Taking Down Risk in a Chutes & Ladders Economy

Our 2025 Capital Markets Forecast centers on the idea of late-cycle economy and leadership change in Washington creating a wider distribution of possible outcomes for the economy and markets in the year ahead. The potential for higher highs—but also lower lows—is what we refer to as a “chutes & ladders economy.” Investors must always weigh upside risks against those that could negatively impact the economy and markets. What makes today unique is the magnitude, speed, and high degree of uncertainty surrounding policy change—all occurring against a backdrop of a slowing economy and elevated valuations.

The tariffs announced on imports from Mexico, Canada, and China—while in the case of the first two countries has been delayed for 30 days—are but one example of policy that could not only significantly impact businesses and the overall economy but also change on a dime. While this is one “chute” we highlighted in our 2025 outlook and one that investors were anticipating, there are numerous others, including the failure to extend current federal tax rates, deportations, and a weaking labor market, to name just a few. The new administration is “flooding the zone” with new policies and details, causing news cycles to be measured in mere hours rather than weeks or months. The pace of change risks unsettling markets and increasing volatility, at least until events settle down, which we expect will occur over the first half of 2025. As a result, we are further reducing risk by taking our equity overweight to neutral versus our strategic benchmark.

Solid economy with risks to the downside

Our baseline expectation for the U.S. economy has not changed since the start of the year; we still expect GDP growth to slow to a solid but below-trend pace of 1.8%, the unemployment rate to increase to 4.6%, and the Federal Reserve (Fed) to cut rates by 100 basis points, or bps (approximately 50 bps more than is expected by markets). However, we are increasingly wary of downside risks emerging, particularly with the chute of tariffs looming large.

Economic growth in the final quarter of 2024 revealed consumer spending was stronger than expected. Spending growth accelerated in each quarter last year and posted an annualized rate of 4.2% in 4Q 2024. This is caveated by the possibility that consumers accelerated purchases following the November election and ahead of potential tariffs, as evidenced by a sharp jump in spending on durable goods, many of which are imported. We expect inflation to continue decelerating alongside some weakening of the labor market, enabling the Fed to cut rates by 100 bps this year. This should help support both the economy and equities.

Just this week we have been provided a view of how quickly government policy can change—and then change back again. Tariffs, a tax on imports or exports, are a key tenet of President Trump’s policy agenda as a negotiating tool as well as a means of exacting better trade terms and a revenue raiser. Tariffs levied in his first term had a direct impact on trade deals and subsequent flows, with U.S. imports from Mexico and Canada increasing about 35%^[1] since the passage of the U.S.-Mexico-Canada Agreement (USMCA), while imports from China are lower than they were on the eve of the first U.S.-China trade war in 2018 (Figure 1).

Figure 1: The U.S.’s trade relationship has evolved since President Trump’s first term

This time around, the tariffs being discussed and potentially imposed are much larger (though, again, at the time of writing, tariff collections on imports from Mexico and Canada have been suspended to allow for border- and drug-related negotiations). If left in place permanently or for an extended period, tariffs of this magnitude would severely disrupt supply chains—especially for smaller, less nimble businesses—and increase recession risks.

Tariffs are more consequential today than they were during President Trump’s first term for another important reason: inflation. U.S. consumer spending surprised to the upside in 2024, but lower-income consumers are showing strain due to the cumulative effect of years of inflation. Further price increases could either slow consumer spending even more or weigh on corporate profit margins if companies decide they no longer enjoy pricing power to pass on these higher input costs. The Fed is also on edge about inflation remaining above target. They will surely be more sensitized to the price impact of tariffs than they were in 2018 when the impact on growth took precedence. Tariffs, therefore, could raise the prospects for a more hawkish Fed in 2025.

