What Could Derail Stocks in 2025?

Susan Dziubinski: Hello, and welcome to Morningstar’s 2025 US stock market outlook. My name is Susan Dziubinski, and I’m an investment specialist with Morningstar.com. Now although there were some bumps along the way, the US stock market finished 2024 up more than 20% for the second year in a row. Inflation moderated, the economy remained resilient, and the Federal Reserve began easing monetary policy. So heading into 2025, investors have many questions. Can the economy continue to hold up? What might a new administration mean for the economy and markets? Will inflation remain sticky? And will the Fed continue to cut interest rates in 2025?

Here today to share their outlooks for the year ahead are Dave Sekera, senior US market strategist for Morningstar Research Services, and Preston Caldwell, senior US economist with Morningstar Research Services. Dave, over to you.

Dave Sekera: Welcome, everyone, to our 2025 stock market outlook. As always, I’m going to start off with a broad overview of our valuation of the US equity market. I will then turn to our valuations by sector, highlight a couple of top picks from our equity analyst team. We’ll take a look at the valuation by economic moat, and then I’ll turn it over to Preston, who will provide his overview for his outlook for the US economy, inflation, interest rates, and so forth. And then we’ll wrap things up by taking a look at valuations, looking at mega-caps, and then I’ll wrap things up with a quick fixed-income overview. And as Susan mentioned, we will take as many questions as possible in the end of the webinar.

So to start things off with, our US equity market was trading at a price/fair value of 1.04 as of Jan. 6. Markets sold off a little bit. Of course, it’s rallying here this morning, so I would say these numbers are going to be pretty substantially similar where we are today. So that 1.04 means the market is trading at about a 4% premium over composite of our valuations.

For those of you that are new to our webinar series, or just as a reminder to some of you that have been watching us for years now, the way that we calculate that price/fair value and think about market valuation is pretty different than I think what you hear from a lot of other market strategists. Many other strategists start off with a top-down approach. They use some sort of model, some sort of algorithm. They come up with what they think S&P 500 earnings are going to be. They then apply some sort of forward multiple to that. And in my view, it always seems like they come up with a value where it’s 8% to 10% higher than wherever the market just happens to be. In my mind, I think oftentimes it’s just more goal-seeking than anything else.

We do the exact opposite. We cover well over 700 stocks that trade on US exchanges, and we take the composite of the market valuation of all of those companies, and we compare that to the fair value or the intrinsic valuation as assigned by our analyst team. So really it’s a bottom-up approach for that market by looking at what we think each of those individual stocks are worth as compared to where they’re actually trading in the marketplace.

Now at today’s market level, at that 4% premium, that puts us at the very top of the range that I consider to be fairly valued. We usually look at fair value for the overall market being within a plus or minus 5% range of fair value. So not necessarily overvalued just yet, but I have to admit I am getting increasingly more cautious with the market at these levels. And we’ll talk about that on the next slide, what’s going on with the macro dynamics in 2025.

Just taking a look at the valuations: According to the Morningstar Style Box, you’ll note that the value sector is still trading at a pretty significant discount from fair value. That’s one of the areas of the market that we will continue to advocate to overweight going into 2025. Core stocks trading pretty close to the market premium, but growth stocks this year having just run far and away well over our valuations, getting the levels that we’ve rarely seen on a price/fair value basis in the past.

In fact, the last time growth stocks traded at this much of a premium was in early 2021. And of course, if you remember what was going on back then, a lot of disruptive technology stocks, those stocks identified by Cathie Wood and the ARK funds and a lot of other disruptive tech stocks had skyrocketed. It was a bit of a bubble within those stocks that of course then popped in later 2021 and into 2022, with all of those stocks pretty much giving up all of their gains over the next 18 months. And then looking at valuations by market cap, large-cap stocks also trading well above our fair values, mid-cap stocks looking slightly more attractive, but then small-cap stocks really being the most attractive part of the capitalization structure today trading at a very deep discount to our fair values.

So in this case, we had also looked to underweight the large-cap space, overweight the small-cap space. I’d also note, too, that with large caps, the last time they traded at this much of a premium or more was back in 2018. And if you remember in 2018, the market took a pretty substantial hit at the very end of the year when we had some global growth concerns. So again, we think that large-cap stocks are trading at well above market value and see much better value on small caps on both a relative value as well as an absolute value basis.

