Current Markets
In 2024 much was written about substantial macroeconomic uncertainty and its potential impact on financial markets. One source of this uncertainty was commonly attributed to the upcoming election in November. An optimistic view was that once the election passed, the path forward for the economy would be more certain. Well, as we move through the first quarter of 2025, one thing is clear – there has not been a decrease in uncertainty but rather a dramatic increase. Geopolitical concerns remain and executive orders by President Trump have triggered market turmoil. Further, developments relating to artificial intelligence have also magnified the uncertainty.
The policy of the Federal Reserve has been shifting recently which can also complicate matters. Back in mid-2024, the thinking was that the fed funds rate should be decreased significantly through 2025. Inflation appeared to be on track to meet the two percent target and the job market was showing signs of slowing. However, that view has changed. Inflation is currently “stuck” between 2.5 and 3 percent and the job market has remained solid.
The Fed chose not to cut the fed funds rate at the January Federal Open Market Committee meeting. During the chairman’s press conference on January 29, Jerome Powell stated “we do not need to be in a hurry to adjust our policy stance” suggesting that a rate cut is not imminent. This stand was a disappointment to many market participants given the sensitivity of asset values to the level of interest rates.
In terms of presidential action, the executive order initiating tariffs on China, Mexico, and Canada is particularly noteworthy. While the jury on the impact is still out, many economists agree with Phil Gramm and Larry Summer who state that “broad-based tariffs will impede economic growth, risk triggering a trade war, and inflict long-term harm on the economy.” 1 Phil Gramm and Larry Summers. “A Letter From Economists to Trump.” The Wall Street Journal. January 31, 2025. The duration of the imposed tariffs will be a critical consideration.
The source of current market uncertainty is not solely driven by the macroeconomic environment. The rise of artificial intelligence (AI) has introduced new dimensions of volatility. The potential key role of AI for future productivity growth has important implications for the overall economy. However, given the technology sector is approximately one third of the stock market’s value, sector specific effects can also be significant for investors. A recent example of this impact occurred when a Chinese startup launched its AI product DeepSeek R1 which is lower cost and more energy efficient than US AI products. The market value of Nvidia stock fell by $600 billion on Monday, January 25 in response to the Chinese product launch. This fall represents the largest one-day dollar decline in value for a company ever in the US market. Clearly, technological innovation is an important source of economic uncertainty in the current environment.
In the stock market today, many valuation measures are high on a historical basis. For example, the current forward price to earnings ratio of the S&P 500 Index is 22 compared to the ten-year average or 18.3 (source: FactSet). These high measures lead to the growth of corporate earnings being more important than usual for justifying market values. Current earnings forecasts are solid with earnings on average expected to grow at an annual rate of 14.3 percent. Such a level of growth should support current market values but there is downside risk.
For the economy as a whole, the much discussed “soft landing” outcome is intact. Economic growth as measured by GDP increased at an annual real rate of 2.3 percent for the fourth quarter of this past year. Looking forward, growth is expected to moderate in 2025 but still to remain reasonable at an annual rate above 2 percent.
Looking further in the future, there is concern with respect to economic growth. A potential problem on the horizon is that the federal debt is very high relative to GDP and on an increasing trend. The ratio moved above 100 percent in 2019 and spiked to about 125 percent in 2020 during the pandemic. The ratio has stayed well above 100 percent since then and is likely to continue to be high with government deficits projected going forward. Over the time-period beginning with 1940, the only time the debt as a percent of GDP was as high as the current value is in the middle 1940s. In that case, the high level of debt was due to wartime needs. From an investment perspective, this is not an issue that calls for immediate action but does warrant careful observation going forward. Since it is difficult for the economy to grow its way out of this problem, there is a need for government spending cuts and/or tax increases. However, in the world of politics, specific proposals including cuts are sparse.
To summarize, while the economy is currently in good condition, uncertainty with respect to market values is high. Careful monitoring of one’s portfolio is essential. Perhaps more than ever, portfolio diversification is critical.
