The financial markets are contending with a wide range of uncertainties that have resulted in post-Labor Day turbulence. Recent economic data has been mixed, the Fed is just now embarking on an easing campaign, and election outcomes and resulting policies have a seemingly broad scope. Markets dislike uncertainty, and in the short-term we have that writ large. 

As we approach and move into 2025, however, each of these concerns will break in a certain direction. As such, it is crucial to disentangle these elements, assess their direction and likely impacts, and then re-assemble the picture. The current uncertainty is both varied and weighty, but the resolutions are near and circumscribed.

The economic narrative has an unusually short-term focus

Recent economic data is scrutinized for Fed policy implications and the likelihood of a soft landing. Yet, this “mixed” data is exactly what we expect to see at this stage – it is the “soft” in soft landing. Job growth has slowed but not stalled, and high-frequency data on unemployment claims remains low and stable. The manufacturing sector has indeed slowed, but the service sector remains in expansionary mode. Even amid this backdrop, corporate profits growth is high and is expected to remain so (Exhibit 1). Our “no recession” call, a steadfast position for almost two years now, remains in place and is predicated on both the consumer and corporate sectors not exhibiting the degree of imbalances or leverage that would lead to downward economic momentum. 

Exhibit 1: S&P 500 Projected Earnings Growth 

Source: S&P Global (2024), BMO Wealth Management (2024)

Despite these economic factors coming together as expected, the financial media has given scant attention to the question of what follows after a soft landing. As discussed in more detail below, we believe that a brief period of stabilization will be followed by growth reacceleration during 2025.

The Fed will push on a stick, not a string

The Fed’s steering of the economy will generate immense media focus and perhaps short-term market gyrations. The bigger picture, which will eventually drive markets, is that lower interest rates stimulate the economy and the Fed’s rate¹ cutting campaign should persist throughout all of 2025. Low inflation plus a softening labor market (Exhibit 2) gives the Fed broad latitude to offset any further weakness through looser monetary policy. These “balanced” risks1 indicate that the path of the Fed Funds Rate should be toward neutral, or in the range of 3% to 3.5% by the end of 2025. 

Exhibit 2: 

Source: Bureau of Labor Statistics (2024), Bloomberg L.P. (2024), BMO Wealth Management (2024)

A salient aspect of our forecast is that we expect the corporate sector to respond more favorably to Fed interest rate cuts in 2025 than is currently anticipated by the markets or most forecasters. The same underlying economic strength that supported the economy over the past year amid higher rates is likely to resume with pent up demand once short-term interest rates are closer to being normalized. Corporate spending continues to hold up well and will have additional boosts in the coming year due to AI-related spending and productivity gains, as well as recently improved corporate profitability.

Why then did certain previous Fed rate-cutting cycles (e.g., 2001 and 2007/2008) have a significantly delayed effect on the economy, so much so that the Fed was regarded as “pushing on a string”? The difference is that Fed interest rate cuts in those cycles were undertaken to counteract non-interest rate problems in the economy, namely the bursting of the dot com bubble and the housing bubble. In the current environment, lowering interest rates directly solves the primary economic problem, which is that short-term rates are simply too high and economically restrictive. 

Election foreground

Our discussion on the elections and political considerations focuses solely on the potential impacts to the macro economy and financial markets. While we recognize the breadth of potential outcomes and resulting policy differences, the first point of consideration is that neither party is running on a platform of spending cuts and austerity. The Congressional Budget Office (CBO) estimates that the 2025 federal deficit will total 6.5% of GDP and be 38% greater than federal government revenues (mainly taxes). At a baseline, the U.S. economy is bolstered by a level of fiscal stimulus that is typically seen only during recessions and in order to offset a slowdown.

The two next most impactful election considerations for financial markets are proposed corporate tax increases from Vice President Harris and proposed tariff increases from former President Trump. Given that tax increases would require legislation and a Democratic sweep, we view these changes as highly unlikely. In particular, the math of contested Senate seats favors Republican control.²  As for the prospect and impact of tariffs under a Trump administration, high tariffs on China are very likely but across-the-board tariffs on the rest of the world are less likely. Even assuming 10% tariffs on all imported goods, the impact on inflation – while real – would be modest and dissipate after a year or two. The financial market impacts of other policy differences are likely to be more sector and industry specific rather than broad-based. It is also important to remember that proposals can deviate significantly from eventual policy/legislation.

Portfolio positioning, opportunities, and inertia

We continue to recommend a balanced approach to risk with targeted overweight exposures to areas such as Reinsurance, Japan Equities, and U.S. Infrastructure which we expect to perform well over the medium term. A natural response to the current uncertainties is to let those expected resolutions play out and await more clarity. That said, given our expectation that eventual market impacts are relatively circumscribed, the next few months could also provide favorable opportunities. 

For some investors with cash on the sidelines or who have been biding time with investment decisions, the heightened uncertainty over the next couple of months warrants an additional consideration. Taking action amid higher uncertainty, while uncomfortable, may provide three advantages: 1) Enacting a portion of the contemplated changes across time provides an implicit portfolio hedge, 2) Using multiple entry points removes some of the emotion from the decision-making process, and 3) the prospect that the markets are currently “pricing in” high uncertainty and that, on average, there is an expected benefit from acting during such times rather than fully waiting them out. 

Currently, the markets are facing a rare mix of close elections, an intense focus on the short-term economic path, and a Fed that may be behind the curve with interest rate cuts. We believe that policies resulting from election outcomes are relatively circumscribed and that economic developments will break in a positive direction once the Fed’s rate cutting campaign is further underway. Some re-assembly is required, but we see the big picture coming together favorably in 2025.  

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¹ In his 8/23/2024 remarks at the Jackson Hole Conference, Fed Chair Powell described the risks to inflation and to the labor market as being “balanced.”

² The “2024 Senate Elections: Consensus Forecasts” by 270 To Win (270towin.com/2024-senate-election/consensus-2024-senate-forecast) aggregates ratings by several forecasters and as of September 9th has forty-eight Republican Senate seats listed as “Safe” and two seats listed as “Likely.” For Democrats, however, only forty-two Senate seats are listed as “Safe,” two are “Likely,” and four are listed as “Leans.” Two other states, Ohio and Montana, are listed as “Toss-up.”