Here’s a graph that we showed that price/fair value metric going all the way back toward the end of 2010. So we’re not really that much below where we were a couple of years ago when the market peaked at 1.06, or a 6% premium. At that point in time, we actually advocated for an underweight in the market, and it wasn’t necessarily just because of valuations at that point in time. It was a combination of valuations were not only too high, but we saw a number of different headwinds that we expected the market to incur. At that point in time, we were projecting inflation to start heading higher. We’re expecting interest rates to move up. We’re looking for the Fed to start taking monetary policy and for the economy to slow.

All of those came to fruition. And of course, markets do what they always do: They act like a pendulum. They swung too far to the downside. And by later that year, we had noted that the market was then at that point trading at some of the most undervalued levels that we had seen over the past 14 years. I would say we are in pretty rare territory at that 4% premium. Markets have only traded this much of a premium or more, only 10% of the time. But I would note that we still have some tailwinds behind us here in 2025. But I would note that those tailwinds are definitely starting to recede. And I think that that’s going to keep the market from moving much higher in the near term until earnings can start catching up to valuations, most likely in the second half of the year.

Just reviewing what some of those tailwinds are. These are the ones we identified in our outlook last year at the beginning of 2024. So again, right now what we’re seeing is that the rate of monetary-policy easing is now slowing. Market is definitely pricing in fewer rate cuts this year than what people had originally projected. What we’ve seen for inflation, barring today’s number for CPI, but inflation for the past couple of months has remained sticky. And in fact, depending on which inflation metric you want to focus on, some of them actually have ticked up a little bit. Taking a look at long-term interest rates, they were on a downward trend for a good portion of 2024. However, following the end of the third quarter and into the fourth quarter, we saw the 10-year rise about 100 basis points. So again, that tailwind that we’d expected a multiyear decline in interest rates, seeing that 100-basis-point tick-up. We do expect interest rates will come down over time. Preston will highlight that in his commentary.

I’d also note that economic growth last year was faster than pretty much anybody expected. So that was also a very good tailwind in the second, third quarter. And in fact, looking at the Atlanta Fed GDP now, it looks like we’re ending 2024 on a relatively high growth rate as well.

Then lastly, you can’t talk about 2024 without just talking about the explosive demand for AI that we had last year. The demand for hardware for AI platforms for certainly at least the first half of the year was not only increasing, but it was increasing at an increasing rate. Going forward, we expect that we will still see increases in demand for the AI hardware, but we’re now seeing that that’s increasing at a decreasing rate. So according to Brian Colello, who’s the strategist for technology team, he doesn’t think we’re going to see anywhere near the same type of upside surprises that we saw in 2024. A lot of those being what really propelled the market specifically in those AI-leveraged stocks last year.

So taking a look at market returns here in the fourth quarter: pretty good overall at the broad market level. Of course, value stocks did end up selling off a bit in the fourth quarter. We saw all the growth really coming in the growth category. Similarly by capitalization, large-cap stocks doing the best, with mid-cap and small-cap stocks lagging behind.

We had seen in the third quarter the beginning of that market rotation that we were expecting into small caps, into value stocks. That did reverse a bit here in the fourth quarter, but we do expect that that trend will end up emerging over the course of this year as well when we look at valuations for those categories compared to the growth stocks and the large-cap stocks.

Taking a look at returns overall according to the year: again, very strong year. I think this is now the second year in a row that we had over 20% gains. Those gains really being led by those stocks tied to artificial intelligence, those in the core category and the growth category. Value stocks in any other year, I think that would have been considered to be a pretty good return, but compared to core and growth, certainly lagging behind the rest of the market. Then similarly, large-cap stocks really being the story of the year last year, specifically because some of those stocks most tied to AI are of course in that large-cap category.

I always like to show the evolution of how things evolved over the course of the year. This shows coming into 2024 what price/fair value was. At that point in time, we thought the market was pretty fairly valued. Over the course of the year, the market became slightly more overvalued. At the end of the year, Dec. 31, the market was trading at a 2% premium, had a bit of a move up since then, getting now to that 4% premium.

The thing I’d really want to highlight here is while in 2023 and even back in 2022, I think our valuations were ahead of the market. I think in 2024, we largely really kept up with a lot of the big market movers over the course of last year. In fact, when I look at the price/fair value of our coverage across all the stocks we cover the trade in the US, we increased our valuations over 20% on stocks that are about 25% of our coverage overall. So some very large valuation increases on a lot of those stocks. Of course, as you can imagine, a lot of the biggest valuation increases came within the AI, or the artificial intelligence, space just with that demand increasing on an increasing basis for much of the year.

