Q1 2025 Conversations on Markets

The Art of the Deal?

FIRST QUARTER, 2025

CONVERSATIONS ON MARKETS

Conversations on Markets is an extension of Bel Air’s Conversations Series, featuring insights on the economy and shifts across sectors, policies, and geopolitics.

In 2024, investors welcomed what they had long anticipated: a strong economy, disinflation, and a shift toward easier monetary policy. This favorable combination was further enhanced by remarkable technological progress in the development of artificial intelligence (AI). Investors celebrated this confluence of positive news, bidding risk asset prices to new record highs. However, in light of the uncertainty surrounding policy outcomes under the Trump presidency and elevated market valuations, we examine the key drivers of returns, analyze associated risks, and present our return forecasts for various asset classes in 2025.

The 2024 Bull Market

At the end of 2023, U.S. equity markets remained approximately 15% below their 2022 peak, weighed down by inflation concerns, rising interest rates, and fears of an economic slowdown. Bel Air, however, foresaw a soft landing and continued economic growth despite widespread predictions of a recession amid a high-interest-rate environment.

In 2024, investors grew more optimistic as the American economy proved more resilient than many had forecasted.  U.S. GDP is now projected to grow by 2.7% for the calendar year 2024, driven by robust productivity growth as output per hour surged by 2.5%, a significant improvement over the prior trend of 1.5%.^[1] Investors were further encouraged when the Federal Reserve began cutting interest rates in September 2024—its first reduction since 2020—lowering rates from the post-financial-crisis peak of 5.25%-5.5% to the current range of 4.25%-4.5%.

^[1]The post-war average growth in output per hour has been 2.2%. The average from 2005 – 2019 has been 1.5%.

Source: Bloomberg. Data as of September 30, 2024.

Adding to the favorable landscape was the rapid advancement of AI, which fueled gains for many technology-oriented companies, most notably Nvidia (ticker: NVDA) and the rest of the “Magnificent Seven.”^[2]

^[2]In addition to Nvidia, the Magnificent Seven also includes Apple (ticker: AAPL), Microsoft (ticker: MSFT), Alphabet (ticker: GOOGL), Amazon (ticker: AMZN), Meta (ticker: META), and Tesla (ticker: TSLA).

The Trump Trade

In early November, when it became evident that Donald Trump would return to the White House for a second term, U.S. markets responded decisively.^[3] Equities soared, Treasury yields rose, and the dollar strengthened. Trump’s proposed economic agenda, which includes substantial tax cuts and deregulation, is poised to deliver a short-term stimulus to the economy. However, his broader policies, such as higher tariffs and stricter immigration measures, may weaken America’s long-term economic trajectory.

From a bilateral trade perspective, countries with substantial trade surpluses versus the U.S. are most likely to face significant tariff increases. In this framework, China emerges as the primary target, with a trade surplus exceeding $250 billion. Trump has suggested imposing a 60% tariff, a fivefold increase over current levels. Mexico, with a $150 billion surplus, has also been threatened with a 25% tariff.

^[3]The S&P 500 index hit fresh new highs from November 6th to November 11th.

Source: U.S. Census Bureau. Data as of December 31, 2023.

China has already signaled its willingness to retaliate, restricting exports of critical minerals like gallium and germanium, which are essential for high-tech equipment and defense applications. Further disruptions could arise in the pharmaceutical sector, as many biologics and antibodies used by American firms are exclusively produced in China. While some experts estimate that the full implementation of Trump’s proposed tariffs could reduce Chinese exports to the U.S. by up to 85%^[4], Bel Air considers a 10% tariff increase more plausible, equating to an annual economic drag of $50 billion^[5]. The potential 25% tariff on Mexico, meanwhile, is less about trade and more about leveraging immigration policy.

All this tariff speculation should be put in context, however. For example, Trump’s proposal to end the student loan forgiveness program alone could save approximately $150 billion annually. Combined with strong tax receipts from 2024, driven by elevated capital gains, the economic effects of higher tariffs are not likely to be meaningful.

^[4]https://www.crfb.org/blogs/donald-trumps-60-tariff-chinese-imports

^[5]https://www.strategasrp.com//Document/Index?strResearchProductID=qrpelbIcofCgUzPgFQWKXQ%3D%3D

Global Capital – Coming to America

Should Trump proceed with further tariff increases, multinational corporations are likely to accelerate efforts to reconfigure their supply chains, favoring domestic production. Combined with technological advancements and improving productivity, this reallocation of capital could drive substantial thematic growth in the U.S. economy, particularly in sectors like supply chain security, energy independence, and defense-related technologies.

The U.S. dollar has already appreciated by 4.3% against a basket of foreign currencies since November 6th, providing additional support to U.S. equity markets. American companies stand to benefit further from Trump’s deregulation agenda, which promises to reduce environmental restrictions and lower energy costs. This shift could enhance the competitive advantage of U.S.-based firms over their global counterparts, particularly those burdened by higher energy costs and stricter regulatory environments.

Source: Bloomberg. Data as of January 10, 2025.

