Markets started 2025 off with a solid January. Equity markets, both in the US and abroad, rose with developed international equities leading the way. Market breadth broadened, marking something of a change from the recent past, whether that breadth continues or not is an open question.
Bond markets also rose as rates retreated some. While base rates for treasuries remained elevated, the environment for corporate borrowers appeared to remain healthy. Spreads for riskier borrowers remained narrow and, in our opinion, reflect market expectations that benign conditions in capital markets continue. Whether that is the correct view will be revealed over time as the economy evolves.
January marked a change in leadership in the US, which means changes to the policies and priorities of the federal government. Many of the changes at this stage are prospective in nature, some are perhaps hypothetical, others may be an effort to begin a negotiation. Getting a firm read on potential changes, given the quantity and nature of them, ranges in difficulty from hard to confusing.
Looking at the policy priorities there are incremental positives, as well as potential negatives and risks. Extending, and possibly expanding, the Tax Cuts and Jobs Act would be an incremental positive. A wave of deregulation would be a positive, but too much could allow future risks to develop. Tariffs could lift the inflation rate or dampen its deceleration, but perhaps the effects would be more one-time in nature. The Department of Government Efficiency could help reduce the budget deficit and slow inflation, but a decline in government spending could weigh on economic growth. The devil is in the details, of which there are relatively few right now.
As it relates to the economy, it seems to be relatively normal. Growth is still decent, though possibly decelerating. The employment market seems more or less in balance, but that could change. Inflation is still higher than the Federal Reserve’s target but seems to be gradually decelerating in a two-steps forward, one-step back fashion. The market has reduced expectations for interest rate cuts and increased expectations of where the Fed Funds rate settles out. Lower end consumers are getting squeezed, but that is not unusual.
In the market, valuations for the S&P 500 in aggregate are on the higher end. However, the top 10 holdings, which make up nearly 40% of the index, lift valuation considerably. Those companies tend to have better growth prospects, so the valuations are perhaps justified, but there is the risk that growth forecasts are too rosy. They also tend to be exposed to the same exogenous tail risk. Outside that group, the S&P 490 trades at a valuation we would characterize as more “normal”. Further outside, valuations for profitable mid and small size US companies could be characterized as “reasonable” and may benefit more from a deregulatory wave and normalizing inflation than the largest companies.
One month in, 2025 has already been more interesting than 2024 and promises to bring more change. As we evaluate the evolving situation, all else equal our bias is to prioritize the long-term over the short-term.
