ECONOMIC REVIEW January 2025

Economy Remains Strong, But With Higher Uncertainty:

In December, Federal Reserve Chairman Jay Powell described the U.S. economy as being in “remarkably good shape.” Despite a new incoming administration, the overall economic outlook remains largely unchanged. However, uncertainty surrounding potential economic policies has increased. For example, the following chart highlights the significant rise in uncertainty related to trade policy.

Rate Hikes Did Not Stall Economic Growth:

Despite significant Federal Reserve rate hikes from March 2022 to July 2023, economic growth has remained robust, and financial conditions have remained accommodative. Consequently, the recent Fed rate cuts that began in September 2024 are unlikely to have a dramatic impact on growth. The U.S. economy has proven less sensitive to interest rates compared to past cycles, with 2024 GDP growth projected at 2.7%. 

This resilience is partly attributed to healthy corporate balance sheets. Many companies refinanced debt during a period of historically low interest rates, resulting in lower interest expenses during rising rates. Remarkably, this is the first period of rate hikes in which corporate net interest expense has declined, as illustrated in the accompanying chart.

Household balance sheets have also strengthened significantly over the past five years. U.S. household cash holdings have risen 38%, from $13.4 trillion to $18.4 trillion, while stock holdings increased 49%, from $34.5 trillion to $51.5 trillion. These gains have supported robust consumer spending, further bolstering economic growth.

Consensus Economic Views Shifted Modestly Following the Election:

Investor surveys, including those by Goldman Sachs, suggest that the new administration’s policies will likely lead to:

1. Modest increases in tariffs.
2. Slightly tighter immigration policies, though still near pre-COVID averages.
3. Extension of the 2017 tax cuts, with potential for additional modest cuts.
4. Reduced regulation.
5. Very modest government spending reductions.

The recurring theme is “modest.” However, risks include significantly higher tariffs sparking a global trade war, or deep cuts to the government workforce affecting employment. Although unemployment remains low, it has edged higher in recent months.

Goldman Sachs projects these policy adjustments may result in a slight increase in inflation, greater business investment, and a slower pace of Federal Reserve rate cuts. However, the effects of policy changes are expected to offset each other to some extent. While inflation has declined significantly, it remains above the Federal Reserve’s 2% target and has ticked up recently. This warrants close monitoring as policies like tariffs, tax cuts, and reduced immigration could push inflation higher.

Positive Corporate Earnings Outlook:

Corporate earnings are projected to grow 12% in 2025, following high single-digit growth in 2024. A potential reduction in the corporate tax rate from 21% to as low as 15% could further enhance earnings, with Bank of America estimating a $100 billion increase for S&P 500 companies—equivalent to an additional 4% growth. Recent surveys indicate a surge in optimism among large-company CEOs regarding economic improvement.

Smaller companies are expected to fare even better. After a 6% earnings decline in 2024, small company earnings are projected to rebound with a 39% increase in 2025. These businesses, which have been disproportionally impacted by inflationary cost pressures and higher interest rates, are seen as primary beneficiaries of the new administration’s economic policies and are less exposed to global trade tensions due to their limited reliance on international revenue. Notably, a post-election survey of small business optimism recorded its largest monthly gain in its 50-year history. Reflecting this outlook, we have increased our allocation to U.S. small-cap stocks, as detailed in our Investment Themes report.

U.S. Economy Set to Outpace Europe:

Over the past two years, U.S. economic growth has surpassed Europe’s, reversing Europe’s initially stronger post-COVID recovery in the previous
two years. Projections for the coming year indicate 2.1% growth in the U.S. compared to 1.0% in Europe. Recent forecasts over the past three months have revised U.S. growth higher while lowering European growth expectations.

Challenges weighing on European growth include slowing global trade and weak productivity. In comparison, U.S. unemployment stands at 4.1%, significantly lower than Europe’s 6.4%. Corporate earnings growth projections for 2025 are also stronger in the U.S. (12%) versus Europe (4%), with recession probabilities estimated at 20% for the U.S. and 30% for Europe.

Conclusion:

The U.S. economy remains strong, but risks and uncertainties are rising. Monitoring of inflation trends and policy impacts will be essential in evaluating the economic outlook.