, remain at levels typically associated with a recession. The present situation component of consumer confidence has also recently weakened.

The U.S. housing market. The housing market continues to struggle. Existing home sales, which fell to Great Financial Crisis levels in 2023 following a sharp rise in mortgage rates (which remain at decade plus high levels), continue to be near trough levels. Housing starts, which had experienced periodic signs of strength through and post the pandemic, experienced a challenging 2024. However, home price gains, up 4.3% year-over-year as of October 2024, remain a bright spot, helping to boost consumer net worth and financial outlook.

The U.S. government’s fiscal condition. Concerns persist about the U.S. government’s fiscal condition and its potential impact on spending, tax policy, and future economic growth. The U.S. gross debt has risen by $13 trillion (56% since 2019), reaching $36.2 trillion by December 31, 2024.^v The Congressional Budget Office (CBO) estimates that net interest payments on the national debt will account for over 18% of total government revenue in 2025, up from 14.8% in 2023 and an average of 8.7% from 2013 to 2022. 

The incoming administration. Arguably the biggest source of uncertainty stems from changes in Washington, D.C. with the incoming Trump administration and a unified government with slim Republican majorities in both the House and Senate. Theoretically, this could facilitate the passage of many of the Trump administration’s policies. However, uncertainty surrounds the specifics of several proposed policies, many of which could have significant economic and financial impact, adding a large degree of variability to forecasts. Key areas of focus include tariffs, tax policy, regulation, immigration, and initiatives from the Department of Government Efficiency (DOGE).

Arguably, the biggest source of uncertainty stems from changes in Washington, D.C. with the incoming Trump administration and a unified government with slim Republican majorities in both the House and Senate.

Financial Markets

Positive economic momentum continues to support overall corporate earnings and stock prices, though valuations remain at a premium. Fixed income markets are challenged by stubborn inflation and rising interest rates, despite the start of a Fed easing cycle. However, the higher yield environment provides attractive income opportunities and the potential for price appreciation should rates begin to decline.

Fixed Income

Treasury yields. Treasury yields rose sharply in Q4 2024, maintaining levels near 15-year highs. The two-year Treasury ended 2024 yielding 4.24%, up from 3.64% at the start of the quarter and aligning with its 4.25% yield at the end of 2023. The 10-year Treasury yield closed at 4.57%, up from 3.79% at the start of Q4 and 3.88% at the end of 2023. These yields remain attractive when compared to their 15-year ranges of 0.09%-5.21% for the two-year and 0.50%-4.99% for the 10-year Treasury. 

Inflation concerns. Inflation, as measured by the Fed’s preferred PCE Core Price Index (excluding food and energy), is hovering close to 3% (2.8% as of November 2024). Expectations are for inflation to moderate closer to the Fed’s 2% target. This combination of moderating inflation and Fed rate cuts could provide a favorable environment for fixed income returns, as lowering yields would boost bond prices. However, some proposed Trump administration policies, such as tariff adjustments, could place upward pressure on inflation, raising yields and lowering bond prices.

On balance, there are opportunities to extend portfolio durations and lock in higher yields for the long term. Current high money market yields are likely to decline if the Fed continues reducing the federal funds rate. 

Credit spreads. Credit spreads, however, remain historically tight. Investment-grade spreads at 80 basis points are below the 20-year average of 149 basis points and significantly lower than spreads seen during economic slowdowns. High-yield spreads at 287 basis points also remain significantly below the 20-year average of 491 basis points. 

Given this, it may still be too early to add exposure to lower-quality corporate bonds or other higher-risk credit-sensitive segments of the fixed-income market.

Equity Markets

Equity markets performed strongly, with the S&P 500 closing 2024 up 25.0% on a total return basis. Stock prices initially rallied following the presidential election but lost some momentum as the year-end holidays approached. The S&P 500 reached an all-time high of 6090 on December 6, at the time reflecting a 29% year-to-date return, before settling at 5882. The rally was driven by expectations of pro-growth, pro-business policies, such as tax cuts, deregulation, and a more favorable stance toward mergers and acquisitions.

For the full year, the S&P 500’s gains were underpinned by a robust economy, strong corporate earnings, and the anticipation of Fed rate easing cycle. The "Magnificent Seven" continued to be a key driver of S&P 500 performance, contributing approximately 54% of the index’s performance, with their median return at 44%, compared to a median return of 14.9% for the remaining S&P 500 stocks. 

Corporate Earnings. The U.S. economy’s strength has bolstered corporate earnings growth, supporting stock prices. Consensus S&P 500 earnings estimates project growth of 8.7% for 2024 and 14.6% for 2025, following modest growth of 0.4% in 2023. However, historical patterns suggest the 2025 projection may moderate as we go through the year. Additionally, earnings growth concentration remains a concern, as the "Magnificent Seven" accounted for approximately 70% of the S&P 500’s adjusted net income growth in 2024. This dependence is expected to decrease to 34% in 2025.

