Where are we headed in 2025? Uncertainty reigns, and we break out the telescope to do some stargazing. Importantly, we will talk about change. Markets respond to change, not level, and there is potential for plenty of change in 2025.

The economy and inflation

The economy is doing fine globally and gaining some near-term momentum in the U.S. Even slow-growth regions like Europe and China show little danger of plummeting into recession. Certain elements – such as tariffs – can redistribute growth, but they should have less effect on aggregate global growth. The same holds true for tax cuts. In summary, we expect growth to moderate somewhat in 2025. Disinflation, a tailwind for the last 18 months, is largely behind us. Major central banks (outside Japan) will continue easing in the near term, although a failure to meet inflation targets in the U.S. will likely force a pause by the U.S. Federal Reserve (Fed) in the first half of 2025.

The Republican party’s clean sweep in the U.S. election rewrites the rules and will have important global implications. Some combination of tariffs, an extension of tax cuts, and the introduction of some new tax cuts is a near certainty. Immigration reforms should be a bigger worry than tariffs and could substantially slow jobs growth in the next two to three years. Add in deregulation, and the most likely net effect is a modest deceleration in U.S. gross domestic product (GDP) growth. Already, however, there is a substantial push to cut spending that was not part of the original platform. Aggressive spending cuts are unlikely to arrive before the second half of 2025 but would hinder growth prospects if they arrive.

There will almost certainly be an extension of the tax cuts enacted in the first Trump administration, most likely in the first quarter of 2025. An extension will have limited impact on the fiscal impulse, which is already poised to exhibit a small contraction in 2025. Corporate tax rates in the U.S. may be lowered – although the proposal to move them from 21% to 15% may struggle to gather sufficient momentum.

Lower corporate taxes will not materially boost growth (although the Inflation Reduction Act – through the tax code – has helped redirect investment toward clean energy projects). Theory holds that a lower tax rate unleashes investment. This does not happen in capital-rich economies, as seen in previous tax reduction episodes. Developing economies do not lack access to capital; they already have the means to undertake projects that are economically additive. Lower taxes will increase after-tax profits, however, and play an important role in shifting wealth to the owners of capital.

The effect of tariffs is highly variable as it depends on whether costs are passed through to consumers, currency exchange rate movements, and the level of retaliation. A 60% tariff on Chinese imports and 10% tariffs on the rest of the world may shave 1%-2% from Chinese growth and circa 0.4%-0.8% from U.S. and rest-of-world growth by 2026.¹

As tariffs are easily reversible, they tend not to spur expensive, long-term projects to onshore jobs. Much of the fear – and potential impact – is overstated. The more extreme projections are unlikely to be fully implemented.

Inflation: Weak gravity

Inflation has been on a steady trend downward. Supply bottlenecks were the first to dissipate following the pandemic. Next came goods prices, and then rents. Rents can moderate further but that may be the end of the good news. Services prices remain sticky and are now heading up. As rent inflation stops declining in the next two to three months, a new challenge may emerge as the economy loses its convenient offset to sticky services prices. Tariffs would further exacerbate the trend.

The Fed has expressed confidence that inflation is retreating to their 2% target. Much of this is because of the well-established trend in their preferred metric – core personal consumption expenditure (PCE). The Fed’s confidence may be misplaced, because PCE may be understating the underlying pace of price increases. Trade friction and tariffs will likely push U.S. inflation up and keep it above the 2% target.

The neutral rate of interest (R-star or R*)

R* is defined as the real rate of interest which is neither expansionary nor contractionary. If R* is 1% and target inflation is 2%, then theoretically policy interest rates would need to be at 3% for the economy to be in balance. The idea is to achieve satellite orbit at full employment and then find the proper neutral rate. With a satellite, too high a velocity (speed it takes to travel in a straight line) and it drifts into space;  too low and it crashes to earth. With interest rates, too high an interest rate risks recession, while too low a rate risks inflation.

The problem with a neutral rate is that it is not observable, although we do know it has gone higher. The Fed does not really know by how much but has estimated that neutral policy rates have moved up and has moved its (long-term) federal funds rate expectations from circa 2.5% five years ago to 2.9% in recent years. R* bottomed after the 2008/’09 Global Financial Crisis but has risen on the heels of long-term factors such as demographics and a rise in productivity. The pool of global excess savings, long a suppressant on global rates, is shrinking as more economies lean on dis-saving (i.e., budget deficits). Cyclical factors are also at work.

If R-star is estimated to be at 1.22% recently and target inflation is 2%, this suggests a neutral policy rate around 3%-3.5%. With the fed funds interest rate at 4.5%-4.75% in November 2024, does this mean U.S. monetary policy is restrictive? And how does this square with a relatively strong U.S. economy?

