Ketu Desai
By Ketu Desai
This year in many ways will be the opposite of the last couple of years. Moderation in growth, inflation, and rates was the theme in 2023 and 2024. Nominal growth has moderated from double-digits to below 5%. Inflation has moderated from nearly double digits to 2.5% and rates have moderated from 5%.
This year will see growth, inflation, and firmer rates. The consumer remains in good shape. Real wages are growing, initial jobless claims are historically low, household debt service for disposable personal income remains at low levels, and spending is running north of the trend. The incremental GDP growth will come from corporations. Behind de-regulation, tax incentives, and pent-up demand, we will see a resurgence in CapEx, M&A, and business activity.
Corporate CapEx will grow in the mid-single digits, led by AI-related spending. AI-related cloud CapEx alone is expected to grow 24% in 2025. This spending is structural and wide-ranging, driving growth of the infrastructure supporting it, from semiconductor design and manufacturing to the building of data centers, increased energy generation needs, and further automation of supply chains. This spending will be augmented by the CHIPS Act, Infrastructure Act, and Inflation Reduction Act. Total construction spending is running at a 5.2% growth rate. This type of spending has a meaningful multiplier effect on the economy. With real consumer spending running north of 3.5%, continued fiscal spending north of 20% of GDP, and a resurgence in corporate CapEx, GDP growth will run above trend.
M&A will likely make a comeback with an easier regulatory backdrop. Goldman Sachs estimates M&A activity to grow 25% in 2025. There is nearly $1 trillion in private equity dry powder that is running out of time to be put to work. Small business sentiment saw the largest jump since 1980, which will lead to more activity in 2025. With the expectation of tariffs, many businesses will front run them in the first half of the year, which has the impact of boosting growth.
The resurgence of business activity will lead to above trend growth, but also firmer inflation and rates. The 5-year breakeven rate (proxy for future inflation) is nearing 2.5%, up from 1.86% in September 2024. The market expects the Fed to cut two- or three times next year. However, if inflation does firm up, it’s likely that the Fed will be on hold, similar to 1995 when mid-cycle adjustment cuts were made, and then were on hold until 1996. The combination of firmer growth and inflation, a Fed on hold, a high fiscal deficit, and a heavy issuance calendar, means rates will be higher for longer.
The drivers of the market are also likely to be different in 2025 than they were the past two years. The defining feature of the rally over the last couple of years has been its narrowness. The “Magnificent Seven” large cap tech names have outperformed the equal-weighted S&P by over 100% in the past two years. In fact, the S&P is at its most concentrated since 1932. The driver behind the performance gap is a growing excitement involving AI, which has been moving in phases. It started with the infrastructure names, led by the semiconductors; peaking in July 2024, and since then the trade moved on to software.
The market is now rewarding applications such as ServiceNow, Salesforce, and Palantir. In 2025, we will likely move to the next phase, the consumers of technology. Technology consumers will start to show margin improvement, which will instill a re-rating for many names across healthcare, financials, industrials, staples, and consumer discretionary. Walmart, on its earnings call, highlighted the potential for AI. Their CEO said, “We’ve used multiple LLMs to accurately create or improve over 850,000,000 pieces of data in the catalog. Without the use of generative AI, this work would have required nearly 100 times the current headcount to complete in the same amount of time.” I suspect we’ll see more of this type of AI commentary as the year progresses.
These AI consumers will also see margin improvement are large cap value stocks. Goldman Sachs estimates that AI will expand margins by 4%. This will likely lead to multiple expansion and re-rating. Value stocks trading at 17.5x with double-digit earnings growth have plenty of room for multiple expansion. The value of stocks trade at a 45% discount to large cap tech. The multiple on large cap tech is likely capped with rates higher for longer, earnings decelerating, and they are in a CapEx spending cycle. The spread between value and growth is wider than the dot.com bust.
Value stocks had a historically poor performance in December 2023, and after similar occurrences the value factor went on to gain 24.4% over the following year. The current positioning in large cap tech is in the 96% percentile. Many investors have waited for the new tax year (and potentially a lower tax rate) to reduce these names. High positioning, valuation, and concentration will likely cause re-allocation into large cap value in 2025.
Looking forward, the market will focus on the new administration, fourth quarter earnings, economic data, and an upcoming Fed meeting.
