2025 Outlook Blog: Dividing Lines

Executive Summary

Though forecasting is never easy, the summary below covers some of the dynamics that we see shaping opportunities and influencing our asset allocation decisions next year:

• Our base case calls for US GDP growth to ease back to its long-term trend of 1.5%–2% while interest rates find the sweet spot between stimulative and restrictive.
• The incoming Trump administration’s policies, including tax cuts and tariffs, will significantly impact the economic landscape. Investors should be prepared for potential inflationary pressures and shifts in market dynamics.
• Outside the US, major economies face more significant challenges. The eurozone and the UK are particularly vulnerable due to their reliance on manufacturing. Japan and China also face unique economic pressures.
• Bonds look favorable. Any further decline in rates will only boost bond returns, but even if rates just hold steady in this largely benign environment, we believe expected returns should prove worthwhile.
• The stock market is highly stratified, with significant divergences between sectors and market caps. Valuation concerns persist, but we expect solid EPS growth driven by a positive macroeconomic base case.
• Given the valuation risks in equities, risk-averse investors should consider risk management solutions such as buffered ETFs and tactical tilts to reduce portfolio volatility.
• Alternatives are no longer alternative. Private credit remains a top investment opportunity, particularly in direct lending, opportunistic credit, and commercial real estate lending.

Bifurcation: The Defining Theme of 2025

As we transition to 2025, stark divergences in the global economy and markets have emerged.

What makes these divergences so striking? In a word—bifurcation. In our latest outlook discussions, the first three senior investors we consulted immediately raised this concept. Each investor pointed to different examples, but the theme remained the same. Whether thinking about the impact of new policy proposals from the Trump administration, the dominance of the Magnificent 7 stocks, or other prevailing market dynamics, the idea of bifurcation was central. For investors, this spells an opportunity to outperform.

Where are some of the key dividing lines? As we look across the economy and markets today, several clearly emerge:

• Manufacturing vs. services
• US vs. the rest of the world
• Stocks vs. bonds
• Magnificent 7 vs. other large-caps
• Large-caps vs. mid-caps vs. small-caps
• Growth vs. value
• Public vs. private markets

To be fair, aside from the Magnificent 7, these divides are often in focus. Yet, today’s contrasts seem even more pronounced. What’s more, each of these areas could see further disruption from the incoming administration’s policy agenda.

How might these divides shake out in 2025? Let’s explore.

The US Economy—Stronger for Longer

The post-pandemic economic recovery in the US remains impressively strong, surpassing other countries and past downturns. Central to this strength is the labor market. Initially, it was far too hot, with both the high quits rate and wage growth gap between job switchers and stayers signaling excess (Display 1). While those indicators have settled down, real wage growth and an expanding workforce continue to fuel the nation’s aggregate paycheck. This, in turn, drives most of the demand in the economy, sustaining growth as long as it holds up well.

The labor market’s health will be crucial in determining the pace of next year’s rate cuts, too. If it remains sturdy, then the Federal Reserve can proceed with gradual cuts. But if it deteriorates sharply, faster cuts will become necessary to support the economy. We currently expect a rate cut at every other meeting, for a total of a full percentage point over the course of the year.

The broader economic landscape is also shaped by the balance between goods and services. The pandemic caused a significant shift, favoring goods over services. Now, these sectors have returned most of the way to their historical balance (Display 2). Yet unfortunately for the goods sector, this shift has effectively led to a two-year recession in US and global manufacturing. While interest rate cuts may start to ease some of the pressure, policy will likely remain restrictive, in our view. For that reason, we do not foresee a recovery in the goods sector until late 2025 at best.

This services versus manufacturing divide has also complicated economic forecasting overall. Many long-standing indicators are now less reliable due to their ties to the goods sector, which has become less important in the modern economy. Nonetheless, sometimes we’re focused on the broader economy, rather than just sectors, such as when we weigh the probability of a recession or the GDP glide path overall.

Let’s start with our economic base case. This could well be the year that GDP growth eases back to its long-term trend of 1.5%–2% while interest rates find the sweet spot between stimulative and restrictive. The scenario is overwhelmingly probable, in our view.

The bull case is also quite feasible—the economy could exceed expectations, as it did in 2024. GDP growth could outperform, and with it, growth in earnings per share for US stocks. Sentiment, too, could further improve from already-positive levels.

What about the downside scenario? Judging by several models and our own discretion, we estimate a relatively low chance of a recession in 2025. If one did unfold, likely catalysts would include an economic shock or rapid deterioration in the business cycle.

