By Corrado Tiralongo, Chief Investment Officer | Jan. 2, 2025

What do you expect will be the big story as we move into 2025? What investment themes do you expect to be hot topics?

We expect the big story to be U.S. President-elect Donald Trump’s potential trade policy. The markets are fluctuating. Part of the market uncertainty relates to whether the punitive tariffs that Trump has pledged, including a 60% tariff on all imports from China and a 10% universal tariff on imports from other countries, represent a serious threat or a starting point for negotiation. But there is also confusion about the economic impact of tariffs and the channels through which they would take effect.

Many economists are trained to think that free trade is “good” and therefore that tariffs are “bad.” In the long run, this is generally true. But it is possible that in the short term, imposing tariffs can boost output in the country that levies them. This is because tariffs can act as an “expenditure switching” tax that diverts demand towards domestic producers.

The problem is that, aside from their level and their coverage, the immediate impact of tariffs will be determined by at least five other factors.

1. Is the revenue raised by tariffs used by the government to either cut other taxes or raise spending? If it is not, then an increase in tariffs represents a fiscal tightening that will squeeze demand and therefore output.
2. Assuming that revenue is recycled by the government, is the impact of tariffs blunted by moves in exchange rates? This was the case during Trump’s first term as president of the U.S., when a stronger U.S. dollar blunted the effect of the tariffs he imposed.
3. What is the elasticity of demand for the goods which are subject to tariffs? This factor determines how likely it is that consumers will respond to the higher cost of the imported good by diverting their spending towards domestic producers.
4. Is the economy operating below full employment, and therefore capable of increasing output in response to any rise in demand for domestic production?
5. Most importantly, will trading partners respond to U.S. protection by imposing tariffs of their own? Our sense is that governments in most major economies will retaliate in some form but stop short of triggering a global trade war.

All of this means that economic consequences of tariffs are far from straightforward. We suspect that an increase in tariffs under a second Trump administration will lead to a modest one-off increase in U.S. prices and thus a short-lived burst of inflation. They could also accelerate U.S.-China decoupling, as China appears to be the main focus of attention. But if other countries avoid significant retaliation, it is likely that the long-term impact on global trade volumes will be smaller than many now fear.

It is also a reasonable bet that the Trump administration will fail to deliver on its promise to bring large numbers of manufacturing jobs back to the U.S. This is partly because the economics of reshoring¹ don’t stack up. Many of these jobs are labour-intensive, and wage costs in U.S. manufacturing are more than 10 times higher than in Mexico and 20 times higher than in Vietnam. Moving jobs back to the U.S. or other advanced economies would raise firms’ costs, which in turn would bleed into higher consumer prices.

But the loss of manufacturing jobs in the U.S. and other advanced economies is not just the result of low-wage competition from other countries. It is also a function of economic development: as economies get richer and move up the value chain, it makes sense for lower-end production to move to lower-cost centres. Automation has also played a role. This helps to explain why U.S. manufacturing output is higher than it was in 2000, but employment in manufacturing is substantially lower.

We aren’t convinced that Trump’s win is a net positive for U.S. stocks. After all, we think his policies will be negative for growth and doubt that he’ll deliver another major fiscal expansion, either.

However, we have lower expectations for stock markets in many other economies amid concerns that – much like during 2018, following the start of Trump's initial ”trade war” – tariffs will take a heavy toll.

The prospects are particularly poor for China. While the MSCI China Index is down about 15% since its most recent peak in October, it is still more than 30% above its January trough, as expectations for government support gave the stock market a big boost, on net, this year. And not only do we think the measures announced so far won’t be enough to trigger a sustainable turnaround in the economy, but the country should also be the main target of the trade war we expect will start with the U.S. – our assumption is that the U.S. will place a 60% tariff on all goods from China. 

Meanwhile, eurozone equities are also likely to suffer. Companies in Germany could be particularly vulnerable to a trade war, given the country’s strong trade ties with China and big trade surplus with the U.S. Meanwhile, France’s stock market is heavily tilted towards the luxury sector, which has been hit hard by concerns about growth in China. With France and Germany accounting for roughly 60% of MSCI’s eurozone Index, we expect poor performance from the region overall.

