The first in a two-part detailed analysis about what the financial markets could do in the next year, and how the arrival of a new US administration affects risks, asset allocation and positioning.

The chief investment officer of WELREX, Kirill Pyshin, gives his investment outlook for 2025 and reflects on the recent currency and stock market behaviour in the wake of the US Presidential elections. This is the first article of a two-part analysis. 



Kirill Pyshin

The editors are pleased to share these views; the usual editorial disclaimers apply to views of guest writers. To respond, email tom.burroughes@wealthbriefing.com and amanda.cheesley@clearviewpublishing.com

Summary
US equities have delivered excellent returns and enthusiastically greeted Trump but in 2025 we believe that they will take a breather, and better returns may be available elsewhere. We suggest almost equal allocation to equities and bonds but with a preference for Europe over the US. 

We are concerned about US inflation, and in our portfolio have gold and the Swiss franc as a hedge. Bitcoin would also be a good hedge for those who could stomach its volatility. We are cautious on hard and soft commodities for geopolitical reasons.

This view is driven by three important observations:

1. US equities are very expensive, especially in certain sectors such as IT. What makes the situation critical now is already high margins, which means that earnings are unlikely to grow as fast as before, while valuation multiples are already extreme.

2. US debt is unsustainable: The federal budget deficit is high and likely to grow further, and the most likely way out is through inflation. Tariffs and immigration controls could contribute to inflation. In combination with signs of a cooling US economy, this could mean stagflation.

3. The conflicts in the Middle East and in Ukraine are likely to be resolved quickly under Trump. This will remove supply restrictions on a range of important commodities with a negative impact on price, making them unsuitable as a US inflation hedge. We prefer gold and the Swiss franc. At the same time lower energy costs could spark European equities into action while contributing to lower EU inflation.

US equities are expensive
Even before their enthusiastic reaction to Trump, US equities have rarely before been more expensive vs bonds. According to a recent report by UBS (1), the Equity Risk Premium (ERP), which is the excess return that investors demand from stocks over the risk-free rate, was at the 15th percentile of a 100-year distribution.

US equities were not just expensive vs bonds as the extremely low ERP shows, but also expensive vs their own history practically on any metric. They were over 100 per cent more expensive on an important Schiller P/E metric, according to the BoA Quant team (2). This metric considers earnings over the full business cycle, for example, to account for the fact that margins today are high, which artificially lowers P/E by inflating earnings.

One could argue that the S&P 500 deserves a higher multiple because the larger proportion of the index is taken by technology companies, which trade at a premium. However, each individual sector is also extremely expensive. As of 1 November, all sectors of the S&P 500 except energy were overvalued vs their own history on P/E (3). IT was particularly expensive. We have our geopolitical concerns about the energy sector.

Another argument sometimes used to justify high valuation is that the adoption of AI should lead to such productivity gains that margins would move higher. In this case, the P/E multiple, where margins are in the denominator, should be depressed. In fact, bar the short-term falls and rises, over the last 10 years the S&P 500 EPS has been on a straight-line trajectory equivalent to just under 10 per cent annual growth but the price action on the S&P 500 is by far overshooting this trajectory over the last two years (4).

If AI will lead to future growth in margins, this should be reflected in increasing bottom-up EPS growth forecasts for the S&P 500. But for calendar year 2024, analysts are again projecting earnings growth of 9.4 per cent and revenue growth of 5.1 per cent. This indicates an expectation for margin expansion. However, the reported earnings growth in Q3 2024 was 5.3 per cent with 5.5 per cent growth in revenue, which means actual margin contraction. For Q4, analysts are projecting EPS growth of 12.2 per cent and 14.8 per cent for calendar year 2025. We will see what the earnings growth will be, but for now these high growth expectations are baked into the 12 months forward S&P 500 P/E of 22.2 [per cent] which is above the 10-year average of 18.1 [per cent].

US corporate earnings are likely to slow
Equity market performance is driven either by the valuation multiple expansion, as in the case of the current bull market, or growth in profits. However, corporate profits are already high. The above-mentioned UBS report (5) calculates that the corporate profits vs GDP today are at the 95 percentile. This points to limited margin upside from here and in the best case, mediocre equity returns in the US, but in the worst case a US equity market sell-off.

Typically, high valuations by themselves do not necessarily lead to a sell off. However, during a recession this is almost guaranteed to happen. To be clear, we do not forecast a recession in the US but there are signs of cooling. Specifically, we point to slowing employment; rising credit card, auto and commercial real estate loans delinquencies; falling manufacturing PMI new orders and weak capex intentions, according to BCA (6).

We prefer less expensive US stocks, that benefit from exposure to attractive investment themes that would ensure earnings growth over the long term, such as security. We also like exposure to less expensive factor biases, such as high dividend yield, which we also like for income. We try to avoid over-hyped technology market darlings. Most of all, we think it is time to look for equity exposure outside the US.

