2025 Investment Directions: Navigating Market Trends

• We expect U.S. outperformance to continue amid solid economic growth, relatively easy financial conditions, and the potential for tax cuts and deregulatory policies.
• We continue to prefer large-cap, high quality U.S. equities and see tactical opportunities in financials. In fixed income, we prioritize income over price appreciation and prefer the front and belly of the yield curve to long duration exposures.
• Uncertainty associated with both trade and immigration policy could lead to slower growth, higher inflation – or both – over the course of 2025 and beyond. We look beyond traditional sources of ballast in an environment where long term bonds have been an unreliable source of diversification.

We take a pro-risk stance heading into 2025 but acknowledge that consensus positioning can increase the likelihood of near-term pullbacks. Even so, record amounts of cash held in money market funds suggest that such technical dips are prone to be bought. Indeed, across our investment platforms, BlackRock’s portfolio managers have taken an overweight position in U.S. equities. We anchor our medium-term directional expectations on fundamental macroeconomic data and their flow through to corporate earnings.

Solid U.S. growth, healthy consumer balance sheets, relatively easy financial conditions, and the possibility of deregulation and tax cuts underpin our positive view of risk assets. We continue to favor U.S. equities over the rest of the world, leaning into strong recent momentum, with a preference for quality in a highly uncertain global landscape. The flip side of solid U.S. growth and low unemployment, even with Fed funds above 4%, is that further large cuts are unlikely.¹ Within fixed income, we favor income over duration and seek higher yields outside of core bond allocations – a view shared by many of our fixed income portfolio managers.

But the uncertainty associated with both trade and immigration policy could lead to slower growth, higher inflation – or both. As a result, we pair our pro-risk stance with a set of targeted hedges to help counter these risks, cautioning that the antidote may need to be specific to the ailment. Stock/bond correlation in U.S. assets has become less reliably negative, so we see expanded scope for alternative diversifiers within a portfolio.²

AI is a mega force that could fundamentally reshape economies, and markets have been more sensitive to data surprises than in the past. As detailed by the BlackRock Investment Institute in the Global Outlook, this is an environment in which dynamism and granularity are both essential. We see this as motivating greater use of ETFs, active strategies and a broad range of diversifiers.

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2024 was a year of U.S. exceptionalism; we expect 2025 will continue the trend. While many equity benchmarks cleared fresh highs in 2024 – the Nikkei 225, FTSE 100, TSX Composite – U.S. gains led the way, outpacing ACWI ex-U.S. by double-digits. Positioning reflected the divergence, with investors overweight U.S. equities.³ We see reasons to continue to lean into the positive momentum.

• Corporate earnings support relative U.S. outperformance: 12-month forward earnings growth projections for the S&P 500 have been revised higher from 1-month, 3-months, and 6-months ago, with growth expected to broaden further.⁴ Bottom-up consensus looks for all sectors to deliver positive earnings growth in 2025, compared to just four of the 11 in 2024. By contrast, forward EPS growth estimates for both Europe and Asia have been revised lower as regional growth slows more sharply.

Rich valuations and high concentration in U.S. equity benchmarks are frequently cited concerns but may not represent the near-term risks many investors fear. Rather than reducing exposure to U.S. equities, we prefer managing around these risks, leveraging a combination of targeted exposures, active management and explicit hedges.

• We entered 2024 with equity market concentration a chief – though not a new - concern. Performance has broadened out from narrow leadership – in 2024, 80% of S&P 500 names were positive, a sizeable pick up from 2022’s 34%, and above the longer-term average of 70%, with the average name up 17% on the year.⁵
• While earnings growth was the key driver of 2024’s equity rally, multiple expansion also played a part. The market’s 12-month forward PE currently trades at a 22% premium relative to its 10-year average.⁶
  • But today’s growth-skewed index makes it difficult to compare to history’s more value-oriented one. The rapid growth in the Magnificent 7, and their investment in future revenues, also help justify index-level multiples. Consider that the Mag 7 companies re-invest 60% of their cash flow from operations back into growth capex and R&D - triple the rate of the other 493 names in the index.⁷
  • Even pockets that have contributed the most to equity market outperformance trade at reasonable valuations relative to expected growth. The tech sector’s current PEG (price-to-earnings-to-growth) ratio is in-line with the broader index.⁸
• We see the best opportunity for further upside at the intersection of growth, quality, and reasonable valuations. While select, high quality multiples can be justified by their investment in future growth, we keep an eye on lofty valuations elsewhere. We maintain our constructive outlook on growth exposures but prefer screening out companies with unsupported valuations. Dynamic factor strategies may have an edge in a more demanding valuation environment with rapidly shifting policy priorities.