Turning now toward what we saw by sector, so in the fourth quarter: Big diversions across a lot of different sectors in the returns, basic materials being down the most. Actually, this is starting to concern me a little bit that whether or not maybe that’s the market giving us a little bit of a red flag warning that maybe global growth is slowing down more than expected. That’s an area that I’m certainly keeping my eyes on. Having said that, because that sector has fallen as much as it has, it’s actually starting to look more attractive on a price/fair value basis as well.

Real estate, long been the most hated asset class for probably the last year to year and half on Wall Street, started to see a recovery in the third quarter, but then we gave up those gains in the fourth quarter. Realistically, I think it’s mostly just because we saw such a big increase in long-term interest rates and that certainly put a lot of pressure on valuations downward. Then the healthcare sector also seeing a selloff in the fourth quarter. I think there’s really two factors at play there.

First of all, Eli Lilly is the largest within that sector by market cap. The decrease that we saw in Eli Lilly over the course of the quarter was accounted for about 15% of the decline in the healthcare sector in the fourth quarter. That of course is a stock that we’ve long highlighted as being one of the more overvalued stocks under coverage. We think the market is overextrapolating too much growth for too long in its weight-loss drugs. I think also, too, the market is being concerned about what type of rules or changes the Trump administration may put in place that could impair returns in the healthcare sector. Of course, to the upside, those sectors that are most green here are going to be the ones that are most tied toward artificial intelligence.

Taking a look at returns for the full year, I think really the biggest thing to note here would be looking at that basic-material sector being the only sector that was down for the full year. Again, it does give me some pause as to what the market might be thinking for global growth for the next couple of years. And then the sectors with the darkest green here being those that have the most leverage to artificial intelligence. We also see financials had a very good year last year as well. With the yield curve normalizing, we’re seeing the banks see much better improvements in their net interest margins. I think that’s a big reason for JPMorgan’s beat when they reported earlier today. Then lastly also the utility sector. Now the utility sector was one that a year and a half ago we had thought got into some of its lowest levels on the price/fair value basis compared to its fundamentals. Coming into the year, the utility sector was still undervalued. The market then started picking it up as a second derivative play on artificial intelligence. Of course, GPUs, other artificial intelligence hardware takes multiple times more electricity to power them as compared to traditional. So we do expect to see a lot of long-term growth within the utility sector. But at this point we think utilities have probably moved too far up to the upside, specifically the independent power producers, which are trading multiple times higher than our long-term intrinsic valuations. But again, a sector that was considered really that second derivative play on AI.

Of course, you can’t talk about 2024 without talking about just how concentrated market returns were last year. These 10 stocks accounted for 58% of the market gain last year. It’s actually less than the 67% where I think it peaked in June of last year. And in fact, in our third-quarter outlook, we had noted that we expected returns to broaden out in the second half of 2024. We have seen that at this point. I’d also note, too, that these 10 stocks only account for 30% of the market capitalization but yet provided almost twice that amount as far as the market gain for the year.

But when we take a look at where these stocks are trading today, I would just note that very few of these we consider to be undervalued. There’s only two of them at this point that are still rated 4 stars. Only two more that are rated 3 stars, meaning we think that those are trading within the range we consider fairly valued. The rest of them now being 2-star and 1-star-rated stocks. So we think that the outperformance for the most part for this concentration is behind us and would expect over the course of this year to see the market look for more undervalued opportunities specifically in the value space as well as the small-cap space and that returns should broaden out in 2025.

As far as some of the economic metrics we’re looking at, I’ll let Preston review these in his section as far as our view for inflation as well as GDP on a quarterly basis and annual basis. But really just want to focus on our calls here for value stocks and small-cap stocks. Value stocks we do believe are trading at a very significant margin of safety from the intrinsic valuation. On an absolute valuation basis, we think value stocks look attractive. But in this chart I show how value stocks are trading on that price/fair value basis as compared to the broad market valuation. So in this case, we’re off the lows or the most undervalued levels that we had seen a couple of years ago.

We did see a bit of a bounceback in the third quarter, giving up some of that there in the fourth quarter. But overall we’d expect for long-term investors to see better performance in that value category as the market starts appreciating the value that we see there.

And then lastly a similar chart looking at the relative value on a price/fair value basis of small caps as compared to the broad market. Still trading near some of the most undervalued levels compared to the broad market that we’ve seen over the past 14 years.