Current valuation levels leave little margin for error, whether from economic challenges, corporate earnings shortfalls, or other unforeseen risks.

Stock Market Valuation and Sector Analysis. The ongoing rally in stock prices puts the current S&P 500 p/e ratio based on 2025 estimates at 21.5x.  This is not a cheap valuation, especially in a still relatively elevated inflationary and interest rate environment. If inflation and interest rates fail to decrease in the coming year, there could be downside risks to valuation. 

Historically, there has been an inverse correlation between inflation and P/E ratios. Higher inflationary environments tend to result in lower P/E ratios, and vice versa. Since 1960, inflation levels of 2%-3% (as measured by the Consumer Price Index) have corresponded to average P/E ratios ranging from 17x to 21x. While the current P/E ratio of 21.5x is at the high end of this range, it does not necessarily mean stock prices are poised to fall. However, it does indicate a higher level of valuation risk.

It is important to note that high P/E ratios have shown limited predictive value for one-year stock returns but are more strongly correlated with longer-term returns. High P/E environments typically result in lower subsequent five-year returns, and vice versa.^vi

In summary, current valuation levels leave little margin for error, whether from economic challenges, corporate earnings shortfalls, or other unforeseen risks.

Small- and mid-capitalization stocks. Small- and mid-capitalization stocks appear undervalued relative to large-cap stocks. They are trading at P/E ratios that represent a 27% discount to their 20-year historical P/E valuation relative to large-cap stocks. However, small- and mid-cap indices have less exposure to high-growth sectors of the economy. For instance, Information Technology stocks account for only 12.8% and 10.6% of the S&P Small-Cap 600 and Mid-Cap 400 indices, respectively, compared to 32.5% for the S&P 500. Similarly, Communication Services stocks represent just 3.5% and 1.4% of the small- and mid-cap indices, respectively, versus 9.4% for the S&P 500. 

Until economic growth broadens beyond the information technology sector, particularly areas like artificial intelligence, small- and mid-cap indices are likely to continue trading at a discount to large-cap stocks.

Fed pivot. Nevertheless, the Federal Reserve’s pivot toward more accommodative monetary policy and rate cuts could improve the valuation discount for small- and mid-cap stocks relative to large-cap stocks. These stocks have greater exposure to cyclical and interest rate-sensitive sectors such as Industrials, Materials, and Financials. Potential tariff plans from the Trump administration could also favor more domestically oriented small- and mid-cap stocks compared to large-cap stocks. Currently, we maintain a neutral position on small- and mid-cap stocks relative to large-cap stocks, though this could shift as the Fed’s and the Trump Administration’s policies evolve.

Fed and Trump Administration policies could improve the valuation discount for small- and mid-cap stocks relative to large-cap stocks.

International Equity

We continue to underweight our exposure to international equities. While valuations appear significantly lower than in the U.S., earnings growth rates across developed international markets are less attractive, partly due to their more modest exposure to global-scale information and medical technology companies. Geopolitical conflicts, such as Russia/Ukraine and Israel/Hamas, have a much greater and more direct impact on economies outside the U.S. Economic growth projections for Europe in 2024 and 2025 are relatively poor and lag those of the U.S. In emerging markets, risks remain elevated, particularly those tied to geopolitical concerns involving China.

Currency fluctuations also play a significant role in international investment returns. A weaker U.S. dollar boosts unhedged international returns, while a stronger dollar has the opposite effect. Since the election, the U.S. dollar has strengthened by 5%, reversing a weakening trend observed throughout most of 2024 and negatively impacting international stock returns when measured in U.S. dollars. Consensus forecasts suggest the U.S. dollar could weaken in the coming year and over the longer term.

In summary, we maintain a cautious outlook for stock prices. While corporate earnings growth is broadening and remains supportive, it remains heavily reliant on a small number of information technology-related companies. The current P/E ratio of 21.5x leaves little room for any disappointment, whether from the economy, corporate earnings, or other unforeseen risks.

A Final Word

The twists and turns of 2024, and every year, reinforce the importance of focusing on a long-term financial plan and investment strategy. While short-to-medium term forecasts should help inform decisions on near-term liquidity needs and availability, they should only have a minimal impact on a long-term asset allocation investment strategy. As we have seen time and time again, market-timing is difficult and can compromise long-term investment performance.

As we start the new year, it may be a good time to speak with your Washington Trust Wealth Management portfolio manager/investment advisor and review your investment objectives and asset allocation.