Animal Spirits Resurface Post Election
- January 29, 2025
Equity positioning and risk sentiment are near extremes, but investors shouldn’t ignore potential risks on the horizon.
In Summary
Optimism around a deregulatory, pro-growth agenda in Washington, D.C. drove U.S. equities to new highs, but high valuations for large cap equities may keep the S&P 500 from achieving lofty expectations.
The U.S. economy remains resilient and corporate fundamentals have been strong, but investors appear to be underestimating risks surrounding growth, fiscal policy, and inflation.
OAM Research stresses the importance of diversification. Although large cap growth valuations are extended, we believe there are opportunities within value, small cap, and international stocks. In our view, fixed income yields remain attractive, while diversifying strategies seek to provide uncorrelated returns.
Expectations of a deregulatory, pro-growth agenda in Washington, D.C. unleashed market optimism, driving the S&P500 to record highs and capping a second consecutive year of 20% growth – its best two-year result since the late 1990s. There are fundamental reasons for continued optimism, and we believe more reasonably-priced cyclical equities can do well given the fiscal tailwinds. In our view, U.S. large cap indices may fall short of elevated expectations set for 2025 due to their concentration in mega-cap growth stocks with high valuations.
Equity Euphoria Reaches New Highs
The expectation of and resulting impact from the “red sweep” in the U.S. election contributed to a strong market rally. Expected beneficiaries of deregulation, lower taxes, and protectionist trade policies such as small cap stocks and Financials notably outperformed. Even though momentum in these areas faded into year-end, giving way to renewed Magnificent Seven and AI gains, optimism for policy-driven growth has fueled lofty expectations for stock market performance in 2025.
According to Bloomberg, the average projection from Wall Street strategists points to another year of double-digit returns, reflecting widespread optimism. This sentiment is echoed broadly among asset managers, who are maintaining high equity exposures – while retail investors remain confident, steadily increasing their risk asset allocations. This enthusiasm has driven aggregate household equity holdings to record levels, with equity ETFs experiencing another record year of inflows in 2024.
Main Street sentiment notably improved post-election too. The NFIB Small Business Optimism Index jumped in November to its highest reading since June 2021 and continued to climb in December. Consumer confidence also rose precipitously, exemplified by spikes in the University of Michigan Consumer Sentiment and Conference Board Consumer Confidence indices following the election results.
Optimism for the future has pushed equities higher, and valuations now appear even more extended. The S&P 500 currently trades at 24x forward consensus earnings and 38x on a cyclically adjusted price to earnings basis (“CAPE ratio”), levels last reached in November 2021. Such rich valuations typically portend lower future returns.
Underappreciated Risks on the Horizon
The U.S. economy has remained resilient, but the market appears to be ignoring the possibility of downside surprises. We see three risk factors that are not appropriately priced going into 2025: growth, fiscal policy, and inflation.
Growth
Although recession risk appears to be reduced, investors seem to be dismissive of the possibility that growth disappoints lofty expectations. The consumer, bolstered by healthy real wage gains, has been the primary driver of the above-trend domestic growth. Early reads on U.S. retail sales from November 1 to December 24 indicate 3.8% annualized growth compared to expectations of 3.2% coming in to the holiday shopping season. Yet, data suggests that consumers are relying more on credit to maintain their spending. Total consumer credit continues to build, and consumer delinquencies have risen to the highest levels in a decade. Supporting consumer strength is a healthy labor market. The unemployment rate remains low at 4.2%, though it has risen from the cycle low of 3.4% in April 2023. But job growth is slowing, and employment is increasingly harder to find.Economic growth shocks at home or abroad could further weaken the labor market and undermine the strength of the consumer.
Policy
The market has celebrated the change in Washington. Financial markets appear to be expecting a more nuanced implementation of the tariff and immigration policies than conveyed during the campaign, but the policy specifics, and thus impact, remain uncertain. Moreover, deficit spending persists, adding pressure to the U.S. fiscal budget. The largest risks relate to inflation, and thus interest rates, which could dampen consumer spending and business activity over time
Inflation
Recent monthly inflation prints have remained above the Fed’s target, and the implementation of proposed policies could make that target elusive. Inflation risks tied to tariffs and immigration and the potential monetary policy mistakes in response to those pressures appear underappreciated. Tax cuts helped to offset negative price impacts from tariffs in 2017-2018, a counterbalance that is unlikely to be reciprocated in 2025-2026. A reemergence of pricing pressures would not be welcomed by the Fed, which for a moment seemingly had shifted its gaze from inflation to a softening labor market. Expectations for higher terminal rates realized after the December FOMC meeting shocked markets, sparking concern around the sustainability of the disinflationary narrative.