Take a quick look here at our sector valuations. Again, very hard to find undervalued opportunities in today’s market. More often than not, over time, I think we’re much closer to 50% of the market where we can find 4-star and 5-star-rated stocks. At this point in time, it’s just a hair over a quarter of the market that we’re seeing undervalued stocks. And we’re also seeing a greater and greater number of 1-star and 2-star-rated stocks today. And then we break that down by percentage of our coverage for each of the individual sectors.

Taking a look at our sector coverage today, I would just note real estate is the most undervalued sector today, trading at about 11% discount to fair value. Personally, I still like more-defensive-oriented plays within the real estate category: things like public storage, hospitals, medical office buildings, research and development facilities, and so forth. I’m still a little concerned about some of the valuations that we could see in the office space. But even then, for investors willing to take a little bit more risk, in that office space we do see a lot of stocks trading at pretty undervalued levels there.

Another sector I’d highlight is going to be the energy sector, trading at a pretty decent discount. Again, what I like about energy is not only that it trades at a discount to fair value, but I think it also plays a good hedge in your portfolio if we were to see any kind of increase in geopolitical risk. If oil prices were to move higher, if inflation were to come back, I think the energy sector would help you insulate your portfolio from some of those negative drawbacks.

Taking a look at the healthcare sector: That’s also trading at a pretty significant discount from intrinsic valuation, an 8% discount. The thing I’d note about healthcare is that if you were to strip Eli Lilly out of our valuations there, the healthcare sector actually would be the most undervalued sector, would be trading at a 12% discount. A lot of interesting opportunities within the healthcare sector.

And then lastly, basic materials with as much as it sold off last quarter, it’s now trading at a 7% discount to fair value whereas it was trading at a 3% premium last quarter.

And lastly just want to wrap up talking about communications. It’s now only trading at a 5% discount. For the past couple of years, it actually had been the most undervalued sector. It was the most undervalued sector coming into the year this year, both as much as names like Alphabet and Meta, who of course are well over half of the market cap of that sector, have moved up. We’re seeing a lot of the value in that sector dissipate. I would note that Alphabet is still an undervalued stock. I think it’s between a 10% and 12% discount to fair value. Still have enough of a discount to put it in a 4-star territory. We also like a lot of more traditional communications names as well, Verizon Communications being one that we’ve talked about several times.

Probably the biggest difference that we’ve seen this past quarter would be in that consumer cyclical space, trading now at a 19% premium. I think that’s, if not the highest, certainly up there as far as the highest premiums we’ve ever seen consumer cyclicals trade at. A large portion of the reason for that is because of Tesla. Tesla, I think, was up maybe over 50% following the presidential election. That’s the second-largest stock by market cap within the consumer cyclical sector. We think Tesla has moved up way too far. I believe it’s a 1-star-rated at stock at this point. And when I look at our price/fair value metrics over time on Tesla, it may not necessarily be the most overvalued it’s ever traded compared to our evaluations over time, but it’s certainly pretty close to that as well.

Financial services also getting long in the tooth in our view, having traded up very significantly over the course of last year. A lot of that really just because we think the market is overextrapolating for too long and too much the impact of the increase that we’re expecting in net interest margins. Again, we are looking for a soft economic landing that will help keep defaults and bankruptcies relatively low here in the near term, but that will end up normalizing over time.

And then lastly, I’d also highlight the insurance sector. Some of the more overvalued stocks that we see within the financial-services area are going to be in insurance. A lot of those, especially the P&C, have been under pressure the last couple days because of the fires in California and what their exposure to that might be. But even irrespective of the losses that they’re going to take there, we still think that insurance sector and insurance companies are significantly overvalued. Companies like Progressive and All State, too, that I would highlight there.

Technology not necessarily as overvalued as a lot of people think that it might be. Again, it’s trading at a 7% premium. That’s actually pretty close to the 6% premium that it was trading at last quarter, even though this sector was up 5.6%. I’d say largely the reason that it’s still in the same premium level even after it’s moved up is because we did make some relatively large valuation increases in the technology sector following third-quarter earnings as well.

Just to highlight some of the best picks: So again, every quarter, our analytical team will come up with the three best picks that they have for each of their individual respective sectors. New to the list of this quarter is going to be Corteva, Polaris, and Under Armour. For those of you that have an interest, I’d recommend going to whatever Morningstar platform you use in order to read our equity research on those names. Coming into some of the more economically sensitive sectors, we have Paramount, A.O. Smith, Caterpillar, Huntington, all new to the list as well. Caterpillar is a company that we made a relatively large fair value increase in. So again, I think now is a good time to review maybe your investment thesis on that company.