We continue to prefer quality and growth at the core of U.S. equity allocations but see tactical opportunities in select cyclicals and value. We continue to expect the AI trade to be a growth engine, but we also like adding to value via sector and industry allocations and maintain our positive view on financials. Steeper yield curves, a shallower path of Fed easing, and heightened deregulation provide continued tailwinds to the sector, especially amid positive earnings expectations. Deal flow beneficiaries continue to post strong results as confidence builds in the M&A cycle, and we expect stronger capital markets activity on easier policy under the new administration.⁹ Indeed, Goldman Sachs forecasts that M&A activity will jump by 25% in 2025, a change that could continue to benefit broker dealers in particular.

While small caps narrowly beat large caps in the second half of 2024, that performance has stalled since the end of November. The post-election small cap rally reflected risk-on sentiment, but we expect fundamentals to potentially cap performance from here. Just 1% of S&P 500 companies are unprofitable vs. 43% of the Russell 2000, the second largest spread since 1988.¹⁰ As rates stay high and translate to higher funding costs, we see further headwinds ahead.

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Despite U.S. exceptionalism and potential tariff risks, selective international exposures can provide differentiated returns and enhance equity portfolio diversification. In developed markets, we continue to prefer companies with quality characteristics as higher margins may better weather potential trade shocks from U.S.-enacted or retaliatory tariffs. We also see opportunities in high quality international companies that pay attractive and growing dividends as both a unique income source and potential portfolio diversifier amid volatile markets.

• We prefer Japanese equities for a more targeted exposure to a developed market economy outside of the U.S. We are constructive on Japan’s economy as inflation and growth continue to embed in the economy. Further, shareholder reforms are working - companies are returning cash to investors via buybacks and dividends, which they were incentivized to do. In the third quarter earnings season, stock buybacks totaled 3 trillion yen, extending the 2 trillion yen of buybacks from one year prior.¹¹
• We continue to believe in the structural trends that may drive long-term economic growth in India. India is on the path to becoming the world’s third largest economy by 2030, with real GDP expected to grow at a 6%-7% annual rate, lifted by the country’s expanding formal labor market and mature digital infrastructure.¹² We like India on a stable political backdrop and strong growth prospects, and the recent equity market pullback providing a more attractive near-term entry point.

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For core fixed income exposure, we favor the short end of the curve through the 3-7 year ‘belly’, focusing on income and yield rather than duration and spread. Solid economic growth and the possibility of inflationary policy measures have dampened our enthusiasm for extending duration. Staying active in duration management, seeking opportunity in “plus” categories, and considering option writing strategies could be a good way to earn additional income.

Owning longer duration rates exposure looks risky to us in 2025 – a view shared by BlackRock’s fixed income portfolio managers. First, we anticipate persistent federal deficits to require additional new Treasury issuance. Much of this issuance will occur in longer-dated maturities, helping to keep rates firm. Secondly, we anticipate that term premium could continue to normalize, potentially taking 10-year rates as much as 1.3% higher than they would have otherwise been.¹³ Finally, the anticipated end of the Fed’s quantitative tightening (QT) may not be as positive for longer-duration yields as some have speculated. The Fed may choose to reinvest funds from maturing mortgage-backed securities disproportionately into shorter maturities.

Investment grade corporate investors will likely need to move down in credit quality or use option strategies to appreciably outperform Treasuries. As in Treasuries, we believe investment grade credit return will most likely be driven by carry over price appreciation in 2025. However, perhaps reflecting the uncertainty in long-term Treasury rates, the investment grade curve only offers a significant spread over Treasuries for 10+ year maturities (Figure 5). Instead of taking duration risk investors could seek additional income via options strategies. Selling covered calls, or buy-write strategies within ETFs, are particularly attractive when the prospects for price appreciation are limited and implied volatility is relatively elevated.

