Ketu Desai
By Ketu Desai
The story, so far, in 2025 and likely for the whole year is yields and the dollar; the way each can go and how the year will go for equity and risk-asset investors. January was a microcosm of this. During the first half of the month, yields and the dollar rallied, while equities were volatile. They sold off in the second half of the month, and then equities rallied. Yields and the dollar encapsulate inflation, growth, the deficit, tariffs, productivity, monetary policy, and fiscal policy into a single number.
Yields and the dollar are key to determining how easy or tight financial conditions are. The US Debt to GDP stands at 121%, up from 60% pre-Great Financial Crisis in 2007. The primary strategy to normalize this ratio is to grow our way out of it. Deregulation, tax cuts, America first investments are policies to stimulate American growth. Pro-growth policies along with tariffs and deportations have the potential for inflation, which in turn will pressure yields and increase the dollar upward. It is a challenge to get growth to lower the deficit without spiking yields. This battle between growth and inflation will be fought all year, reflected in yields, making the market highly sensitive to each economic data point.
The key to this battle is productivity, which allows for growth without significant inflation. The good news is that productivity began to increase in 2024, running upwards of 2%. AI will likely accelerate productivity growth. Goldman Sachs estimates that AI will lift productivity growth by 1.5% per year. While it is early, the release of DeepSeek could accelerate AI, even as the cost of development has gone down in recent weeks. Even prior to DeepSeek, we started seeing preliminary results.
Goldman Sachs’ CEO said, “The initial registration prospectus for an IPO – might have taken a six-person team two weeks to complete, but it can now be 95% done by AI in minutes.” Meta CEO Mark Zuckerberg said, “Probably in 2025, we at Meta, as well as the other companies that are basically working on this, are going to have an AI that can effectively be a sort of midlevel engineer that you have at your company that can write code.” JPMorgan stated that its free cash flow intelligence AI tool helped cut manual human work by 90%. According to Duke University, more than 60% of large US companies plan to use AI within a year to take over tasks previously completed by human workers. The combination of cheaper costs of AI development, leading to lower energy costs, and an acceleration in adoption, is likely to lead to an upside surprise in productivity and help keep a lid on yields.
From an equity market perspective, productivity growth will drive margin expansion. S&P margins are up nearly a percent over the last year. Sectors such as financials have expanded margins by over 5% in the last year. Goldman Sachs estimates that AI will lead to another 4% margin expansion. This expansion is driving strong earnings growth. Earnings grew 13% in the fourth quarter, led by sectors showing margin expansion, such as financials, communication services and healthcare.
Not coincidentally, these sectors have led the market so far this year. For the full year, earnings are expected to grow by 15%. There is an upside to these numbers. If AI development costs are much lower than anticipated, expect innovation and productivity enhancements to occur even quicker than previously believed. This could have significant ramifications for EPS growth, margins, inflation and the cost of capital. With elevated multiples, earnings will have to do the heavy lifting. 2025 is a year where there will be a lot of headline risk and many crosscurrents. Use yields and the dollar as the signal through all the noise.
Looking forward, the market will focus on earnings, the latest from Washington, and further developments in AI.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. [email protected]
