Market Commentary

Top Ten Surprises for 2025

By Rob Sigler, MBA

January 2, 2025

As we outlined in our piece entitled “The Trump Trade,” the outlook for 2025 is shrouded by policy fog.  While the core policy pillars of the incoming Trump administration are known (corporate tax relief, less regulation, punitive tariffs, and immigration control), the timing, implementation, and reaction function of impacted parties are highly variable.  We believe that it is naïve to expect that the market will behave the same as it did during the first administration given that our starting points are so different.  Considering that uncertainty, instead of delivering a 2025 outlook piece, I have borrowed a page from my former Morgan Stanley colleague, and esteemed Wall Street strategist, Byron Wien.  Byron authored his first “Ten Surprises” list back in 1986.  It encompassed opinions on financial markets, economic conditions, and geopolitical considerations that he felt had a much higher chance of occurrence than the prevailing consensus view.  That tradition carried on for 38 years until his passing in 2023.  Much like Byron, I do not expect all these predictions to come true.  They are meant to stretch our thinking and outline risks that could threaten the prevailing investor frame of reference.  In that spirit, we present our “Top Ten Surprises for 2025.”

1. The 490 strike back. Virtually everyone who watches the markets is familiar with the Magnificent 7 and their outsized influence on the S&P 500.  And to be clear, there is nothing inherently wrong with market concentration.  However, the peculiarity that we observe today is that the largest 10 companies in the S&P 500 comprise 13% of the index’s collective sales, 24% of operating income, and yet represent a record 36% of the index weighting.  Said differently, we are valuing the top 10 much differently than the rest of the index.  Valuations on the top 10 have risen to 140% of average since 1996 and reside at 29x earnings.  The remaining 490 stocks in the S&P 500, by contrast, are trading for 19.6x earnings.  What could cause a reversal in trend?  We see several risks.  First, we worry that market enthusiasm over artificial intelligence boosting revenue and earnings will materialize slower than anticipated (more on this in a later theme).  Second, tariffs in the first Trump administration hit technology stocks hardest.  This is likely to repeat.  Seven of the top 10 securities in the S&P 500 are tech stocks.  Third, several of these companies are in the crosshairs of regulators for market power abuses, inadequately policing hate speech and age-appropriate content, as well as violating user data privacy.  Finally, while profit margins for the top 10 are starting to plateau, margins for the 490 are rising.  Our sense is that 2025 will see better performance in the bulk of stocks versus the top 10.
2. GDP growth in 2025 will disappoint. While the consensus broadly believes we will see a marked acceleration in economic growth, we see several impediments.  In its simplest form, GDP is easily derived.  It is a function of population growth (every mouth to feed creates a lifetime cycle of consumption), labor force participation (workers generate output, income, and stimulate consumption), and productivity (more output per worker creates growth).  Examining each of these factors reveals some potential pitfalls.  The birth rate in the United States has been declining for decades and reached a record low in 2023.  Helping to offset that powerful headwind has been immigration.  The State Department estimates nearly 2.6mm immigrants entered the U.S. in both 2022 and 2023.  However, that is poised to change.  Goldman Sachs estimates that immigration could fall to less than 1mm people per annum in the new Trump administration.  If that is exacerbated by material deportations, we could see population growth stagnate to generational lows.  At the same time, labor force participation has risen back to pre-pandemic highs and has little room to creep higher as our population ages.  That leaves us highly dependent upon productivity to drive growth.  Unfortunately, that figure has been rather consistent at roughly 2% per annum.  This leads us to believe that growth could fall short of expectations.
3. Further corporate tax relief will not make it out of Congress. Interest on the Federal debt is consuming $0.13 of every revenue dollar the U.S. government generates.  For a frame of reference, we are now spending more on interest than we are on defense.  This is obviously unsustainable and further reductions in taxation will not pass muster with Congressional leaders.  This will disappoint many in the equity market who expect rising margins and faster earnings growth as a result.
