Ketu Desai
By Ketu Desai
With new administration comes new policies. The economy was headed toward moderating growth and inflation, both settling into a range between 2% and 2.5%. The market now expects an environment with higher growth, higher inflation and higher rates. Treasury yields have settled into a range between 4% and 4.5%. Higher nominal growth, higher inflation, and a significant budget deficit will likely keep Treasury yields high. Perhaps more importantly, the market’s expectation for inflation is meaningfully up.
The 5-year break-even rate (a proxy for future inflation) is now just under 2.5%, up from 1.86% in mid-September. The Fed has also sent signs of recalibrating its expectations for policy. In a speech in November, Chair Powell said that the Fed isn’t in a rush to reduce interest rates. Further, the Dallas Fed President said, “I see substantial signs that the neutral rate has increased in recent years, and some hints that it could be very close to where the fed funds rate is now.” The market is adjusting to the reality that the cutting cycle might be much shallower than originally thought. The market is now expecting just three more cuts through the end of 2025. We appear to be moving into a higher for longer environment.
As the macro and rate expectations have recalibrated, so have the equity markets. With a clear shift in post-election leadership, the market rotated to areas with clear beneficiaries of the new policies and sold those that aren’t. For instance, the expectation for deregulation, lower capital requirements, increased M&A and capital market activity drove a significant rally in financials.
Financials will also benefit from a steepening yield curve, as they are not subject to potential tariffs. The risk of tariffs was a driver behind a rotation from semiconductor stocks into software. The expectation of a smaller government took defense and government contractor stocks down. The nomination of a new Secretary of Health and Human Services presents a risk to pharma, biotech, and many packaged food companies. They all saw their stocks make a move down.
The clear winner in the post-election trading has been crypto. It is not only benefiting from the removal of the current adversarial policy makers, but the new government is a major crypto advocate. Many pro-crypto policies are being discussed, but it remains unclear what will actually become policy. The point is that the industry now has a significant tailwind. The reasons for an allocation to crypto are increasing, including the fact it’s not subject to tariffs, there can potentially be an inflation, central bank and fiscal spending hedge, options trading on major ETFs (beginning this November), and we are in the early stages of institutional involvement.
Finally, I suspect as new policies are rolled out and institutional adoption accelerates, crypto’s correlation to other asset classes will start to break down, making it even more valuable to a portfolio.
We are likely to enter an environment that is choppier with increased dispersion and violent rotations. Stock picking and asset allocation will become increasingly critical, as we have witnessed in recent weeks. There are many crosscurrents, with rates higher for longer and inflation firming up, meaningful return from multiple expansion seems unlikely. Fiscal policy uncertainty will further cap multiples.
While these multiples are capped, we are likely to see an acceleration in earnings, which are expected to grow 15% in 2025. There is an upside to these numbers. Stronger than expected nominal growth will drive toward positive revenue. Deregulation, especially in sectors such as financials, will drive margin expansion. If the corporate tax rate is cut to 15%, S&P earnings will increase by another 4%. Certain sectors such as consumer discretionary would see nearly a 7% EPS benefit. Companies were able to buy back nearly a trillion dollars of their stock in 2024. That number will rise to north of a trillion in 2025.
Buybacks further increase EPS. As buybacks are snapping up supply, and the IPO market has largely been frozen, the net supply of equities continues to shrink. We are entering a period with multiple contractions driven by higher rates and policy uncertainty, offset by earnings growth and reduced equity supply. Sectors and stocks that are out of favor will have violent moves down, as we have witnessed with healthcare, semiconductors, and government contractors.
With multiples already high, these out of favor sectors have little room for error. At the other end, sectors that are seeing their earnings re-rated upward will see meaningful rallies, as we have seen with sectors such as financials, consumer discretionary, and industrials. Risk management, position sizing, and being nimble will be critical in this new backdrop.
Looking forward, the market will focus on the economic data, updates from the new administration, the Fed meeting, and year-end flows.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com