High US federal deficit leaves little room for fiscal stimulus
The market expects further tax cuts from the Trump administration. Yet the federal budget deficit of 7 per cent, which is high for an economy close to full employment, leaves very little room for fiscal stimulus. Instead, perhaps the previous Trump tax cuts worth $390 billion (7) should have expired and additional increases in individual and corporate taxes would have been needed to reduce the budget deficit.

There is an opportunity to reduce spending. Elon Musk is reportedly ready for the job of the government “chief efficiency officer” and has been warning voters to prepare for economic “hardship” (8). This is not going to be easy and will take time. We would like to witness his progress before changing our view.

One particular item of $1.1 trillion (9), which is already larger than the defence and medicare spending, is likely to grow even further driving the budget deficit higher. This item is the net interest to service the debt. With rising yields on longer-dated US borrowing (10) and the large amount of debt with low interest rates, which will need to be refinanced at a significantly higher rate, this may be hard even for the mighty Elon Musk to rein in.

Escalating national debt is becoming an issue for US fixed income
The US national debt is now $36 trillion (11), including $28.57 trillion (12) in debt held by the public, which is 97 per cent of GDP of $29.35 trrillion as of 3Q24 (13). The ratio was only higher after WWII at 106 per cent. This debt almost tripled in absolute terms and doubled as a percentage of GDP in the decade after the great financial crisis as the budget deficit was consistently high in comparison with the achieved GDP growth.

For example, between 2012 and 2019, debt rose, on average, by nearly 6 per cent annually (compared with nominal GDP growth of about 4 per cent) and at the end of 2019, federal debt held by the public was equal to 79.2 per cent of GDP (14). Following the pandemic debt increased further, exceeding previous forecasts by the Congressional Budget Office (CBO) (15). Now analysts (16) forecast further growth to above 150 per cent of GDP over the next 30 years.

The escalating US national debt will most likely be resolved by inflation, in our view.

Tariffs and immigration controls may further contribute to inflation. The ideal way out of the debt spiral would have been to grow the economy faster than the budget deficit.

Unfortunately, this is unlikely given the wide deficit in combination with already high US corporate profits and signs of cooling discussed above.

This means that the most likely outcome will be inflation, which would make longer-term bonds unattractive in the US. The Fed will have a difficult balancing act controlling inflation yet reducing the interest rates. The fact that the 10-year US bond yields rose after the Fed implemented their most recent 50 bps cut, may indicate that the bond market is already worried about inflation.

US corporate credit seems to be equally sending mixed signals. For example, according to BCA (17), high-yield spreads have dropped 60 bps since February 2022 even though the trailing 12-month default rate in the US has risen to 5.4 per cent from a low of 1.2 per cent during this period.

Footnotes

1  https://www.morningstar.com/news/marketwatch/20241030218/stocks-have-rarely-been-thisexpensive-versus-bonds-now-ubs-expects-that-to-change

2  https://www.linkedin.com/posts/charles-henry-monchau-cfa-cmt-caia-4003096_this-is-oneof-the-most-overvalued-markets-activity-7257609762484240385-jFTB?utm_source=share&utm_medium=member_ios

3  Source: https://worldperatio.com/sp-500-sectors/

4 https://advantage.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_110824.pdf

5  https://www.marketwatch.com/story/stocks-have-rarely-been-this-expensive-versus-bondsnow-ubs-expects-that-to-change-24a76869

6  BCA Research, global investment strategy, “Fourth Quarter 2024 Strategy Outlook: Soft Landing or Quicksand?” September 2024

7 https://www.cnbc.com/video/2024/10/22/paul-tudor-jones-we-are-going-to-be-broke-reallyquickly-unless-we-get-serious-about-our-spending.html

8 https://www.nbcnews.com/business/economy/economy-if-trump-wins-second-term-couldmean-hardship-for-americans-rcna177807

9  https://fiscaldata.treasury.gov/americas-finance-guide/nationaldebt/#:~:text=Maintaining%20the%20National%20Debt&text=As%20of%20September%202024%20it,spending%20in%20fiscal%20year%202024.

10 https://www.reuters.com/markets/us/yields-soar-trump-win-stirs-bond-vigilantes-2024-11-06/

11 https://fiscaldata.treasury.gov/americas-finance-guide/national-debt/

12 https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny

13 https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny

14 https://www.cbo.gov/system/files/2020-03/56165-CBO-debt-primer.pdf

15 https://www.cbo.gov/publication/56309#_idTextAnchor048

16 https://www.alliancebernstein.com/content/dam/global/insights/insights-whitepapers/the-usnational-debt-debt-or-alive.pdf

17: BCA Research, global investment strategy, “Fourth Quarter 2024 Strategy Outlook: Soft Landing
or Quicksand?” 28 September 2024

Important disclaimer
This article is provided for information purposes only. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors and, if in doubt, an investor should seek advice from a qualified investment advisor.