Of course, we can’t discuss next year’s US economic outlook without considering the incoming Trump administration. Overall, we expect both stimulative and inflationary policies—namely tax cuts and tariffs, among others. Tax policies may take longer to implement and flow through the economy, with the effects not visible until 2026 or beyond. Tariffs, however, could be implemented quickly, raising near-term inflation expectations. We believe this one-time policy shift shouldn’t affect the Fed’s rate cutting cycle, which will be more influenced by the labor market. Trump’s stated policies should also be favorable for the strength of the dollar, though it’s unclear how much of this is already priced in since the election.

Tougher Sledding Around the World

Despite a fairly upbeat US economic outlook, we’re less optimistic about other countries’ prospects in 2025. Continental Europe is more tied to manufacturing than the US, so the global manufacturing recession has weighed more heavily on that region—a dynamic we expect to continue. Germany, one of the major commercial drivers of the European economy, is particularly reliant on exports, which may make them more sensitive to US tariffs and heightened global trade barriers. Likewise, much of the hoped-for economic growth in the region has hinged on Chinese demand. Given China’s ongoing woes, those tailwinds have been conspicuously absent. Fiscal policy has also been less stimulative in Europe than in the US, so they’ve endured a slower recovery from the pandemic.

The UK is in a similar boat, though on a slightly different cycle. Given their post-Brexit trade restrictions, they’ve had a tougher battle against inflation, along with their own fiscal issues.

Japan has experienced its own slowdown this year, as policymakers grappled with their highest inflation in decades (albeit relatively low compared to the rest of the world). That’s put upward pressure on Japanese interest rates—which have been near zero for years—hurting economic growth and shocking capital markets as the yen carry trade (borrowing cheaply in yen and investing that capital into higher-yielding assets elsewhere) blew up several months ago. With that in the rearview mirror, we now expect the economy to continue recovering and for rates to hold steady or rise marginally from here.

China continues to outgrow the rest of the world, but at a much slower pace than in the past, as policymakers try to unwind the property bubble carefully without severely impacting growth. Though some stimulative policies were announced late this year, they’re not nearly enough to jumpstart economic activity, likely by design, to allow for gradual adjustment. That creates a persistent overhang for the economy, leaving markets to grapple with whether that weight has become too heavy. With China being a central focus of the Trump administration, the world will also have its eyes on the effects of trade policies and other geopolitical developments.

Prime Time for Fixed Income?

The backdrop for taxable and municipal bonds seems about as attractive as it’s been in years. For a decade, near-zero rates and TINA (“there is no alternative”) markets funneled capital into stocks. Then, a post-pandemic inflationary shock drove interest rates up, pushing bond prices down but resetting yields to more appealing levels. As a result, bonds now look quite compelling. What’s more, the rate-cutting cycle reduces the risk of another upward shock. Any further decline in rates will only boost bond returns, but even if rates just hold steady in this largely benign environment, expected returns should prove worthwhile (Display 3).

The major risk to bonds? The policy front. How broad-based and large will tariffs be and how much inflation will be caused as a result? Will Treasury Secretary nominee Scott Bessent successfully guide the federal government to a 3% deficit target? Will the new blue-ribbon commission (the Department of Government Efficiency, or “DOGE”) unearth cost savings? Or will enacting Trump’s campaign platform expand the debt by even more than expected? If the two former scenarios win out, bond vigilantes may stand down. Gauging the market’s reaction to the latter scenario is much harder. The market may shrug it off—or may have a more intense reaction. Lastly, though we don’t anticipate it and hope it doesn't happen, any attempts by the White House to undermine the Fed’s independence could trigger a sharp spike in long-term Treasury yields.

Ultimately, bonds remain appealing for both their underlying interest rates and credit exposure. While the incremental return from taking credit risk—whether investment-grade or high-yield, taxable or municipal—is relatively low by historical standards, bond issuers appear quite healthy. In a stable environment, credit spreads can remain at these levels for an extended period; the last time they were this low, they held steady for 27 months.

So Many Dividing Lines for Stocks

Please pardon the oft-used cliché, but the stock market is not a monolith. That is particularly true today, as it has become even more stratified than usual. There’s the Magnificent 7, the “Other 493” S&P 500 stocks, mid-caps, small-caps, US stocks, international stocks, growth stocks, and value stocks. At the moment, we find ourselves much more intrigued by what may be happening under the surface compared to what’s happening to the stock market overall.

