2025 Market Outlook-Bridging the Divide

Key Observations

  • Full valuations, concentrated U.S. large-cap indexes and the risk of reigniting inflation are shaping the key themes we believe will drive markets and portfolio positioning in 2025.
  • Recent market successes have pushed our 2025 10-year forecasts lower across most major asset classes. Long-term return premium for equities over fixed income is now at its narrowest since 2007, sparking important conversations about portfolio posture and risk allocation.
  • We have modestly increased our preference for assets outside of U.S. equity to help mitigate concentration risk and skewed relative valuations.
  • Moving beyond passive toward active management and alternatives may offer a compelling opportunity to enhance portfolio resilience and adapt to the shifting landscape.

As we begin the year, we reflect on our 2024 outlook, “Prepare, Not Predict,” and the dynamic and unpredictable nature of the financial markets. Our 2024 themes manifested with varying impact. Inflation remained in the Messy Middle and stabilized within a manageable range. The Federal Reserve (the Fed) ultimately began to cut interest rates in September, which brought fixed income yields broadly lower from 2023. In 2023, we emphasized the importance of Preparation over Prediction, a sentiment that proved prescient as we navigated a landscape marked by continued volatility, unexpected geopolitical events and a presidential election. Yet markets broadly performed quite well, and the economy remains resilient, despite the recent uptick in unemployment. Our third theme of Concentrated Consequences carries through as we enter 2025. We highlighted the fragility within U.S. equities, driven by the narrow leadership of the “Magnificent 7” and the potential for opportunity in areas beyond U.S. large-cap equities. That narrative only intensified and by November 30, 2024, the top 10 stocks of the S&P 500 accounted for 35% of the index, up from 31% at the start of the year(1). Still, green shoots remain. Small caps outpaced large caps for the one-year period ending November 30, 2024(2). As we begin 2025, our focus sharpens on resilience and adaptability that empower us to navigate any fragility that may lie ahead.

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2025 Themes

Markets stand at a fascinating crossroads. While opportunities and optimism remain, the path forward for allocations is anything but straightforward. This year, our outlook centers on three pivotal themes: fragility, durability and the age of alpha. Fragility captures the vulnerabilities embedded in global markets derived from full valuations, concentration and inflationary pressures. It is a call for caution and strategic foresight to mitigate risks. Durability shifts the focus to building resilience through thoughtfully diversified asset allocations designed to withstand today’s risks and position portfolios for long-term success. Finally, The Age of Alpha highlights the growing potential of active management and alternative investments to drive outcomes in a market where traditional beta opportunities are scarce. Together, we believe these themes provide a framework for addressing uncertainty while identifying opportunities to enhance portfolio resilience and performance.

Fragility

Elevated valuations, intensified market concentration and the risk of a second wave of inflation sow the seeds of vulnerability in markets today. Both equity and fixed income valuations hover at precariously high levels. U.S. equity markets have surged in 2024, with the S&P 500 Index gaining 28.1% through November(3). Valuations for the index, as measured by price-to-earnings ratio, sit above 22x, close to the 20-year high and more than one standard deviation above the long-term average(4). When compared globally, U.S. large-cap equities appear even more stretched relative to their non-U.S. counterparts, adding a layer of risk for investors overly concentrated in this space. Meanwhile, in the bond market, credit spreads (one valuation measure for fixed income) have compressed close to levels last seen before the ’07-’09 financial crisis.

Fueling a portion of these valuations has been the continued strength of large cap companies concentrated at the top of the market. This narrow market leadership means that the fortunes of a handful of companies disproportionately influence the broader market. Any misstep—be it a disappointing earnings report or adverse development—could lead to significant volatility.

Further adding to the complexity is the threat of reinflation. While inflation has eased in recent years (U.S. CPI now sits at 2.6%5), it has not vanished, and there are potential rising inflationary pressures. Should reinflation materialize, it could upend expectations for financial markets.

Can the party keep going

Inflation Reignition

Durability

Investing is synonymous with taking risk and there are few, if any, investments that generate sufficient returns without it. While the risks we outlined above are not new to investing, they are particularly pronounced in today’s market. We believe this makes portfolio durability more critical than ever. The good news? Building a durable portfolio comes at a surprisingly modest “cost” for long-term investors. As we demonstrate below, the gap between our forward return expectations for fixed income and U.S. equities is the smallest it has been since 2007. Furthermore, incorporating global equity allocations may enhance durability by mitigating the acute concentration risks often seen in U.S.-centric portfolios.

Relative Value of Stocks and Bonds

The Age of Alpha

We believe three factors have converged making active management and alternatives more compelling today:

  • Valuations: With U.S. markets trading at elevated valuations, our forward 10-year return forecast is a modest 5.6%(6). We believe this presents a relatively low hurdle for alternative investments to outperform while potentially reducing exposure to full market risk.
  • Concentration: A heavy reliance on a handful of stocks increases the overall risk for broader markets to sustain recent performance.
  • Volatility: Higher market concentration typically results in increased volatility and inflation volatility may reduce the diversification of some traditional assets. Volatility has important impacts on asset allocation, but it also creates fertile ground for stock selection and targeted opportunities for active management.

Final Thoughts

Full valuations, index concentration and the potential for a resurgence of inflation have set the stage for a fragile market environment. Can prices rise further from here? Absolutely. Yet the possibility of setbacks is equally real, underscoring the importance of durability in 2025.

This year, intentionality is key. Reaffirming portfolio positioning and risk exposure is a prudent annual exercise, particularly in light of recent market gains. While timing markets is inherently fraught, the relatively modest long-term trade-off between equity and fixed income forecasts opens the door to thoughtful conversations about portfolio posture.

Mitigating acute risks, such as concentration and inflation, calls for thoughtful diversification—leveraging global equity allocations, tailored fixed income strategies and a broader spectrum of investments. Moving beyond passive and traditional approaches into active management and alternatives has the potential to enhance portfolio resilience.

We recognize that some of these adjustments may not align with the comfort of chasing what has performed best recently. But as only Cliff Asness can turn a phrase: “Simply looking at historical results and urging investors to ‘buy the thing that’s gone up the most over the long term’ is not financial analysis; it’s finger painting.”

As we look to the year ahead and beyond, our commitment remains steadfast: to make disciplined, forward-looking decisions that empower portfolios to weather uncertainty with the goal of achieving long-term success.


1.Morningstar, Standard and Poor’s. As of November 30, 2024.

2.Morningstar. As of November 30, 2024. Small cap = Russell 2000 Index, Large Cap = S&P 500 Index.

3.Morningstar. Year to date 2024 performance through November 30, 2024.

4.FactSet. As of November 30, 2024. Based on forward 12-month price-to-earnings.

5.FactSet, Bureau of Labor Statistics. As of October 31, 2024.

6.Source: Fiducient proprietary 10-year forecasts for U.S. All Cap Stocks as of October 31, 2024. Contact a Fiducient professional for a copy of capital markets assumptions and methodologies.

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