Tight high yield credit spreads can stay tight or even creep tighter. High yield spreads are at levels last seen in 2007 on strong corporate fundamentals and a benign default outlook.¹⁴ Even so, positive supply dynamics, the improved credit profile of high yield issuers, and the growth of high yield ownership by longer term investors such as insurance, pensions and foreigners could take spreads even tighter in 2025.

The interest coverage ratio for high yield companies has deteriorated from the record highs of 2023 but remains healthy relative to its longer-term range (Figure 6). High yield bonds typically have shorter duration than investment grade credits, but investors who worry about duration can also gain exposure to high yield via floating-rate leveraged loans or collateralized loan obligations (CLOs). We believe that active management can outperform broad index strategies in 2025 by tactical bond selection from a relatively lean list of options.

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We have a pro-risk stance but recognize the uncertainty of diverging global growth and a new slate of domestic policy priorities. We focus on key risks in 2025 and highlight useful hedges from across asset classes to counter each.

1. Curbed immigration leads to rising wages. From a peak of 9.1% year-over-year headline inflation in 2022 to five consecutive months of sub-3% year-over-year price changes, the worst of the pandemic era inflation appears to be behind us.¹⁵ However, if growth continues at solid rates and restrictive immigration policy spurs a tighter labor market, wage growth and broader inflation could reaccelerate.

Within fixed income, investors could look to short-dated TIPS to help hedge against rising prices. Allocations to high growth U.S. technology firms may also serve as an inflation hedge, particularly if declining immigration is met with adaptation through greater automation. Optimizing for income via dividends or options strategies may also help guard against price increases by pulling cash flows forward. Limiting exposure to consumer staples and discretionary firms can also make sense if already tight margins are further compressed by rising labor costs.

2. Across-the-board tariffs spark retaliation. We looked to the Trade Policy Index, a gauge that measures media attention to trade policy, to find exposures with the lowest sensitivity to trade disruptions as a potential hedge. Since 2006, aerospace and defense exposures have seen the highest monthly correlation with the TPU, meaning the industry historically rallies during times of rising trade uncertainty.¹⁶

Further, we favor domestic manufacturing as a thematic exposure under the new administration. An increase in tariffs or export bans is a likely engine for domestic manufacturing competitiveness relative to foreign exporters.

3. Concerns over rising deficits mount. The ratcheting up of geopolitical uncertainty has punctuated the post-COVID global economy. That has been accompanied by persistently high government deficits, particularly in the U.S., where interest payments on the U.S. debt have gone from approximately $1bn per day in 2019 to $3bn today.¹⁷ Taken together, both have eroded confidence in fiat currencies.

Scarcity serves as a key component of value creation in a world of possible currency debasement. Gold and bitcoin may be in greater demand if concerns over rising deficits or increased money supply mount. Additionally, central banks have been a key tailwind, increasing their gold purchases by 20% year-over-year.¹⁸ That dynamic played out in gold ETPs, which swelled to $128 billion in net assets in 2024.¹⁹

4. U.S. economic growth slows sharply, triggered by multiple or unanticipated risks. Traditionally ballast came from duration. However, stock-bond correlation has been inconsistent in the current regime, leaving us pessimistic about the diversification benefits of long-term bonds. Alternately, investors without a specific view on policy or macro risks may simply want to consider employing explicit hedges against a broad equity index, such as those found in moderate or deep buffer funds. (Learn more about outcome-oriented ETFs.)

Incorporating buffered ETFs into a portfolio can offer investors a more defined outcome for their core holdings. By limiting some upside potential while providing targeted downside protection, buffer ETFs enable investors to stay invested in the market while mitigating the impact of market volatility. For instance, a classic 60/40 portfolio will face greater ex-ante risk and be more sensitive to downside shocks (Figure 7).

This approach – lower overall portfolio risk – allows investors to lean into tactical upside opportunities as they arise, without exposing their entire portfolio to significant downside risk.