But first a word on the big picture. Whether looking at individual stocks or the broad market, we focus on the fundamental outlook and how that compares to expectations. Our fairly positive macroeconomic base case should support solid growth in earnings per share (EPS)—somewhere in the mid-to-high single digits, perhaps a tad more than the 6% long-term growth rate for US EPS. Looking out another year, the picture grows foggier. Yet we concede that those estimates may be too low if the Trump administration successfully passes another corporate tax cut. Should that come to fruition, the market may be able to retain its multiple while delivering another solid year.

Much like our economic outlook, a bear case and a bull case are also on the table. Should a recession materialize, we expect it would be quite shallow, with EPS taking a small hit and more of the impact showing up in multiples and eroding sentiment. Alternatively, if we have more positive surprises like we saw in early 2024, EPS growth could settle in the low-double-digits. Valuation multiples could also climb from here on the back of mounting expectations and improving sentiment.

There are, however, two near-term risks we’re watching.

First, the current consensus is quite bullish. Aggregating analysts’ earnings estimates for individual stocks (“bottom-up”) calls for 15% EPS growth next year. Wall Street strategists’ broader market estimates (“top-down”) also paint a fairly optimistic picture, with anticipated EPS growth of 12%. While the bottom-up number almost always overshoots eventual earnings this far in advance, even that top-down figure suggests a strong year for corporate earnings. This bullishness could sow the seeds of unmet expectations.

Second, valuation is a commonly cited concern among clients. For us, valuation always factors in at the end of the research process. It’s rarely a catalyst on its own but can amplify or dampen the impact of how expectations confront reality.

Last year, we had mild concerns over the market’s multiple, but our hesitation was mitigated by the source of those multiples—the Magnificent 7 and their outsized growth potential. We noted: “At 19.4x 2024’s expected earnings, valuations for the S&P 500 in aggregate are certainly elevated relative to history. Yet most of that is fueled by the ‘Magnificent 7’ stocks, which have led performance this year (partly on a reversal of a weak 2022 and partly on hopes for AI). On an equal-weighted basis, the S&P 500’s 15.9x 2024 multiple falls close to the middle of its historical range.”

This year, we find it tougher to mitigate our concerns. At 21.9x next twelve months’ (NTM) earnings, the market’s capitalization-weighted valuation is in the 94^th percentile of its range dating back to 1990. What if we try to find comfort in the equal-weighted version? It has risen to 17.5x, or the 90^th percentile (Display 4). Neither of these metrics offset the strong potential fundamental backdrop—nor does it prompt us to sell equities and endure the tax hit from capital gains. In our view, the expected return from stocks over both a 1-year and 10-year horizon stands at reasonable levels. It’s higher than the returns offered by bonds and allows stocks to continue playing their role as the capital appreciation engine for traditional assets.

However, these lofty metrics do prompt us to look beneath the surface for potential mispricings. And even more importantly, they underscore the importance of private assets in helping to attain our clients’ financial goals.

Looking across the dividing lines we’ve mentioned, we hold a neutral or positive view on most of the Magnificent 7 stocks. Among other large-cap companies, two relative risks stand out—the valuation issue we mentioned for the equal-weighted S&P 500 and overly optimistic margin expectations. These factors make the rest of the large-cap space look somewhat less attractive. In contrast, mid-caps have more conservative expectations baked in, while small caps may face a higher bar due to current earnings expectations.

When it comes to growth versus value, much of the market’s EPS growth and price performance over the past two years has been fueled by the AI trend. That tailwind is expected to fade in 2025. Other stock-specific growth drivers have been prized by the market, making it challenging for our portfolio managers to find idiosyncratic growth without paying a high premium. On the flip side, value stocks stand out for two main reasons:

• The underlying quality of the companies currently in the value universe is high relative to historical standards.
• Meanwhile, their multiples remain low relative to the rest of the market.

At a sector level, our portfolio managers tend to avoid large tilts. With that said, we are seeing more opportunities in healthcare and consumer staples.

Two factors have driven underperformance in those sectors over the past year and the past month, respectively. First, the rise of GLP-1 drugs—initially prescribed for obesity and now being tested for a range of other ailments—has had a significant impact. These drugs can suppress appetite and alter dietary habits, raising concerns among many food and beverage companies. Plus, by mitigating obesity and related complications, GLP-1 drugs are reshaping the landscape for healthcare companies that traditionally profit from treating these chronic conditions, while simultaneously boosting the fortunes of the drug manufacturers themselves. Additionally, the potential influence of Robert F. Kennedy Jr., should he assume leadership of the Department of Health and Human Services, has cast a shadow over many of these companies. Those perceived to be in his regulatory crosshairs have experienced notable challenges in the past month, adding another layer of complexity to the sector’s performance.