Huntington Ingalls is one we’ve highlighted a couple of times now. Huntington has been having a very difficult time keeping up with cost pressures under the existing contract that they have with the US Navy in order to build nuclear submarines. We believe that they are in negotiations right now for a new contract for another new 17 submarines, which will certainly improve the company economics going forward. Our analysts expect that they’ll assign that new contract here in early 2025. We think that’ll be a good catalyst for that stock when that occurs.

And just wrapping up some of our best picks here: new to the list, CVS Health and Duke Energy. And Duke Energy, I think, is just indicative of how hard it is to find interesting opportunities in the utility space. It’s a 3-star-rated stock. So puts it within the valuation category that we consider to be fairly valued. It does trade at a 7% discount, but it’s one of the utilities that, even only a slight discount to fair value, we think has pretty clear pathway of achieving the high end of their earnings growth targets.

Switching gears here to valuations by economic moat. I would just note that, last year, wide-moat stocks did perform better than the broad market index. So if you look in the Morningstar Wide Moat Composite Index, that was up over 30% last year as compared to the market, which was up 24%. And as you’d expect with that kind of outperformance, wide-moat stocks are now trading at a bit of a premium, a 5% premium, to a composite of their fair values. So to find value within that wide-moat space, really need to move into the mid-cap and small-cap space as well as the value space. No-moat stocks are trading at fair value. For those investors that have a little bit more speculative appetite, looking for companies that maybe are trading at a much larger discount from intrinsic valuation, I would just make sure I urge caution here to make sure that, for those stocks, for those companies that we don’t think have long-term durable competitive advantages, just make sure that you are buying those at enough of a discount from intrinsic valuation to be able to help protect yourself to the downside if we were to see any kind of strong market selloff.

Again, depending on what Morningstar platform you use, I do like to do screens every quarter just looking to identify new stocks that are 4- or 5-star-rated. In this case, looking for large-cap stocks with a wide economic moat with either a Low or Medium Uncertainty Rating, a similar sort here looking for those stocks. The ones that are bolded are new to the list this quarter. And again, these are going to be stocks in that mid-cap space with a wide moat with a Low and Medium Uncertainty. And then lastly, stocks that are in the small-cap space. Now, again, there aren’t nearly as many small-cap stocks with wide economic moats that we assign. So, I include in this list those narrow-moat stocks. But again, looking for those that have Low or Medium Uncertainty levels.

So, with that, I would like to hand it off to Preston to provide his US economic outlook.

Preston Caldwell: Thank you, Dave. Good morning, everyone.

So, to sum up our economic outlook, we continue to expect a quintessential soft landing, but this is contingent on a low risk of large tariff hikes or other policy disruptions.

Now, we are expecting GDP growth to slow slightly in 2025 and 2026. As you can see on the top chart, a step down of about 1 percentage point compared to the growth rate over ‘23 and ‘24. The strength of GDP growth over the past few years in the face of the largest Fed rate hike in four decades has been surprising. Back in 2022, we were in the minority of forecasters not calling for a US recession, but we certainly didn’t expect growth to turn out this strong.

I think there’s a number of factors that help to explain the strength of the economy. First, on the supply side, we’ve seen strong growth in productivity and labor supply. And to some extent, supply has created its own demand, but on the demand side itself, we’ve seen a number of factors. Most importantly, consumers remain eager to spend. But I do think that several of these factors will diminish in impact in 2025 and 2026, pushing growth slower. And meanwhile, we do expect growth to rebound in 2027 and 2028 as the effects of Fed rate cuts kick in.

On inflation, looking at the bottom chart, we’ve gotten very close to return to normal with inflation, in terms of the PCE Price Index, set to average 2.5% in 2024. Core inflation was about 2.8%, but excluding housing, it was about 2.3% in 2024. So, really, housing was the main impediment to getting inflation back to normal in 2024.

We are expecting inflation to clear that last mile in 2025 and converge back to the Fed’s 2% target and remain there in following years. But this is contingent again on a low probability of large tariff hikes.