Equity markets on edge

As we look at the investment landscape, we see a high degree of uncertainty on three fronts: 1) fiscal policy, 2) monetary policy, and 3) tech. We discussed the first two above, and the third has emerged with the very recent news of Chinese hedge fund-owned company, DeepSeek, releasing an artificial intelligence (AI) large-language model that outperforms U.S. models with fewer, less sophisticated chips at a fraction of the training cost. Our initial take on this development is that it is a long-term net positive for AI, particularly for users of AI. But investors have put tech stocks—particularly chip companies—on notice, and there will be more urgency for mega-cap tech companies to prove that the amount of capital they are investing in AI chips, software, and infrastructure will translate into future profits. The S&P 500 is just 2% off its January all-time high, but the poster child of AI—Nvidia—has traded down more than 22% in just a few weeks^[2]. With the S&P 500 more concentrated in the largest stocks than ever before, the fate of megacap tech is incredibly important for the overall direction of the market.

At current valuations for U.S. large-cap equities, and tech stocks in particular, there is little room for disappointment on any of the three risk fronts. Today there is a great deal of good news priced into the markets based on current valuations (more than 22^[3] times next-12-month-earnings estimates, Figure 2) and consensus expectations for corporate earnings growth. As evidence, Bloomberg consensus estimates are expecting 15% earnings growth over the next year^[4], which is a robust expectation in an environment of sub-trend GDP growth (even with expanding productivity) and policy discontinuity. Even though we retain a constructive view on the economy and equity markets over the medium term (our tactical investment horizon is 9-12 months), investors are simply not being compensated for taking on above-benchmark risk at what is a highly unpredictable time.

Figure 2: Equity markets look increasingly priced to perfection

S&P 500 price-to-earnings ratio, based on next-12-month earnings estimates

^{Data as of February 5, 2025. Sources: Bloomberg, WTIA.}

We are now allocated neutral across asset classes (Figure 3), as we wait for some of the post-inauguration dust to settle. This trade entails taking our U.S. large-cap equity overweight to neutral and shoring up our underweights to international developed equities and cash, the former of which is trading at an extreme historical discount to U.S. equities and could be primed for outperformance in 2025 if global growth accelerates. Cash is not a particularly compelling asset class if the Fed cuts rates to the degree we expect, as in that scenario the yield on cash would decline, the yield curve would steepen, and equities and bonds could do well. At the same time, we would not be surprised if we have not yet seen the high-water mark for the 10-year Treasury yield this year. If long rates do rise, cash could outperform fixed income, but returns relative to equities would depend on the driver of those higher rates.

Core narrative

A Chutes & Ladders economy warrants patience. There are still ladders available to investors, with productivity growth being the biggest upside driver for growth over the long term. Development and proliferation of AI will be critical for productivity realization, and we do not believe it is yet showing up in the data. In fact, if used as a non-permanent negotiating tool that increases fair trade over time or even improves other aspects of the American economy, even tariffs could become a long-term ladder. However, as we look ahead on the game board, we notice more chutes than ladders in the near term, increasing the potential for market volatility, but also increasing tactical opportunities for the patient investor.

Figure 3: Positioning risk neutral to our benchmark

Current Positioning for High-net-worth portfolios with private markets*

^{Data as of January 31, 2025. Positioning reflects our monthly tactical asset allocation (TAA) versus the long-term strategic asset allocation (SAA) benchmark. For an overview of our asset allocation strategies, please see the disclosures.}

^{*Private markets are only available to investors that meet Securities and Exchange Commission standards and are qualified and accredited. We recommend a strategic allocation to private markets we do not tactically adjust this asset class.} 

^{[1] Source: U.S. Census Bureau, Wilmington Trust}

^{[2] Source: Bloomberg, as of February 3, 2025.}

^{[3] Source: Bloomberg, as of February 3, 2025.}

^{[4] As of February 3, 2025.}

Disclosures

Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. M&T Bank and Wilmington Trust have established information barriers between their various business groups. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports.

The information on Wilmington Wire has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed.

Past performance cannot guarantee future results. Investing involves risk and you may incur a profit or a loss.

Indexes are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses such as management fees and transaction costs which will reduce returns.