Additionally, some parts of the healthcare industry are feeling the effects of lower demand in China. This decline is partly due to the country’s economic slowdown and partly because China has been slower than other nations in depleting its stockpile of medical supplies post-pandemic. However, this trend appears to be bottoming. Lastly, health insurance companies are experiencing mixed reactions to the new Trump administration. Those connected to more secure programs like Medicare Advantage are performing well, while those connected to Medicaid are struggling, as the administration will likely attempt to reduce funding. As we navigate these crosscurrents, we’ve been able to find attractive opportunities in these sectors.

What about the geographic divide? After roughly 15 years of US market outperformance compared to the rest of the world, this remains a hot topic among clients, and we regularly update our analysis on this issue. As highlighted in our recent blog, we continue to favor the US due to strong earnings growth, which we believe will be enough to offset the cheaper valuations in international markets. Finally, accounting for the new US administration, we anticipate an even wider potential gap in growth, interest rates, valuations, and the performance of the US dollar (Display 5). That said, our certainty around relative geographic performance is low, so investors may find it unwise to tilt portfolios too dramatically toward the US.

Outside the US, the investment landscape is a mixed bag. India, for instance, looks expensive, with declining quality and earnings estimates. Europe remains cheap but is also seeing reduced estimates. On the other hand, Latin America may present opportunities given relatively high growth for relatively low multiples. China has been cheap for over a year now, but we’ve held off pounding the table and remain cautious for the time being. That said, we are beginning to see rising estimates, though the key question is whether China finally delivers value or becomes a value trap. Within the Chinese market, we’ve uncovered promising opportunities that are less entangled with geopolitics—for instance, companies in the video game industry.

Whether through geopolitics or domestic policy, the incoming Trump administration could have a profound impact in certain sectors and stocks. These potential outcomes tend to be binary, making them extremely difficult for us to assess and use to gain an edge over other investors. As a result, our actively managed strategies are focused on managing the risks of policy exposures.  Instead of betting on specific legislative outcomes, we’re aiming to avoid material policy-driven swings in either direction.

Alternatives Are No Longer Alternative

Given the moderate returns we expect from publicly traded stocks and bonds, we believe investors seeking both elevated long-term returns and more attractive risk-adjusted returns should incorporate more private assets into their portfolios. For regulatory reasons, access to these strategies has remained constrained, keeping the supply of and demand for private capital in a more favorable position for investors.

Private credit has topped our list of compelling investment opportunities for a few years now and continues to do so once again (Display 6). In particular, we see attractive backdrops for three areas of private credit: direct lending, opportunistic credit & specialty finance, and commercial real estate lending.

Earlier this year, we noted the growing supply of capital in the private credit space. While we believe the market's relative attractiveness compared to other asset classes has peaked, it remains highly appealing in today’s landscape. Despite not being as enticing as it was a year ago, private credit still stands out when compared to other available options. Based on our current quantitative modeling, we expect this sector to offer the most attractive long-term, pretax, risk-adjusted returns in our universe.

In direct lending, the demand for credit from small- and medium-sized businesses remains strong. While banks are becoming more competitive in this space, which they once dominated before the rise of private credit, the scale of private credit capital solutions continues to attract borrowers. Here, we keep our eyes on the level of competition in providing capital, as this sector often serves as the first stop for new capital entering the private credit space, and terms have become more borrower friendly in the past year. Despite these competitive pressures, we remain confident in our own direct lending investments for two key reasons. First, we only operate in a select universe of higher-quality industries and business models. Second, thanks to this focus and our team’s stringent underwriting standards, we have maintained a strong track record of extremely low-targeted and realized credit losses, dating back to the Global Financial Crisis era.

Should other investors need capital partners for new investments or assistance with underperforming investments which were underwritten in the past, we see attractive opportunities to deploy capital into opportunistic private credit and specialty credit. Such openings vary widely, from offloading an asset or portfolio of assets from an existing lender, to helping a bank more efficiently finance a transaction, or directly working with a company to finance large assets such as a fleet of aircraft.

