At this time last year, we thought the probability of the U.S. tipping into recession was uncomfortably high. Nearly all of the economy’s historically best leading economic indicators were pointing to weakness. The labor market was already softening, and consumers had almost fully depleted their COVID-19 pandemic savings. Meanwhile, the Federal Reserve was at the end of the fastest and most aggressive tightening cycle since the 1960s. 2024 was likely to prove to be a difficult year, and as a result, we dubbed it “the year of testing resiliency.”
Happily, it is fair to say that the economy passed that test, and a recession was skirted. The unemployment rate has remained low, inflation has continued to fall, the stock market has jumped, and the U.S. election has, thankfully, proved decisive. But what led to this happy outcome? First and foremost was continued solid spending by the U.S. consumer. Second, the impact from higher interest rates continues to lag. Third is the emergence of generative artificial intelligence. Last but certainly not least is immigration, which the majority of whom were spending money on groceries, apparel, services, and housing-related areas. This resulted in both faster GDP growth and lower inflation by putting downward pressure on wages and helping ease labor supply constraints.
The economy avoided a recession in 2024, and the greater probability is that it will be able to do the same in 2025. Overall growth this coming year is likely to moderate from an above potential rate of 2.9% over the first three quarters of 2024 to 2.1%, and inflation is likely to remain sticky at around the 2.5% level. As we look ahead to the first half of 2025, we can anticipate a bump in economic activity fueled first by pent-up demand following the recent elections. Second, companies are expected to engage in significant inventory restocking in an effort to get ahead of the proposed tariff increases. Overall, while growth is likely to revert to more normalized levels following the pandemic’s unprecedented disruptions, the outlook has also become increasingly uncertain following the election.
In our mind, undoubtedly, the biggest risk in 2025 is a resurgence of inflation. While this is not our best-case scenario, the potential for such a situation has increased. The main two risks around inflation emanate from tariffs and deportations. The inflationary impact from tariffs is likely to be transitory in that they are a step up in price, and these are not price increases being driven by “too much money chasing too few goods,” provided they do not cause longer-term inflationary expectations to become unanchored. The risk of deportation emanates from the plan to deport millions of undocumented workers, putting renewed upward pressure on wages in an already structurally tight labor market environment.
The past year has ended up being far more resilient to many of the prevailing economic headwinds than we had feared it might be. The shifting consumption patterns, structurally tight labor market, and strong private sector balance sheets with debt that has been locked in at low rates for the duration have helped boost consumption and moderate inflationary pressures. Growth will likely decelerate closer to its trend rate, driven by further expansion in consumer spending and the ongoing wave of greater business investment in new capital. The Fed is happy with the current economy and thus wants to return to a neutral setting before the lagged effects from those current policy rates further restrict growth. Also, the dollar is likely to remain strong in light of this ongoing U.S. exceptionalism, which President-elect Trump is attempting to double down on. Such an environment is likely to be consistent with the continued outperformance of the small- and mid-cap stocks which began in the second half of last year. They are benefiting from highly attractive valuations, a friendlier regulatory environment, lower interest rates, tariff protection, and investment flows that are increasingly tilting toward diversification into underowned sections of the market.
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