Capital Markets Outlook 1Q 2025: Mind the Gaps

What You Need To Know

In our view, active investors face opportunities to outperform created by looming policy changes and the macro landscape. Bond yields remain healthy, and we see potential beyond the concentrated leaders of the US equity market. It won’t be a smooth ride—but disruption also creates room to maneuver.

Key Takeaways

• As most economies enter the latter stages of the normalization process, investors must square current conditions with the impacts of potential policy changes, particularly in the US.
• A “back to the future” scenario presents an opportunity to tap into attractive yields, with diverse opportunities for active investing. 
• High yields and improved relative valuations suggest a compelling starting point for active investing in municipal bonds.
• We expect earnings to eventually broaden beyond a few high-flying US stocks, setting up the potential reward for owning other stocks.

The Macro Picture: Marrying Current Conditions with Policy Change

Market returns have been exceptionally strong over the past two years—particularly stocks and fixed-income credit—bolstered by the continued effects of normalization (Display) and hope for the AI revolution. But the final quarter of 2024 revealed challenges that reflect the big question for investors today: How can I marry current conditions with potential policy changes, particularly those under new US leadership?

To address this question, let’s revisit the “holy trinity” of economic drivers: inflation, growth and labor. Inflation has trended down, though there’s still room for improvement. Economic growth continues to deliver positive surprises, but sustainability is a question. The labor market, the key growth driver, remains balanced, but the Fed would likely be happy if we see no further cooling in the jobs market.

Interest rates surged late in the year despite continued normalization, as markets digested the potential impacts of looming tariffs and trade spats. During Donald Trump’s first term, the 2018–2019 inflation pattern suggested that tariffs are less truly inflationary and more a one-off price adjustment. But not all tariffs are likely to roll out on day one, so investors should keep a close eye on inflation expectations.

We still expect the Fed to cut policy rates in 2025, as it’s willing to leave inflation higher to keep the labor market stronger. While the Fed currently has two cuts priced in and the market only one, we still see the balance of risks tilted toward more cuts: we expect “air pockets” of soft data over the next year. As we see it, the inflation outlook would have to worsen significantly and/or inflation expectations would need to become de-anchored to justify fewer than two cuts.

Back to the Future for Bond Investors

For bonds, the storyline is “back to the future.” Real, or inflation-adjusted, yields are elevated with policy rate cuts in store, so there’s still opportunity to tap into attractive yields. Monetary policy is less likely to move in lockstep globally, which we think points to diverse opportunities for active investing. 

As the Fed continues to reduce short-term policy rates and fears of fiscal pressures push up longer-term bond yields, the US yield curve has quietly been changing shape. At one time inverted, with short-term rates above long-term rates, the curve has taken on a more normal appearance. This creates opportunities in roll and carry—potential price gains as bonds move closer to maturity and toward the neighborhood of lower-yielding short-term bonds. The potential for more policy easing and a sizable pile of cash still on the sidelines could also support bonds.

Credit—notably high yield—still seems attractive. Spreads are relatively tight, but healthy yields signal more potential ahead (Display). Meanwhile, strong fundamentals and positive technical conditions provide a solid ground, in our view. Beyond high yield, we’re finding opportunities across the globe and sectors as the pace of economic normalization diverges regionally.

A Compelling Starting Point for Municipals

With yields rising and broad market returns marginally positive, 2024 was disappointing for municipal bonds. But it was a good year for active-management opportunities, with a barbell maturity structure and credit positioning providing avenues for enhancing returns (Display).

With yield levels high versus history and with relative valuations improved, 2025 seems to offer a compelling starting point for municipal bonds, with potential to generate strong returns without further tightening in credit spreads. Technical conditions, in contrast, are expected to be weaker given a forecast for heavy issuance of new bonds.

We think income and duration will be the key drivers of credit returns, and it seems sensible to consider upping exposure. We also believe that overweighting duration, or interest-rate sensitivity, may enhance returns—with a barbell maturity structure. Along the way, bouts of volatility and market dislocations could unearth further opportunities for active management.

For Equity Investors, Broader Would Be Better

On the equity front, S&P 500 earnings should continue to grow, but investors should keep an eye on the direction of earnings revisions. Valuations continue to gap away from earnings, though high price/earnings multiples aren’t without merit, given the healthy economic and profit outlooks.

For some time, the dominant theme has been the S&P 500’s historic concentration in a few high-flying large-cap stocks. We saw brief signs last year of earnings broadening out to more stocks, but 2024 was ultimately another year of mega-cap dominance. From our perspective, this backdrop enhances the potential reward for owning other stocks when broadening ultimately happens (Display), which we expect.

Where are those “other” opportunities? In growth stocks, we think the story will be finding gems beyond the popular sectors. Case in point: many consumer and healthcare stocks with solid earnings have been left behind or unduly punished. We also see thematic opportunities, including among the diverse companies that may help solve the expected surge in US power demand.

We think the massive need for many economies to up infrastructure investment is one way to find growth in value stocks. Dividend payers have been fertile ground for income-growth potential, which could be timely as the Fed continues cutting short-term rates. And we view the recent surge in small-caps as being of a lower-quality variety, offering an opportunity to rebalance into higher-quality stocks.

To sum things up, we see outperformance potential in the incoming policy changes and macro backdrop as well as the many segments of the equity market beyond the handful of leaders in a concentrated US equity market. Bond yields also remain healthy to start the year. The ride will no doubt be bumpy—but those bumps have historically translated into opportunity.