In fact, most stock markets would probably fare poorly in the event of a trade war. In particular, Mexico’s strong economic ties with the U.S. could make its stock market very vulnerable to a growing trade tension. After all, our assumption is that the U.S. will impose a 10% tariff on all countries, hurting global companies’ prospects. More generally, a trade war would probably sour risk sentiment and prompt investors to favour safer investments than equities, which could prove particularly harmful for emerging market (EM) equities.

That said, the prospects are brighter in our view for a few stock markets, although not as bright as in the U.S. We suspect that the trade war could prove positive for India, Taiwan and Vietnam, as exporters in those countries could gain market share – although this may not be enough for Indian equities to outperform, given their high valuations. We also expect equities in Japan to do well. While the slight appreciation of the yen that we expect would probably be a headwind for Japanese equities in local-currency terms, our view that enthusiasm about AI will grow further suggests to us that they will still make decent gains thanks to the tech-heavy composition of the stock market. For the same reason, we expect equities in Taiwan and South Korea to deliver strong returns. Equities in the U.K. might also do quite well, at least relative to those in the rest of Europe. This is because the U.K. economy is not as exposed to U.S. import tariffs as many other economies.

What’s more, given our view that Trump’s policies will lead to the U.S. dollar strengthening further against most other currencies, we expect even more underperformance from non-U.S. equities in dollar terms. In fact, the general appreciation of the U.S. dollar is the key reason why we think the trade war will not take too big a toll on the global economy, and therefore why we don’t expect global equities to do even worse.

It is possible that some high-skilled manufacturing jobs relocate to the U.S. and other advanced economies over the next decade. But I suspect the numbers will be relatively small, and that the renaissance of manufacturing employment that Trump and other Western leaders promise will not materialize.

However, I don’t believe that tariffs are the real threat. One area where the economic impact of a second Trump administration could be more significant is immigration. Trump’s early appointments, including Stephen Miller to Deputy Chief of Staff, show an intent to make good on campaign promises to clamp down on both legal and illegal immigration. Those within the President-elect’s transition team have spoken of plans to remove as many as one million undocumented immigrants each year. The economic consequences of this would be potentially substantial.

Immigration has accounted for about four-fifths of the growth of the U.S. labour supply in recent years and has been a key reason why economic growth has remained buoyant, even as the U.S. Federal Reserve Board (“Fed”) has raised interest rates to generational highs to bring down inflation.

Taken at face value, restrictions on immigration coupled with the active removal of the number of undocumented migrants being discussed could plausibly lower U.S. potential gross domestic product (“GDP”) growth by around 1% per year. It is wrong to think of this as solely a hit to the supply side of U.S.’s economy. Migrants spend too, and so demand would also weaken.

But if the COVID-19 pandemic taught us anything it is that the adjustment to a new equilibrium is rarely smooth, and it is likely that sectors that rely heavily on migrant labour (construction, agriculture, leisure and hospitality) would face a rise in costs that is likely to pass through into higher prices. Taken together, the immigration measures that are being floated would represent a potentially significant stagflationary² hit to the U.S. economy.

While the world may be focused on the implications of Trump’s trade policy in his second administration, it’s Trump’s intentions around immigration that could prove to be the real hit to the economy.

However, we doubt that U.S. stock market outperformance will last much beyond the end of next year. If we are right and the S&P 500 does outpace other equity markets due to enthusiasm about AI, that would in our view mean that a bubble has formed in the U.S. and indeed reached the point where it bursts. This explains why we expect the U.S. stock market to fall back in 2026 and deliver poor returns over the next Trump administration. And while equities outside the U.S. would probably be caught in the storm, we suspect they will hold up better overall – for the simple reason that they would not be as overvalued as their U.S. peers. The upshot is that we continue to expect U.S. stock market exceptionalism to end when the AI-bubble bursts.

What asset classes would you recommend investors watch carefully in 2025?

The overarching issue is the finances of advanced economies and potential impacts.

The deterioration in the public finances of advanced economies since the COVID-19 pandemic is made clear in the International Monetary Fund’s (“IMF”) latest Fiscal Monitor, which compares its forecasts for budget balances of major advanced economies this year with how they stood in 2019. Budget balances have deteriorated by an average of 2.5% of GDP since 2019. In France, the deficit is on track to hit 6% of GDP this year. In the U.S., it is likely to exceed 7% of GDP. As a result, government debt ratios are now at or close to their highest levels since the IMF started producing this data in 1980 in every country apart from Germany.