Comparing our views to consensus, we’re pretty close in the near term on GDP, but cumulatively looking over the next five years, we are expecting 1.5% more real GDP growth than consensus, owing to our supply side views, principally labor supply. On inflation, looking at the bottom chart, again, we’re fairly close to consensus in a broad perspective, but we are expecting inflation to come down a bit lower than consensus over the next two years, principally as a result of decelerating GDP growth, which we think will add measurable slack to the economy.

So, looking at interest rates, the fed-funds rate has now been cut by 100 basis points since last September. Prior to that, the fed-funds rate had been held at a target range of 5.25% to 5.50%. Now it stands at 4.25% to 4.50%. Market expectations are that the Fed is almost done cutting, but we think that there’s much more to come. We ultimately expect the fed-funds rate to fall another 200 basis points by mid-2027, reaching a target range of 2.25% to 2.50%. Much closer to where interest rates were before the pandemic.

One reason we expect this is based off of what’s going on in the rest of the yield curve. It’s interesting to look at what happened over 2021 to 2023. The fed-funds rate increased by over 500 basis points, but the 10-year Treasury yield, looking at annual averages here, increased by less than 300 basis points. So, that flattening and eventual inversion of the yield curve was actually a major factor blunting the impact of rate hikes on the real economy because, as you know, so much of how monetary policy transmits to the real economy is mediated by the longer end of the curve, thinking about mortgage rates and so on.

But now that effect is reversing. So, as the yield curve has … the inversion has undone and the yield curve has gotten flatter and even starting to steepen, that means the long end of the curve has actually gone up over the past four to five months, even as the Fed has been cutting interest rates. So that’s blunting the impact of rate cuts. And it means that we need to see much more rate cuts in order to push the longer end of the curve down, which we ultimately think is needed in order to sustain a healthy rate of growth. In particular, if we look at housing, I think we need much lower mortgage rates in order to sustain a recovery in the housing sector and prevent a further downturn.

So, ultimately, we do expect the 10-year Treasury yield to drop to 3.25% by 2027 versus levels of about 4.65% as of this morning.

Looking at GDP growth in the near term, we saw growth at 3.1% quarter over quarter in the third quarter of 2024, 2.7% in year-over-year terms. When GDP growth for the fourth quarter is reported at the end of this month, we expect it to come in at about 2.2%. And then we expect growth to trend down over the course of 2025, extending into early 2026. We expect the trough in year-over-year terms to come in the fourth quarter of this year or the first quarter of 2026 at about 1.6%. And that’s because, even with GDP growth still being strong this long after the Fed’s hiking began, we do think that the strain of high interest rates is still weighing on the economy. And as I mentioned, I think there’s a number of temporary factors that have helped boosted growth, which will start to diminish in impact over the coming two years. And most importantly, it does look like that consumers are overstretched given low savings rates.

So, thinking about some of the temporary factors that I mentioned, this graph tells the story of GDP growth over the past few years, broken out by expenditure, in terms of contribution to year-over-year real GDP growth. You can see that, in 2023, we had this large contribution to nonresidential structures from this factory-building boom, which was spurred by government subsidies. And that started to diminish in impact in 2024 and should continue to diminish.

And then we had a large contribution to government spending, primarily from state and local governments who were spending down their surpluses accumulated during covid and the pandemic support, fiscal support that was passed then. So that’s the factor that’s really yet to fade in impact. But in 2024, certainly consumption has stepped up to play a bigger role in driving GDP growth.

So that’s happened even as the personal savings rate is much below its prepandemic level, about 300 basis points below where we were in 2019. Households are saving much less than they were before the pandemic. Part of this is probably explained by high asset prices. If we look at where household wealth is as a share of GDP and the extent to which it’s increased above normal levels, we estimate that explains about 1% to 1.5% of the deviation of the savings rate below its prepandemic level. And then the remainder of that 300 basis point deviation is probably accounted for by the excess savings.

Looking at the bottom chart, the amount of excess savings remaining depends on which baseline savings rate you use. But I do think that’s continuing to exert some upward impact or some downward impact on the savings rate and therefore upward impact on consumption. But the runway is running out. With the depletion of excess savings, I do think consumers will be pressured to increase their savings rate and slow the rate of consumption growth over the next year.

Turning to the job market, nonfarm payroll employment grew by 1% annualized in the three months ending in December 2024. That’s about in line with the 1.1% pace average from the second half of 2023 to the first half of 2024. It reflects about a normal rate of growth for employment, just a hair below the 1. (Technical Difficulty). The average has held steady at about 4.15% in the past several months. That has eroded earlier fears that the labor market was deteriorating. The unemployment rate had drifted up from 3.6% as of August 2023 to 4.2% by August 2024, which triggered the so-called Sahm rule recession indicator. But now it’s held steady over the last several months.