There are three possible reconciliations: 1) lags mean the economy is not yet reflecting the restrictive level of rates, 2) GDP growth has been respectable, but restrictive policy is manifesting itself through the unemployment rate, which has been trending higher; 3) fiscal policy has been stimulatory and offset some of the restrictiveness. This latter point is another reason why the Fed is likely to cut rates at a moderate pace.

A looming black hole

Debt sustainability issues have resurfaced. How much debt is too much? This is a difficult question to answer because it depends on whether debt is productive or not. Deficits, as a percentage of GDP, will be unusually high in developed economies but need not cause a crisis. Like all markets, the greater supply of debt will force rates higher, all else equal – but all else is not equal. The supply of global excess savings can also grow, keeping rates in equilibrium.

The full range of proposed tax cuts and tariffs, if enacted, may lead to fears that deficits will become intractable later in 2025. It is more likely, however, that only a portion of proposals are enacted. The pace of borrowing may appear reckless, but a day of reckoning in the coming months appears unlikely.

Europe will see a different set of patterns play out. The European Central Bank (ECB) is set to end Pandemic Emergency Purchase Programme (PEPP) reinvestments in 2025. Gross supply of bonds will have to be met by demand from the private sector and could lead to higher term premia. Meanwhile, an anticipated decline in the combined budget deficit across Eurozone countries – from 3.6% of GDP in 2023 to 3.1% in 2024 and 2.8% in 2025 – will create an economic drag just when potential tariffs kick in.² Monetary policy will have to work harder in the eurozone to support Europe’s economy, leading to deeper interest rate cuts.

Dark matter: The role of deficits

Scientists cannot explain many astronomical phenomena and have hypothesised that dark matter, currently unobservable, must exist to account for certain gravitational effects and explain the formation of galaxies. A curiosity in bond markets in recent years has been the low level of defaults. The answer is more prosaic than dark matter: government largesse.

A deficit cannot exist in a vacuum. One person’s deficit is another’s surplus. This is the good side of deficit financing, and the part that is often under-recognized. A government deficit is equal to the level of private savings and corporate profits. In other words, government deficits should support corporate profits.

Companies may get more help from tax cuts, but they don’t really need the assistance. Demand for corporate debt is strong, and attractive yields have lured investors.

We expect corporate default rates to stay relatively low in 2025. Nearly every part of the story is supportive of credit: Fundamentals are strong, private credit is providing an additional source of financing, and central banks are cutting policy rates.

Should the full weight of tariffs unfold, Europe, China and Mexico are most at risk. Deregulation will be good for profits but will also encourage more shareholder-friendly (and less bondholder-friendly) activity in the year ahead. An acceleration in merger and acquisition activity is highly likely.

Sadly, there is no free lunch. Credit spreads (the additional yield a corporate bond pays over a government bond of the same maturity) have moved to near cycle tights in U.S. corporate bonds, although less so among loans and mortgage-backed securities or in European corporate debt. There is therefore limited prospects for capital gains from spreads moving tighter, but also little danger of credit stress in the near term. At this stage, history suggests the spoils will accrue to equity holders – and not to creditors. We look for calm in early 2025, but the evolution of the credit cycle (as higher refinancing costs overwhelm some of the more indebted borrowers) will likely cause issues later in the year.

The great provider

Our own star – the sun – provides us with warmth and energy. We are not about to advocate worshiping bonds as the ancients did the sun, but bonds have advantages – namely reliable income and diversification. Yields are at attractive levels relative to history, and government bonds could offer a potentially useful counterweight against equity market volatility.

Central bank easing will provide an important support for bonds, but our view is that rates will remain higher than they have been. Inflation has bottomed, tariffs are around the corner, and international capital flows are becoming less supportive. Government debt levels and the supply of credit are inexorably rising. These are all reasons for rates to remain higher, but we should not confuse that with reasons for rates to continue rising. Ten-year U.S. Treasuries offer value at 4.3%, just as 10-year German bunds offer value at 2.4%.³ We believe investors should be overweight interest rate duration.

We also believe investors should diversify their fixed income holdings, taking advantage of appealing yields. The role of bonds as a portfolio diversifier should reassert itself and provide ballast to portfolios in this new environment. In our view, it is important to think broadly in terms of asset allocation. Securitized assets appear particularly attractive, as are pockets of emerging market debt. As spreads move tighter, a greater cross-section of assets will be beneficial. Dispersion should remain high, and security selection will remain at a premium.

Safe travels as you seek your North Star. Be aware that risk may play out very differently depending on the sequencing of policy. Like a satellite in orbit, things look supportive today, but there is a danger we may get bumped off course.

IMPORTANT INFORMATION

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Mortgage-backed securities (MBS) may be more sensitive to interest rate changes. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.

Securitized products such as mortgage- and asset-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed income securities.

Past performance does not predict future returns. There is no guarantee that past trends will continue or forecasts will be realized.

References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.