2025 outlook: Will tailwinds trump tariffs?

U.S. Economic Outlook

• Forecasters project 2025 U.S. real GDP growth at 2.5%, a modest decline from the estimated 2.8% in 2024, but remaining above trend and consensus.
• U.S. outperformance is driven by robust real disposable income growth, fueled by inflation falling faster than wage inflation, resulting in real hourly wage growth of approximately 1.5%.
• Financial conditions have shifted from a growth headwind in 2022–2023 to a moderate tailwind contributing roughly 0.5 percentage points to growth.
• The probability of a recession within the next 12 months is estimated at 15%, aligning with the long-term post-war average of one recession every seven years.
• Base case scenarios assume a "benign" policy environment with fiscal stimulus via extensions of 2017 tax cuts and regulatory loosening, boosting business confidence and capital spending.

Policy Impacts and Risk Scenarios

• Tariffs (Base Case): Assumed to be limited to higher tariffs on China and auto imports from Mexico/Europe, creating a growth drag of a few tenths of a percentage point.
• Tariffs (Risk Case): A full across-the-board tariff (10% or 20%) has a ~40% probability; such a shock would reduce growth by approximately 1 percentage point and raise inflation by a similar magnitude.
• Immigration: Net immigration is expected to decline below the historical average of 1 million annually, acting as a minor drag on growth, though not expected to cause significant workforce contraction in the forecast.
• Inflation Trajectory: Core PCE is projected to reach 2.4% by year-end 2025 under base assumptions; an across-the-board tariff scenario could push core inflation to ~3%.
• Lagging Factors: Housing components (rent and owner's equivalent rent) are expected to continue supporting the disinflation trend.

Federal Reserve and Monetary Policy

• A 25 basis point rate cut is expected at the December FOMC meeting, with further cuts anticipated in January and March 2025.
• Policy easing is projected to slow to quarterly reductions in Q2 and Q3, targeting a federal funds rate range of 3.25% to 3.5% by late 2025.
• The Fed's mandate focuses on labor market rebalancing rather than GDP growth; restrictive rates remain a concern given the labor market is still normalizing.
• Tariff-induced inflation is viewed as a one-time price level increase similar to a VAT hike, which may not necessitate a pause in easing if growth risks materialize.

Equity Markets and Valuations

• Current market pricing implies a "friendly" backdrop for U.S. assets, yet valuations are deemed stretched, suggesting lower prospective returns over 10-year horizons.
• Equities and bond yields have risen together since the election, reflecting a shift in growth optimism rather than immediate recession fears or inflation spikes.
• Market downside risks are identified as a potential shift in yield drivers toward stickier inflation or fiscal concerns rather than strong growth expectations.
• European and non-U.S. equities face higher sensitivity to trade policy uncertainty, with a potential half-percentage point growth downgrade already priced in due to European company exposure.

Regional Outlooks: Europe and China

• Europe: Growth is forecast at 0.8% for 2025, below the 1.2% consensus and below trend, driven by trade policy uncertainty and potential auto tariffs.
• Euro Area Inflation: Core inflation is expected to return to 2% by year-end 2025 without significant tariff-induced pressure.
• Euro Area Policy: The ECB is forecast to cut rates by an additional 25 basis points, reaching a 1.75% rate by late 2025 to offset growth weaknesses.
• China: Growth is projected at 4.5% (in line with consensus), down 0.2% from pre-election forecasts as policy easing is expected to offset approximately half of the projected tariff drag.

Currency and Bond Market Dynamics

• A full across-the-board tariff scenario is expected to drive further dollar appreciation, as current pricing assumes a narrower tariff agenda.
• The 10-year U.S. Treasury yield is currently at ~4.5%; forecasters view this level as high but not yet "odd," with yields expected to remain modestly lower over the course of 2025.
• Non-U.S. bonds are highlighted as potential portfolio diversifiers, particularly if the risk case materializes, as ECB cuts could cause European yields to fall sharply relative to Treasuries.
• Bond yield volatility is expected to increase in the risk case, potentially pushing U.S. yields lower in a "risk-off" environment similar to 2019.

Investment Strategy and Positioning

• Investors are advised to maintain exposure to U.S. growth themes while utilizing diversification to hedge against tail risks like tariffs and fiscal expansion.
• Non-U.S. bonds, when hedged for FX, and U.S. Treasuries/TIPS are recommended as hedges against equity portfolio downside in growth-disappointing scenarios.
• Portfolio construction should favor more equal weighting in U.S. equities to mitigate concentration risks associated with high valuations.
• Long dollar positions against long equity positions are suggested to hedge against potential U.S. rate upside and tariff-related equity volatility.
• Options are recommended for expressing views on growth or protecting against macro tails, leveraging the reduced cost of optionality following the election.