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There is no guarantee that integrating environmental, social, or governance (ESG) analysis will provide improved risk-adjusted returns over any specific time period. The evaluation of ESG factors will affect the strategy’s exposure to certain issuers, industries, sectors, regions, and countries and may impact the relative financial performance of the strategy depending on whether such investments are in or out of favor.

Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by M&T Bank, Wilmington Trust, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested.

Investments that focus on alternative assets are subject to increased risk and loss of principal and are not suitable for all investors.

Wilmington Trust periodically adjusts the policy weights’ target allocations and may shift from the target allocations within certain ranges.

The asset classes and their current proxies are: • Large–cap U.S. stocks: Russell 1000® Index • Small–cap U.S. stocks: Russell 2000® Index • Developed international stocks: MSCI EAFE® (Net) Index • Emerging market stocks: MSCI Emerging Markets Index • U.S. inflation-linked bonds: Bloomberg US Treasury Inflation Notes TR Index Value Unhedged* • International inflation-linked bonds: Bloomberg World ex US ILB (Hedged) Index • Commodity-related securities: Bloomberg Commodity Index • U.S. REITs: S&P US REIT Index • International REITs: Dow Jones Global ex US Select RESI Index • Private markets: S&P Listed Private Equity Index • Hedge funds: HFRX Global Hedge Fund Index • U.S. taxable, investment-grade bonds: Bloomberg U.S. Aggregate Index • U.S. high-yield corporate bonds: Bloomberg U.S. Corporate High Yield Index • U.S. municipal, investment-grade bonds: S&P Municipal Bond Index • U.S. municipal high-yield bonds: 60% Bloomberg High Yield Municipal Bond Index / 40% Municipal Bond Index • International taxable, investment-grade bonds: Bloomberg Global Aggregate ex US • Emerging bond markets: Bloomberg EM USD Aggregate • Cash equivalent: 30-day U.S. Treasury bill rate.

Index Descriptions

The Bloomberg U.S. Aggregate Index measures the performance of the entire U.S. market of taxable, fixed-rate, investment-grade bonds. Each issue in the index has at least one year left until maturity and an outstanding par value of at least $250 million.

The Bloomberg U.S. High Yield Corporate Index, formerly known as Lehman Brothers U.S. High Yield Corporate Index, measures the performance of taxable, fixed-rate bonds issued by industrial, utility, and financial companies and rated below investment grade. Each issue in the index has at least one year left until maturity and an outstanding par value of at least $150 million.

The Bloomberg World Government Inflation-Linked Bond (WGILB) Index measures the performance of investment grade, government inflation-linked debt from 12 different developed market countries.

Bloomberg Commodity Index measures the performance of 19 futures contracts on physical commodities.  As of the annual reweighting of the components, no related group of commodities (for example, energy, precious metals, livestock, and grains) may constitute more than 33% of the index and no single commodity may constitute less than 2% or more than 15% of the index.

The Dow Jones Global ex-U.S. Index is an equal-weighted stock index composed of the stocks of 150 top companies from around the world (excluding the U.S.) as selected by Dow Jones editors and based on the companies' long history of success and popularity among investors. The Global Dow is designed to reflect the global stock market and gives preferences to companies with global reach.

The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is composed of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.

The MSCI All-Country World Index ex USA measures the performance of large- and mid-capitalization stocks in approximately 50 developed and emerging equity markets, excluding the United States.

The MSCI EAFE^® (net) Index measures the performance of approximately 20 developed equity markets, excluding those of the United States and Canada. The total returns of the index are net of the maximum tax withholding rates that apply in many countries to dividends paid to nonresident investors. 

The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging markets countries. With 1,198 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in each country.

Russell 1000^® Growth Index measures the performance of those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values.

Russell 1000^® Value Index measures the performance of those Russell 1000 Index companies with lower price-to-book ratios and lower forecasted growth values.

The Russell 2000^® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. As of its latest reconstitution, the index had a total market capitalization range of approximately $128 million to $1.3 billion. 

The S&P 500 Index is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.