But we still see scant signs of overheating in the labor market. As of December growth in wages stood at 4% year over year, which is within range of the 3.5% consistent with 2% inflation. And the job openings rate has converged more or less back to its prepandemic level after once being at record levels back in 2022.

We do expect a bit further softening in the labor market with job growth and wage growth dropping further toward the end of 2025 in response to the deceleration in GDP growth. And that further moderation in wage growth should help to add to broad disinflationary momentum throughout the economy.

And on inflation, as I mentioned, housing was really the main obstacle to getting inflation back to target in 2024. But we can feel assuaged by the very high likelihood that housing inflation will trend down in 2025. It actually has already started to trend down in the closing months of 2024. But the reason why we expect housing to fully normalize is looking at the leading edge indicator of market rents.

Market rents just denotes the average rent on contracts signed by new tenants, people moving into new leases. And you can see there’s a huge runup in market rents in 2021 and 2022. And the housing component of the CPI responded to that with a lag. But the gap between the two is closing, and market rent growth was merely 1.4% year over year in October 2024, looking at composite of various private sector indicators. So, with that gap closing, we should see housing inflation in terms of the official inflation indexes moderate over the course of this year.

And we have seen a bit of a uptick in goods inflation toward the end of this year. But I would note looking at the bottom chart that supply chain conditions remain very much back to normal right in line with prepandemic conditions. So that should support a continued low rate of goods inflation in 2025, assuming that we don’t get major tariff hikes.

Again, to cover a little bit more on the timing of rate cuts that we expect: Again, we expect another 200 basis points of rate cuts by the first half of 2027. That’s quite a bit below market expectations, commensurate with the large uptick in long-term bond yields that I mentioned. The market is expecting little in the way of incremental rate cuts, perhaps just one more rate cut this year and then keeping the federal-funds rate flat. And definitely after that at about 4% for the bottom of their target range.

Our projections are not too far off from where the Fed’s latest—the latest FOMC—projections were at, but we ultimately expect the slowing in economic growth that we’re projecting and a modest uptick in the unemployment rate and other signs of slack in the economy, with inflation dipping below the Fed’s 2% target next year, allowing the Fed to cut a little bit more than its latest projections indicate.

Moving into policy here: Like I said, we have a fairly low probability of the worst-case tariff hikes, a 10% probability assessed on the 10% uniform tariff hike, a 36% probability assessed on the 60% tariff hike on China. And I think the 10% uniform tariff hike is the most damaging one, just because tariffs on China can be, for the most part, easily circumvented by rerouting through third-party countries, so the impact is quite a bit less.

Now, bear in mind these are probabilities. This is the probability that the measures are not only implemented but sustained over a full four-year period. I think there’s some chance that these things get implemented and then with an adverse market reaction they back away from it. I think maybe even more importantly, and we saw this certainly with the last round of tariffs back over 2018, 2019, that exemptions can come into play that are large enough to drive a truck through. And I’ve already seen lots of discussions that the first round of tariffs that we’re talking about implementing are going to be pretty heavy with exemptions for this type of good and that type of goods. So, that’s one thing that will diminish the deleterious impact of the tariffs.

But I think the biggest thing is just that there really hasn’t been a single tariff idea that’s been bandied about that wasn’t discussed before the first Trump administration. So, there’s always a pretty low ratio of what actually gets enacted to what is discussed. And that’s really informing my probabilities to a high degree here.

Population growth is another interesting policy-driven factor. So, we saw a huge increase in immigration, reaching the highest levels we’ve seen in decades for immigration and overall population growth over the past few years. That’s something that certainly we expect to cease over the next few years. We think immigration enforcement will step up enough to staunch the further flow of immigration, but we’re not expecting mass deportations. As you can see, we still expect overall immigration, inclusive of legal and illegal, to remain in slightly positive territory, albeit somewhat below normal levels. And we see mass deportations being unlikely for legal, political, and logistical reasons. Certainly, they’re going to target certain easy-to-handle categories like unauthorized immigrants with criminal records and so on. But I think the idea that they’re going to round up 10 million people who are largely embedded in the labor force and so on and remove them from the country is probably a pipe dream.