The key question is whether any of this matters. The more immediate concern is that of fiscal sustainability.

This is a tricky concept in developed economies. Since governments issue debt in local currencies, national central banks can stand behind sovereign bond markets. Accordingly, unlike in some emerging economies which still issue in foreign currencies, there is little chance of governments defaulting outright on their debt. 

Rather, problems emerge when faith in a government’s commitment to fiscal rectitude diminishes, causing bond yields to rise sharply and forcing policymakers to take remedial action to restore credibility and prevent the fiscal arithmetic from spiralling out of control. This was the case in the U.S. in the mid-1990s, when a jump in yields prompted the White House to tighten fiscal policy. It was also the case in the U.K. two years ago, albeit with the added twist that the drop in bond prices turned into a crisis, as liability-driven investment strategies by pensions created a vicious circle of margin calls and more bond selling.

The challenge comes in knowing at what point the patience of the bond market runs out. There is no clearly defined red line beyond which a crisis becomes inevitable. Instead, several factors play into the maintenance of confidence and keeping the bond market onside. One of these is policy substance: the government that ramps up spending or slashes taxes on top of an already-precarious fiscal position is asking for trouble. But the lesson from the former prime minister of the U.K. Liz Truss debacle is that tone and optics also matter. The violent reaction in the markets was not just a response to expansionary measures themselves, but also the manner in which they were announced. The U.K.’s fiscal watchdog was side-lined and anyone suggesting that unfunded tax cuts threatened long-term fiscal sustainability was dismissed as an adherent of “abacus economics.” This created the general impression that the fiscal guardrails had come off.

With that in mind, we would recommend looking at the following asset classes in the year ahead.

Fixed income

Higher U.S. interest rates will probably continue to weigh on government bonds globally. A Trump administration means higher Treasury yields,³ given his fiscal and protectionist proposals point to stronger inflationary pressures in the U.S. We think the Fed will keep policy tighter than we initially anticipated, ending the easing cycle at a target rate of 3.50% to 3.75% rather than 3.00% to 3.25%. But we still expect bond yields in most developed market economies to fall back by the end of 2025, more so than we had anticipated prior to the U.S. election.

Equities

U.S. equities will likely be the “fastest horse” in 2025, but investors should not put all their eggs in one basket. There are compelling valuations outside of U.S. “growth”/”technology” stocks, however they won’t get the attention of investors until the AI bubble has run its course. 

Most stock markets would probably fare poorly in the event of a trade war. Particularly, Mexico’s strong economic ties with the U.S. could make its stock market very vulnerable to a growing trade tension. Our assumption is that the U.S. will impose a 10% tariff on all countries, hurting global companies’ prospects. More generally, a trade war would probably sour risk sentiment and prompt investors to favour safer investments than equities, which could prove particularly harmful for EM equities.

Alternatives

Commercial real estate – It is increasingly clear to us that pricing has bottomed out. Although we expect recent events – such as the election of Donald Trump and the recent U.K. budget specifically – to lead to an even slower recovery in prices than we previously expected.

Private assets – We are concerned regarding the growth and push of private asset strategies for “retail” investors. As Cliff Asness, Managing Principal and Chief Investment Officer at AQR Capital Management notes, these strategies are “volatility laundering,” or essentially masking their true risks to investors.  Given the complexity of private asset strategies and their investment structures, most investors, in my opinion should not invest directly.

Non-long-only investment strategies – These are useful in a portfolio context as tools to mitigate tail risk, improve overall portfolio performance, etc. The biggest issue with these strategies is sticking with them over the long term. Only the most sophisticated investors and their Boards seem to have the horizon and aptitude to include these in portfolios and stick with them over time in order to realize their benefits.

Currencies

The U.S. election outcome means that Canada and the U.S. will not be trading friendship bracelets anytime soon and leaves the risks to inflation higher, but we still think that growth concerns will prompt the Bank of Canada (“BoC”) to cut the policy rate below neutral (2.25% to 3.25% neutral range), particularly given the hit that tariffs could have on Canada’s GDP. The upside to our forecast is that the BoC will cut the policy rate to 2.0% by the middle of 2025. Earlier interest rate cuts are yet to have much effect on the Canadian economy, which remains trapped in a period of below-potential growth. Making matters worse, any boost to the economy from lower borrowing costs next year will be countered by a decline in population, as new immigration curbs take effect. Therefore, we expect soft GDP growth of 1.5% in 2025 and 1.7% in 2026. We expect the Canadian dollar to fall to a low of US$0.67 in 2025.