Productivity gains from AI, consumer strength supported by real wage gains, and expected growth from deregulation are driving positive sentiment in markets. Though, current equity valuations do not provide a sufficient margin of safety in the event of negative surprises on growth, policy, or inflation.
2025 Asset Class Positioning
OAM Research continues to stress the need for diversification in portfolios. We remain neutral in our overall outlook for global equities but reserve caution due to elevated valuations in certain asset classes. U.S. large cap growth stock valuations are stretched, but relative measures in large value and small cap equities appear balanced. We believe that allocating to strategies that emphasize quality has the potential to offer upside participation and may provide protection if any downside risks emerge. Investors may also benefit from geographical diversification, as we believe that, in contrast to the rosy expectations priced for U.S. equities, sentiment toward international and emerging market equities is extremely negative.
Fixed income markets continue to offer attractive yields. The asset class has the potential to provide diversification benefits in a risk-off market and should perform well barring a hawkish pivot from the Fed.
Healthy corporate balance sheets should limit credit risk for higher quality strategies. However, high yield credit spreads are historically tight and could be prone to widening if credit weakness materializes.
Diversifying strategies continue to play an important role in portfolios, particularly as stock-bond correlations remain elevated. In our view, real assets can continue to perform well given their mix of defensive, yield, inflation protection, and diversification characteristics. Merger arbitrage strategies also seek to provide uncorrelated returns and may benefit from renewed M&A activity under a friendlier administration.
Asset Class Detail
The below outlines OAM Research’s macroeconomic and asset class views.
Global Equity
U.S. Large Cap
Large cap fundamentals remain healthy and earnings growth has been strong. Equity valuations, particularly on the growth side, are stretched compared to history and other asset classes. Higher-quality companies with pricing power should be more resilient, and investors may benefit from allocating to strategies focused on quality and downside protection.
U.S. Small-Mid Cap
Small and mid-cap stocks no longer trade at discounts, though valuations remain attractive compared to large caps. Smaller companies continue to face headwinds from higher interest rates, higher cost of labor, and lending pressures but earnings growth has begun to improve. Smaller cap stocks tend to underperform as economic growth slows, so neutral positioning is warranted.
International Developed
Economic growth remains tepid but positive in most major economies and should improve in 2025 absent a U.S. recession. Earnings growth is expected to trend higher as well. Central banks have made progress on inflation and have begun to cut interest rates, which may provide some relief to more cyclical markets. International equities continue to trade at meaningful discounts compared to U.S. stocks, and sentiment appears to be reaching a trough.
Emerging Markets
Valuations remain reasonable and look attractive relative to developed equities. China’s economy continues to face significant headwinds even after recently announced government stimulus, but other emerging economies have been resilient. Active managers can take advantage of bifurcated performance by allocating to countries with more promising growth prospects.
Global Equity - Alternatives
Long/Short Equity is considered part of the strategic asset allocation for equities based on each fund’s underlying investments.
Long/Short Equity
Long/short strategies seek to generate performance as attribution spreads across a variety of sectors and isn’t just concentrated within the AI and overall technology trade. However, hedge fund managers remain overweight to these themes. Managers are constructive on equity markets coming into 2025 given the incoming administration’s initiatives.
Global Fixed Income
U.S. Core Fixed Income
Yields remain attractive following another move higher in Q4, and the asset class should provide portfolio protection in the event of a bumpy landing. Investment-grade credit spreads are still tight, but corporate balance sheets remain healthy. Spreads for high-quality securitized products represent attractive entry points.
High Yield Credit
Spreads remain historically tight today. The default rate declined in 2024 and remains low relative to history. Absolute yields today remain attractive, but the asset class is priced for perfection and may be subject to a material drawdown if growth stalls or an unforeseen credit event arises.
