After turning the page on an action-packed 2024, here are five questions on our minds as we ponder the potential paths forward for 2025. These questions are intentionally provocative but are an important exercise in thought as we prepare to navigate a multitude of risks, opportunities, and surprises that are in store for us over the next 12 months.

1. Where does large cap margin expansion come from?

Expectations are for the S&P 500® index to grow its revenues at about 6% next year and for earnings to grow at nearly 15%. While a difficult outcome to achieve in an environment of trend-like economic growth, it is possible (e.g., 2018). If achieved, it would involve an expansion of profit margins by about 1% to a new record high of 13.5%. A new record would not be groundbreaking. Growing profit margins has been a trend for large U.S. companies for the past few decades. Research has highlighted a handful of possible drivers, including lower interest rates, lower taxes, globalization, and higher domestic efficiency.

Going forward, interest rates are unlikely to be a tailwind for margins as cheap debt rolls over into a higher-rate environment. Corporate tax cuts have been promised by the incoming Donald Trump administration, but they may take a backseat to extension of personal income tax cuts given heightened budget concerns. Globalization helped lower production costs, but geopolitical winds are shifting toward deglobalization, which will make supply chains more resilient but potentially more costly.

So how might we still get higher profit margins? The answer could lie in the ability for artificial intelligence (AI) and other new technologies to drive increases in productivity. Many goods-producing and service-oriented businesses are investing heavily in AI to make their employees more efficient. If the benefits of those investments come to bear, companies can get more bang for their buck and continue to push margins higher. We believe this is possible and will continue to seek evidence at both the macro and micro levels.

2. Is the small cap earnings recovery for real this time?

Going into 2024, expectations were for the earnings of smaller companies to rebound after falling in 2023. That did not happen. Instead, it looks like we got a second year of falling earnings for small caps, with revenue growth barely positive but profit margins contracting. Looking to 2025, we (and others) are still expecting a recovery. The current consensus is 18% earnings growth for the S&P SmallCap 600 index. Signs in some macroeconomic data make us believe that this time, the recovery is indeed for real.

Improving fundamentals would be a very strong catalyst for small cap stocks. They have experienced brief periods of outperformance over the past few years, but these short bursts have been macro-driven, thematic trades like reactions to the presidential election or excitement about the start of policy easing. Without the earnings to back the story up, these trades fizzled out soon after. If small caps can get earnings momentum back on their side, the asset class can build a lot more staying power, with attractive valuations providing plenty of runway.

3. Do valuations matter? If so, when?

This question tends to get thrown around (usually tongue in cheek) during strong equity markets that push valuations above historical averages. Sometimes the question is directed at individual companies, sometimes entire markets. People ask whether forces like passive investing and set-and-forget 401(k) contributions are distorting the price-discovery mechanism for publicly traded equities. Others suggest that today’s equity markets are of structurally higher quality and more profitable than ever before, and therefore deserve a higher multiple than some long-term average. All good questions—but impossible to answer with certainty.

What we do know is that certain pockets of the market are sill “expensive” (e.g., the Magnificent 7 tech giants) and certain pockets are still “cheap” (e.g., small caps, value sectors, international stocks). Speaking generally, we believe the Magnificent 7 are mostly fantastic businesses that deserved their eye-popping stock performances, having backed them up so far with impressive earnings growth. But we ask the question: is there a point where, even for the best businesses on the planet, prices get too expensive to stomach? Conversely, for everything else, do prices get too cheap to ignore?

We talked about how small cap earnings are expected to rebound. Within large caps, they are also expected to broaden, slowing a bit for the Magnificent 7 and accelerating for many of the other “493.” The question “Do valuations matter?” usually brings with it a negative connotation and implications of a bubble that is bound to burst. But while it’s true that a handful of very large stocks appear to be pricing in aggressive estimates for growth, if valuations do matter after all, that would be a welcome revelation for a large part of the global equity markets.

4. Are ex-U.S. countries due for a cyclical rebound? If so, does it matter?

Since the COVID-19 outbreak, the United States has been the crown jewel of the global economy. In 2024, real gross domestic product grew at an estimated 2.7%, which is well above most other developed economies. In 2025, U.S. growth is expected to slow modestly to a level that is closer to somewhere around 2%. Other nations like Germany, Japan, and the United Kingdom saw 2024 growth rates of less than 1%. They are all expected to rebound in 2025, but none are expected to match the pace of the United States, even as it cools off slightly.

One offshoot of the resilient strength in the United States is somewhat sticky inflation, which is delaying progress on the Federal Reserve’s campaign to get monetary policy back to a neutral stance. With weaker economies and lower inflation, many foreign authorities have much more leeway to try and engineer a cyclical recovery. Would that easing be enough to offset a trade war? Is there anything China can do to offset the impacts of its bursting property bubble, collapsing foreign investment, and ever-increasing trade tensions? And even if any of these countries can pull themselves out of their economic doldrums, would it even matter to U.S. investors? If things are still going well in the United States and foreign economies can’t find a way to keep up, why should investors look anywhere else? The answer should probably incorporate the concept of proper diversification, with the United States now accounting for two-thirds of the MSCI All Country World Index. There have also been plenty of examples in history of extended periods of international outperformance. They just tend to be difficult to predict in advance. So, despite the recent weakness, we still see value in the different risks and opportunities presented by international stocks.

5. Do tariffs disrupt the helpful trends in goods price inflation?

In the United States, shelter costs and other services make up the largest portions of our inflation basket. Inflation for these components has been running relatively high. Durable goods (e.g., washing machines) and nondurable goods (e.g., clothing) make up less of the basket, but inflation for these items has been much cooler, hovering near or even below zero. This is a welcome return to a pre-COVID trend, which when combined with falling energy prices, has served as a good offset to stickier figures like housing costs.

President-elect Trump has proposed a variety of tariffs, including 60% on Chinese goods and 10% universally across all our trading partners. During his previous term, Trump’s first round of tariffs on China coincided with brief and moderate bumps in inflation for nondurable and durable goods. Because shelter and services inflation were subdued, the overall impact was not overly painful, although it was enough to keep the Federal Reserve moving along an attempted tightening cycle. This time around, we are much more reliant on those trends in goods prices given elevated inflation elsewhere.

There are arguments that tariffs may bring about a one-time bump in prices, but after that, they will be more like a tax that restricts consumption and acts as a headwind on future inflationary pressures. But even that initial bump in goods prices may make life uncomfortable for the Federal Reserve. If officials do expect that bump to be temporary, do they dare dust off the word “transitory?” The good news is that markets seem to be pricing in an environment of stickier inflation, whatever the reason may be.

Federal funds futures markets and shorter-term Treasury yields are now pricing in very little further policy easing in 2025. So perhaps Q4 2024 was a necessary adjustment period, and we can now move forward into 2025 with more realistic expectations.

Conclusion

As we reflect on 2024 and look ahead to 2025, we are generally optimistic about the outlook for economies and financial markets. There are sure to be some surprises and bumps in the road along the way. Our goal is always to build portfolios that are robust across a variety of economic and market environments. As we continue to work toward that goal, we will be here to help you navigate whatever 2025 brings.

Sources: FactSet and FRED. Past performance does not guarantee future results.

Please read important disclosures here.