What’s been the effect of immigration? So, in terms of GDP, it’s an unambiguous positive, right, because it’s added tremendously to US labor supply irrespective of the legal status of the immigrant. On inflation, it’s a little more ambiguous because obviously you’ve got an impact downward on inflation because of adding to the labor supply, but immigration also adds to demand. So, you’ve kind of got an offset there. So, that’s a little bit more ambiguous. Probably it’s had a net impact of reducing inflation just slightly because it’s helped bring the labor market into a balance. But by no means would I suggest, by no means would I think that a modest curtailment of immigration be likely to lead to inflation coming back or getting high again.

And just looking at the fiscal situation for the US, we are expecting budget deficits to remain a bit above prepandemic levels. After getting quite high over the past couple of years, we are expecting things to drop back, partly owing to interest costs coming down as our expectations of Fed-rate cuts play out. And also just the baseline expectation is that the primary deficit decreases slightly over the next few years before starting to increase again in the 2030s as a result of population aging.

We’re expecting that most of the tax cuts that are up for sunsetting next year are ultimately renewed. But, obviously, if they push much further in tax cuts than that, then that could add further to the deficit. But it’s quite uncertain right now because they’re still, I think, in the very early stages of negotiation.

With that, I’ll turn it back over to Dave to conclude the presentation.

Sekera: As far as taking a look at mega-cap stocks, I always like to review our valuations here just because they do have such an impact or skewed impact on the broad market indexes because their capitalization is such a large percentage of the overall market cap.

Taking a look at the undervalued mega-caps, I would just say that, for the most part, they did lag behind the broad market returns last year. For the most part, most of these stocks we still think are undervalued today.

Here’s our updated list of undervalued mega-cap stocks for 2025.

And then looking at overvalued mega-cap stocks for last year, just highlighting that, for the most part, most of these overvalued became even further overvalued last year, with growth stocks and, specifically, these large-cap growth stocks moving even further to the upside. And then lastly, just noting that we have an expanded list of overvalued mega-cap stocks here in 2025; a number of new names in bold on the list.

And then lastly, I just want to wrap it up with a quick fixed-income outlook. The yield on the 10-year rose 70 basis points to 4.57%. I think we’re up even higher than that now. That did pressure returns across the fixed-income space. The ones that performed best last year were the lower duration fixed-income products, specifically those that were lower duration and did trade with a credit spread. But I would just be very cautious of fixed income that trades with the credit spread going forward.

So, just taking a look at the corporate bond markets, I would just note here just how much investment-grade and high-yield credit spreads tightened over the course of last year. Now specifically, if you look at the Morningstar US Corporate Bond market index, that tightened 16 basis points to 79, it got even tighter than that. So, in mid-December, the IG index tightened to 74 basis points. That’s a new historical low for our investment-grade corporate bond index, so that’s actually even tighter than what we saw, I think, it was June of 2007. I think it was like 76 or 78 basis points, back then was the prior historical low.

So, again, the credit spreads getting to be as low, if not even lower than where they were trading right before the global financial crisis. Of course, if you remember back then, there were a lot of ways that people were slicing and dicing credit, CDOs, CDO squares, and so forth. We thought credit spreads at that point in time were artificially too low because of those types of products. And in this case, we think the market is way overestimating the low default rates and low downgrades going forward. In my view, I don’t think that this provides any margin of safety at all for any kind of weaker-than-expected economy. It doesn’t provide for any kind of margin of safety for downgrade risks if we see more downgrades and upgrades over the next year or two. So, again, I would look to underweight the investment-grade corporate bond market at this point.

And similarly, high yield had tightened 59 basis points last year, took it all the way down to 290 basis points. Not necessarily the tightest it’s ever been, it was at tighter levels just before the global financial crisis. But again, I don’t think that this provides you any margin of safety, especially when you look at the underlying names within the high-yield index, a lot more lower-rated, lower-quality bonds within that index. So, both of these―I’m very concerned that if we saw any kind of hiccups in the market, you could see a backup very quickly. So, I would also look to underweight high yield.

So, within your fixed-income portfolio, I’d much prefer sticking with Treasury bonds or shorter-duration ABS or asset-backed or structured finance type of bonds.

And then for those of you that just want to get a better idea of, on a historical context, what credit markets have done in the past, this just shows that long-term average of the credit spread for the investment-grade index and the high-yield index.

Dziubinski: All right. I’d like to thank Dave and Preston for their time today. And thank everyone for joining Morningstar’s 2025 US Stock Market Outlook webinar. Happy investing, and we hope to see you next quarter.