4. The biggest geopolitical risk today is not Russia/Ukraine, Iran, or other Middle Eastern conflicts. It is the risk of China resorting to a takeover of Taiwan.  China is at an important economic crossroads.  They have been soldiering through a property bust akin to what the United States experienced during the Financial Crisis of 2007-08 for the past four years.  Unlike the U.S., Chinese authorities did not take immediate action to wall off the negative impacts to the financial system and economy like the U.S. did with the Troubled Asset Relief Program (TARP).  That effectively stabilized our financial system and allowed housing to recover.  By contrast, the Chinese have largely watched as major developers declared insolvency, municipalities suffocated under mountains of debt, and consumers responded by slowing discretionary spending.  At the same time, other external factors are pressuring the Chinese economy.  Seeking more equivalent trading reciprocity, the United States and other nations have been aggressive in deploying tariffs on Chinese imports.  At the same time, the U.S. has repeatedly withheld and restricted sales of leading-edge semiconductors to China to prevent them from gaining economic leadership in key innovation categories.  What could go wrong?  The status of Taiwan has been in dispute since 1949 when the Republic of China (ROC) government was defeated by the current Chinese Communist Party during the Chinese Civil War.  Mainland China, controlled by the People’s Republic of China (PRC), maintains that Taiwan is a province of China and has proposed reunification.  That has been summarily rejected by the ROC for years.  What could incentivize the Chinese to militarily take over Taiwan?  Simply put, Taiwan produces over 90% of the world’s leading-edge semiconductors.  While the United States enjoys tremendous intellectual property leadership in chip design, the actual manufacture of these chips takes place in Taiwan.  If China is backed into a corner economically, this is a very powerful strategic lever that it could pull to hamstring the United States.  It is our sincere hope that the Trump administration brokers a détente whereby we relent on some of these measures in exchange for more equitable trade treatment and safety assurances for Taiwan.  Our fear is that this economic warfare could backfire on the U.S. if not carefully executed.
5. Artificial Intelligence (AI) lacks a killer application. While incredibly impressive, writing college term papers, improving workers written communication, helping draft presentations, and enhancing search queries is not a revenue windfall.  In 2024 alone, over $250 billion was spent developing AI.  For a frame of reference, the top 7 companies in the S&P 500 are spending more on AI than the entire capex budget of the energy sector.  Meanwhile, the revenue generated on that investment approximates $5 billion and losses are estimated at roughly $10 billion.  2025 will be the year that investors question the dollars being spent and the lack of return on investment.  Please do not misunderstand.  We firmly believe AI will prove to be revolutionary and transformative, but much like the internet age that proceeded it, enabling tools often out-race use cases.  Think about the internet.  It was officially born in 1983. That said, navigating it was anything but easy.  AOL was invented in 1985.  It proved to be a wonderful onramp.  However, solving the key puzzle of how to search, find, and obtain information on the internet would have to wait for Google.  It was incorporated 13 years later in 1998.  Ten years after that Netflix completely changed how we consume content, introducing streaming services in 2007.  Zoom started offering its services in 2013, but it took a pandemic in 2020 to crystalize how its technology had the ability to empower remote work.  Even the grandaddy of eCommerce, Amazon, did not become the world’s largest retailer until 2019.  According to the Commerce Department, only 6% of US companies are using AI and most of that involves trials.  I know this may sound strange, but the early winners of AI may not be the winners longer term.  In 1999, Cisco was the equivalent of Nvidia today.  It was the largest stock in the S&P 500 with a market capitalization of $546 billion.  Twenty-five years later its market capitalization sits at roughly $200 billion.  Google had only been incorporated a year at that point.  Its market capitalization is $2.3 trillion today.
6. Homebuilders will enter an extended bull market. With population growth and immigration, household formations have grown 17.2mm since 2012 according to Realtor.com.  Over that same period, the U.S. has added 14.7mm homes (both single-family and multi-family dwellings).  Said differently, the housing supply gap is widening and we need more housing stock.  Additionally, the average age of a home in the United States just eclipsed 40 years of age according to the American Community Survey.  Many of these units are heading towards obsolescence.  We expect an extended period of homebuilder outperformance as a result.  We also anticipate the government will start to sell off Federal land at discounted prices to incentivize development.