Lastly, the commercial real estate sector has faced significant challenges, exacerbated by higher interest rates, leading to a wave of refinancings that is still playing out today. Coming into this year, we preferred to access this sector from the lending side, since lenders had considerably more bargaining power. Yet as we’ve moved through this year, we’ve seen the dynamics become more balanced. We are now identifying compelling opportunities in both real estate lending and real estate equity.

Moving from private credit to private equity, we likewise remain in an attractive environment for deploying capital into middle-market companies and venture capital. Following a boom period in 2020–2021, fresh capital inflows into these areas began to dwindle in 2022 and 2023. As growth stocks deflated in the public markets, the window for IPOs and M&A dried up, impacting funds’ ability to generate liquidity and return cash to their investors. What’s more, the pressures in public markets created a “denominator effect,” causing the weight of private assets in major investors’ portfolios to exceed their targets. This denominator effect has become less of an issue with stocks soaring to new highs this year. However, the liquidity challenge persists. If positive sentiment in public markets continues into the first half of 2025, we expect a wave of IPOs and M&A activity that could largely resolve the liquidity issue and help restore balance to the private equity markets.

As for hedge funds, they remain a critical diversifying and return-enhancing allocation in a portfolio. We’ve been quite pleased with our strategies’ ability to generate uncorrelated returns for investors this year, despite the concentration of market leadership and the challenging search for alpha. If the trends we’ve discussed materialize in the global economy and markets in 2025, it should create an attractive opportunity set for equity market-neutral and diversified/global macro hedge funds, driven by more predictable divergences inside markets.

Risk Management Solutions Become More Essential

For years, we’ve emphasized the value of inflation protection for inflation-sensitive investors. That protection could become even more essential in the coming year, when inflation could re-accelerate or simply remain somewhat elevated (by 0.5–1 percentage point) versus the Fed’s 2% target over the medium term. Such protection may include TIPS, inflation swaps, exposure to commodities and their producers, and the stocks of companies with significant pricing power.

Inflation invariably calls to mind gold. Yet as we’ve written before, gold is more of a disaster hedge than an inflation hedge. That said, while touching on inflation and commodities, it’s worth a quick look at gold—which is up 45% this year and among the most notable movers of 2024. Gold is usually highly correlated with real (after-inflation) Treasury yields, based on the logic that higher yields increase the opportunity cost of holding gold instead of dollar-denominated assets. However, that relationship broke down in late 2023 as the Chinese central bank and population, along with some other global central banks, began hoarding gold. The reasons for that accumulation remain unclear, but we believe it is worth watching—both for its impact on the price of gold and its potential effects on the demand for dollars and other global reserve assets (Display 7).

Finally, given the expectations and valuation risks associated with equities, more risk-averse investors may consider incorporating risk management solutions such as buffered ETFs combined with tactically tilting strategies. These approaches may help reduce portfolio volatility as well as the anxiety it tends to provoke.

What Divisions Lay Ahead?

While we lack perfect foresight, we do attempt to dimension what is happening in the world and the potential impact in the quarters and years ahead. Yet more important than pinpointing a single outcome is recognizing which outcomes are possible, assessing their relative odds, and gauging where expectations and realities may diverge. In other words, we can see the dividing lines and take an educated guess to how they may shape outcomes in the next year and beyond.

Ultimately, we remain optimistic about the path of the US economy and more cautious on other developed economies in the current climate. Bonds remain attractive but are still the ballast—rather than the engine—in a portfolio. Stocks can continue to generate healthy results for an extended time; valuation risks have intensified over the past year, but the risks of a growth shock have fallen. Investors should be attuned to both of those trends, in our view.

Those seeking attractive risk-adjusted and total returns should stop thinking about “alternative assets” as “alternative” and begin viewing them as core or table stakes. They’re crucial elements in any environment and even more so in the current climate given potentially modest (though still reasonably attractive) returns offered by “traditional assets.” Private credit and private equity both look compelling, and the opportunity set for hedge funds could further improve even after a strong 2024.

Finally, members of our team hosted a small event this month in our New York office. Afterwards, one of our long-time clients remarked that it’s clear we sweat the details in our work. That is true. We’re passionate about making our clients’ portfolios as strong as possible. We sweat the details, so you don’t have to. As 2025 unfolds, rest assured that we’ll be closely monitoring the economy and the markets, adjusting our views and exposures as facts on the ground change. However, your strategic, long-term allocation should serve you well whatever 2025 and later years may bring. That is the true north that is designed to guide you from where we stand now to your financial goals in the future.