The euro will likely fall to parity against the U.S. dollar next year. Our assumption is that the U.S. will impose a 10% tariff on all goods imports in the second fiscal quarter next year (apart from those from China, which will be subject to a 60% tariff). However, there is still uncertainty over the U.S.’s trade policy, so the effect of tariffs on foreign exchange markets is probably not yet fully priced in. When it becomes clear that tariffs will be introduced, that would tend to push the U.S. dollar up. What’s more, we think that the European Central Bank (“ECB”) will cut interest rates further than is currently discounted in the market, which would push the euro down. Against other trading partners, the euro will likely be little changed, except for China, which will come under pressure for the U.S. tariffs.

Small-cap equities

We expect renewed underperformance of small-cap equities vis-à-vis larger ones, which is now near its most extreme in two decades in the U.S., to continue there over the next year or so. That’s because we suspect that the stock market will keep being driven up mainly by “big tech,” amid growing excitement about AI. Underperformance of small-cap equities vis-à-vis larger ones isn’t just a U.S. phenomenon. It’s been a feature of the stock market in Japan since mid-2018, and a trait over the past couple of years or so in Europe.

Value equities

Our expectation for the future performance of small- cap equities vis-à-vis large-cap equities is similar to the one that we have for value equities vis-à-vis growth equities. That relationship has evolved in a similar way in recent years. We don’t foresee value equities turning a corner against growth ones much before this bubble bursts, either. We think that shifts in the relative performance of growth and value can often be better understood by how the emergence of new trends in the economy interacts with investor psychology and the tendency to chase those trends. A quick glance at the longer-running picture of the relative performance of growth and value stocks in the U.S. appears to show some general patterns, with multi-year periods of one of the two factors outperforming considerably, punctured occasionally by sharp reversals. We think that a simple and admittedly, very stylized framework that also helps to explain many boom/bust trends in stock markets more generally can put some of these patterns in growth and value into context.

Ex-North America

Investors should remember that assets flow in the stock market where investors feel they will get the best return. It isn’t necessary for a region or asset class to be absolutely better than another, only that the expectations are “less worse” than before. So patient investors should not discount asset classes and regions that are facing headwinds, as it only requires a small change in sentiment for valuation gaps to narrow in short order. 

Investors need to remember that great companies/asset classes, are not always great investments. The price that you pay today determines your long-run return.

What regions surprised you in 2024 and which are poised to outperform next year?

• We came into 2024 with the view that U.S. equities, specifically AI-related stocks would lead the way. In 2023, we viewed that the probability of a hard landing in the U.S. was higher than what market participants were pricing in. That changed in the first fiscal quarter of 2024 and we pivoted to a view that rates were going to fall faster than what the market expected and that AI and U.S. equities would outperform.
• Given China’s structural problems, the rally in Chinese equities is puzzling as a fundamental investor. The stimulus measures that were implemented do nothing to fix China’s long-term headwinds. However, putting on a “behavioural economist hat,” it is understandable, given the retail nature of Chinese equity markets and the propensity for it to form bubbles.
• Canadian equity performance on a relative basis is a bit surprising.

Are there sectors you’re watching closely? Where are the sector headwinds and tailwinds?

• As multi-asset class portfolio managers, we don’t typically invest directly in specific sectors. Instead, we think more broadly in what asset classes we want to be invested in, then what regions, then how we want to get that exposure (passive or active), then what strategies, styles, factor exposure, etc. to apply. Having said that, we need to understand the makeup of those regions and what sectors could be posed to drive performance.
• The commodity market will have headwinds, given slowing global growth. This doesn’t bode well for Canada and other commodity producers. Specifically on oil prices, OPEC has long telegraphed that they will gradually increase output, but they continue to delay doing so. This increases the risk to the extent that OPEC+ members continue to delay output increases, which could paradoxically raise the chances of an even more abrupt ramp-up in oil supply.

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