7. The Healthcare Sector is set to resume a leadership position. The S&P Healthcare sector has been one of the worst performers since the election.  Investors worry that the President-Elect’s nomination of Robert F. Kennedy Jr. as Secretary of Health and Human Services could imperil fundamentals, unleash price controls, and restrict sales of vaccinations.  We remind investors that this pattern of selling off healthcare stocks in past election cycles is not new.  We saw this during the lead up to Bill Clinton’s presidency (Hillarycare), the election of Obama (Obamacare), and in both Trump terms (the first related to fears over allowing the Centers for Medicare and Medicaid Services to negotiate drug pricing, and now the second with RFK Jr fears).  Our message to investors is that very little of consequence changes in these administrations.  In the end, the catch-up trade is very powerful.  If historical context does not put your mind at ease, we urge investors to ask themselves the following questions.  Do you really think that we will roll back over 120 years of historical usage of vaccinations?  These are the very scientific discoveries that allowed us to functionally eradicate smallpox, polio, tetanus, measles, mumps, and rubella.  Could we have tougher, longer trials, with larger control sizes?  Perhaps, but we are not going to radically alter the administration of vaccinations.  Second, do you truly believe that Donald Trump or the Republican party wants to cede dominance in leadership industries like pharmaceutical discovery, biotechnology, or medical technology to foreign entities?  Strangling these domestic companies with regulation, preventing them from selling lifesaving medications, or restricting them from pursuing trials or discovery would absolutely cause that outcome.  The odds seem exceeding low to our team.  Finally, do we think that the Republican party will usher in price controls and extinguish the economic incentive for the industry to spend on research and development?  History tells us the opposite position has been a hallmark of the Party’s political stance for years.  Common sense, and plenty of historical context, tells us the healthcare sector will be just fine.
8. Private infrastructure offers uncorrelated diversification and highly visible returns. Infrastructure can take the form of electricity generation and transmission, energy pipelines, bridges, toll roads, airports, and marine ports to name a few.  Additionally, energy transition to EVs, solar, wind, and other renewables is creating massive demand for capital investment.  Finally, digital infrastructure, fueled by the power requirements of data centers for AI, represents a massive growth opportunity.  Much of the sector involves regulated industries with very predictable cash flows and little market cycle correlation.  We view the category as a very favorable one offering compelling returns with embedded inflation protection.  It is one of our favorite investments for 2025.
9. Asset Backed Credit offers similar credit quality to investment grade corporate bonds with better yields and inflation protection. An asset backed security is simply a financial instrument that derives its value and income from a pool of underlying assets. A quick sample set of some of the securities that are often bundled include residential mortgages, credit card receivables, automobile loans, music royalties, transportation and capital equipment leases.  These instruments are highly collateralized, meaning they are secured by the assets that they comprise (e.g. houses, cars, planes, rail cars, etc.).  On average, asset back credit offers yields 100 – 250 basis points better than investment grade corporate bonds.  At the same time, because many of these credit instruments have floating interest rates or resetting maturities, it affords some measure of protection against inflation.
10. Commercial real estate has bottomed. Three different indices – MSCI, Costar, and Green Street – all independently suggest that valuations for commercial real estate started rising in August and that has continued into the 4^th quarter of 2024.  The continuation of the Federal Reserve’s easing cycle should lower borrowing rates and allow for more transaction activity.  Additionally, a more balanced job environment appears to be giving corporations more leverage in demanding that employees return to the physical workplace.  Our favorite category remains grocery anchored retail where Amazon vulnerable shop owners have largely been replaced by financial services, healthcare, gyms, entertainment, and dining establishments.  Rent growth looks attractive here and occupancy trends are best in class.  That said, we are starting to look into commercial office where over-indebted owners are being forced to sell at distressed pricing levels yielding compelling opportunities for those with an adequately long time horizon.

As always, we welcome your questions and thank you for your continued trust in our financial stewardship.

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