Trump’s Bravado and Economic Risks

While Trump’s policies offer the prospect of short-term economic momentum, they also carry inherent risks. Trading partners could retaliate with reciprocal tariffs or restrict critical exports, causing long-term harm to U.S. industries. Additionally, countries may strengthen trade alliances that exclude the U.S., as demonstrated by the original Trans-Pacific Partnership, which Trump exited during his first presidency.

Another concern is the unpredictability of Trump’s policymaking. As he stated in The Art of the Deal: “Key to the way I promote is bravado. I play to people’s fantasies… A little hyperbole never hurts… I call it truthful hyperbole. It’s an innocent form of exaggeration, and a very effective form of promotion.” While this approach may invigorate markets and investor sentiment in the near-term, the long-term consequences warrant careful consideration.

In summary, Bel Air’s 2025 outlook below incorporates both opportunities and uncertainties of Trump’s return to the White House. While his policies may energize the economy and markets in the short term, their sustainability and broader global impact remain key areas of concern for 2025 and beyond.

Bel Air Investment Advisors 2025 Market Outlook

The global equity bull market is expected to continue into 2025, with U.S. equities likely maintaining their leadership over the Rest of the World (RoW). U.S. companies consistently deliver higher returns on equity (ROEs) and stronger earnings growth across industries, driving their outperformance relative to global peers.

While the Federal Reserve initially misjudged inflation in 2022 by attributing it to transitory factors, it has since made significant progress in controlling it. Core Personal Consumption Expenditures (PCE) Price Index inflation has dropped from high single digits to the mid-2% range, still above the Fed’s 2% target but well-anchored. This has allowed the Fed to cut rates by 100bs in 2024. Encouragingly, these rate cuts are driven by falling inflation rather than economic weakness. The U.S. economy continues to grow at 2.5%-3% real GDP, supported by a healthy labor market and strong aggregate consumer balance sheets.

Some market analysts argue for potential outperformance from non-U.S. equities, citing lower valuations compared to U.S. stocks. However, valuation discounts alone are insufficient to close the gap unless RoW equities demonstrate faster growth and stronger earnings—an unlikely scenario based on current data. Additionally, U.S. companies are leaders in adopting AI and advanced data techniques, further strengthening their competitive edge.

The new Trump administration’s policies of deregulation could catalyze mergers and acquisitions (M&A), particularly among small- and mid-cap companies. These sectors, which have lagged behind large-caps for over a decade, are poised for a potential resurgence as valuation gaps narrow.

Risks to this outlook include a resurgence of inflation or unexpected labor market weakness. The Trump administration’s plans to impose new tariffs and tighten immigration policies could have inflationary effects, but these may be offset by deregulation and liberal fossil fuel policies, especially in energy and financials. Historical data from Trump’s first administration does not strongly support the view that tariffs alone lead to higher inflation.

While the Fed has made progress in managing inflation, structural factors such as tariffs, onshoring, and tighter immigration policies could usher in a higher inflation regime. As a result, the Fed may proceed cautiously with further rate cuts in 2025, complicating the fixed-income investment landscape. Bonds are likely to underperform equities in this “higher-for-longer” environment. We recommend underweighting traditional fixed income while maintaining an overweight allocation to private credit.

Looking ahead, the anticipated policy shift could foster a more active M&A environment, with private credit playing a crucial role in financing deals. Private equity funds, which have been relatively dormant, are likely to see more exit opportunities and resume capital distributions to limited partners (LPs). Additionally, we expect renewed activity in the real estate sector.

The Bel Air View

Markets have responded well to election outcomes due to the prospect of looser regulations and lower corporate taxes.

Financial markets were characterized by uncertainty in the lead-up to elections, but this uncertainty was quickly abandoned as results were verified. The new administration’s potentially looser regulations could encourage more business activity, while lower corporate taxes could increase earnings available to shareholders.

Inflation has moderated modestly over the last year, but it remains above target as economic strength has continued.

Disinflation has continued as the effect of rate hikes has impacted the economy, but, importantly, core inflation is still elevated. Going forward, new trade and immigration policy could place upward pressure on prices as access to goods and labor becomes more difficult.

Continued economic strength could lead to a higher terminal interest rate.

Economic strength has been supported by a strong consumer, healthy labor markets, and infrastructure spending. Because of this continued strength, interest rates might have to remain higher than expected, forcing markets to readjust expectations as they attempt to discern the neutral interest rate.

The new administration has indicated its willingness to impose tariffs, raising the possibility of a global trade war and further deglobalization.

Trump has suggested raising tariffs to support American manufacturing and lower the trade deficit with key partners. This could lead to retaliatory tariffs from other countries, and cause companies to alter their supply chains or pass costs on to consumers.

Many private equity and real estate funds are holding onto assets for longer as buyers are unwilling to sell at lower valuations.

Lower valuations in the private markets have made managers unwilling to sell at current prices, limiting distributions to investors. However, there have been some signs of capital markets opening up as interest rates have gone lower, and this could continue next year.

Key risks to our outlook are: (1) a re-acceleration in inflation; (2) new trade and immigration policies; (3) Fed missteps; (4) extended commercial real estate downturn; (5) escalation in geopolitical tensions; (6) dollar strength.