International Fixed Income
IInternational bonds will likely benefit from declining interest rates as global central banks loosen monetary policy and could see a boost from a pause in dollar strength. Emerging market debt looks more attractive within the non-U.S. market, both from a yield perspective and as a portfolio diversifier, though the asset class may suffer if global growth slows meaningfully.
Diversifying Strategies
Real Assets
Midstream energy infrastructure has remained resilient given strong fundamentals and elevated yields. Utilities and Infrastructure stocks can continue to benefit from thematic tailwinds as well as their defensive characteristics. REITs have been punished by rising interest rates, but that headwind may recede as the Fed loosens policy.
Event Driven/Uncorrelated
Event-driven strategies are expected to benefit from an expected increase in M&A activity in the coming year, with corporate strategic and private equity being the buyers. The decrease in regulatory pressures will also help this effort. Credit investments remain more interesting on the long side of manager’s portfolios across various areas in corporate, investment grade and high yield.
Disclosures
The opinions expressed herein are subject to change without notice. The information and statistical data contained herein has been obtained from sources we believe to be reliable. Past performance is not a guarantee of future results.
The above discussion is for illustrative purposes only and mention of any security should not be construed as a recommendation to buy or sell and may not represent all investment managers or mutual funds bought, sold, or recommended for client’s accounts. There is no guarantee that the above-mentioned investments will be held for a client’s account, nor should it be assumed that they were or will be profitable.<
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S&P Equal Weighted is the equal-weight version of the S&P 500. The index is comprised of the same stocks of the S&P 500, but each company is allocated a fixed percentage (.2%) of the total index.
MSCI AC World ex-USA Index captures large- and mid- cap representation across 22 of 23 developed-market countries (excluding the U.S.) and 24 emerging-market countries.
MSCI EAFE is an index in U.S. dollars based on the share price of companies listed on stock exchanges in 21 developed countries outside of North America. This Index is created by aggregating the 21 different country Indices, all of which are created separately. It is considered to be generally representative of overseas stock markets.
Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 index. Frank Russell Co. ranks the U.S. common stocks from largest to smallest market capitalization at each annual reconstitution period. The Russell 2000 Index represents a very small percentage of the total market capitalization of the Russell 3000 Index. It is considered to be generally representative of U.S. Equity Small and Mid Cap performance
Russell 1000 Value Index measures the performance of the Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
MSCI Emerging Markets Index is a market capitalization weighted Index in U.S. dollars representing 26 emerging markets in the world. The Index is created by aggregating the 26 different country Indices, all of which are created separately. It is considered to be generally representative of overseas stock markets.
Russell 1000 Growth Index measures the performance of the Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
S&P 500 Sector/Information Technology TR Index consists of stocks chosen for their representation in the Info Tech industry. Companies considered are involved in technology software and technology hardware and equipment. It is a market value weighted Index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
LTM PE Ratio is the last 12-month price-to-earnings ratio.
Indices are unmanaged, do not reflect the costs associated with buying and selling securities and are not available for direct investment.
Risk Factors
The success of an investment program may be affected by general economic and market conditions, such as interest rates, the availability of credit, inflation rates, economic uncertainty, changes in laws and national and international political circumstances. These factors may affect the level and volatility of securities prices and the liquidity of a portfolio’s investments. Unexpected volatility or illiquidity could result in losses. Investing in securities is speculative and entails risk. There can be no assurance that the investment objectives will be achieved or that an investment strategy will be successful.
Special Risks of Foreign Securities
Investments in foreign securities are affected by risk factors generally not thought to be present in the United States. The factors include, but are not limited to, the following: less public information about issuers of foreign securities and less governmental regulation and supervision over the issuance and trading of securities. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.
Special Risks of Small- and Mid-Capitalization Companies
Investments in companies with smaller market capitalization are generally riskier than investments in larger, well established companies. Smaller companies often are more recently formed than larger companies and may have limited product lines, distribution channels and financial and managerial resources. These companies may not be well known to the investing public, may not have significant institutional ownership and may have cyclical, static or moderate growth prospects. There is often less publicly available information about these companies than there is for larger, more established issuers, making it more difficult for the Investment Manager to analyze that value of the company. The equity securities of small- and mid-capitalization companies are often traded over-the-counter or on regional exchanges and may not be traded in the volume typical for securities that are traded on a national securities exchange. Consequently, the investment manager may be required to sell these securities over a longer period of time (and potentially at less favorable prices) than would be the case for securities of larger companies. In addition, the prices of the securities of small- and mid-capitalization companies may be more volatile than those of larger companies.
Special Risks of Fixed Income Securities
For fixed income securities, there is a risk that the price of these securities will go down as interest rates rise. Another risk of fixed income securities is credit risk, which is the risk that an issuer of a bond will not be able to make principal and interest payments on time. Liquidity risk is the risk that you might not be able to buy or sell investments quickly for a price that is close to the true underlying value of the asset. When a bond is said to be liquid, there’s generally an active market of investors buying and selling that type of bond. Fixed income securities markets are subject to many factors, including economic conditions, government regulations, market sentiment, and local and international political events. Further, the market value of fixed-income securities will fluctuate depending on changes in interest rates, currency values and the creditworthiness of the issuer.
High Yield Fixed Income Risk
High yield fixed income securities are considered to be speculative and involve a substantial risk of default. Adverse changes in economic conditions or developments regarding the issuer are more likely to cause price volatility for issuers of high yield debt than would be the case for issuers of higher-grade debt securities. In addition, the market for high yield debt may be less attractive than that of higher-grade debt securities.
Special Risks of Event-Driven Strategies
Investing in event or disruption driven strategies carries the risk of the unforeseen nature of events, such as corporate transactions falling through or changes in the economic or political environment. A reduction in money market liquidity or pricing inefficiency, as well as other market factors, can potentially reduce the scope for these investment strategies. Such funds may be adversely affected by unforeseen events, including forced redemptions of securities or acquisition proposals, break-up of planned mergers, unexpected changes in relative value, short squeezes, inability to short stock or changes in tax treatment.
Special Risks of Long/Short Equity
Long/short equity strategies utilize leverage, and may do so through direct borrowing, short selling, options and other instruments (including, without limitation, derivatives) and arrangements with embedded leverage. While strategies, techniques and instruments that employ leverage increase the opportunity to achieve higher returns on the amounts invested, they also increase the risk of loss. Hedging and selling securities short entails losing an amount greater than proceeds received or possible default by the other party to the transaction.
Special Risks of Uncorrelated Strategies
Strategies such as multi-strategy, macro and CTA utilize leverage, and may do so through direct borrowing, short selling, options and other instruments (including, without limitation, derivatives) and arrangements with embedded leverage. Hedge funds, commodity pools and other alternative investments involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. In addition, they may be subject to commodity risk, derivatives risk, foreign investment risk, foreign currency risk, and credit risk. Many hedge funds employ a single investment strategy. Thus, a hedge fund or even multi-strategy hedge funds may be subject to strategy risk, associated with the failure or deterioration of an entire sub-strategy. Strategy specific losses can result from excessive concentration by multiple hedge fund managers in the same investment or broad events that adversely affect particular strategies.
Special Risks of Alternative Investments
Alternative investments are not appropriate for all investors and only may be offered to certain qualified investors. Investors must be able to bear the economic risk of such an investment for an indefinite period and can afford to suffer the complete loss of investment. An Investor’s ability to redeem from such investments is limited to specific time periods (e.g. monthly, quarterly, semi-annually, annually) with certain notice requirements. Investing in securities is speculative and involves substantial risk. There can be no assurance that any investment strategy will be successful. This information is provided for informational purposes only and should not be construed as an endorsement of or a solicitation to invest in any specific program. There is a substantial risk of loss when investing in alternative investments and, for each specific fund, the risk of underperforming the general markets or other funds.
Special Risks of Real Assets
Master limited partnerships are publicly listed securities that trade much like a stock, but they are taxed as partnerships. MLPs are typically concentrated investments in assets such as oil, timber, gold and real estate. The risks of MLPs include concentration risk, illiquidity, and exposure to potential volatility, tax reporting complexity, fiscal policy and market risk. MLPs are not suitable for all investors. Common risks associated with an investment in a REIT include, but are not limited to, real estate portfolio risk (including development, environmental, competition, occupancy and maintenance risk), general economic risk, market and liquidity risk, interest rate risk, sector diversification and geographic concentration risk, leverage risk, distribution risk, capital markets risk, growth risk, counterparty risk, conflicts of interest risk, key personnel risk, and structural and regulatory risk.
Forward Looking Statements
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