What have – and haven’t – markets priced in?

The first month of 2025 ended with a bang. Equity markets fell on news of a low-cost artificial intelligence (AI) model from DeepSeek, a Chinese company, raising investor concerns about the AI capex cycle. Stocks then recovered a portion of their losses over the remainder of the week.

The selloff came against a backdrop of still-solid U.S. economic activity. Indeed, we maintain a constructive outlook on the U.S. economy. It drives our pro-risk view in portfolios, which are positioned to capitalize on the theme of U.S. exceptionalism. But we recognize that healthy economic fundamentals will be needed to blunt any new market selloff. We also expect that uncertainty around monetary policy and government policy—in particular, the trajectory of the new Trump Administration—will keep market volatility elevated this year.

Across key U.S. economic metrics – including purchasing managers indices (PMIs), consumer spending, housing, industrial production and jobs—the data are encouraging. One example: The widely followed Atlanta Fed GDPNow tracker currently projects around 3% growth for the first quarter.

The composite January flash PMI, the timeliest measure of U.S. growth, remains in expansion territory at 52.4. Moreover, it reflects a better balance between the manufacturing and services sectors than it has in recent months. The manufacturing PMI rose modestly, while the services PMI unexpectedly fell 4 points to 52.8. That drop may signal that the long-standing strength in the services sector is starting to moderate.

Consumers are still spending. December retail sales rose 0.4% month-over-month (m/m); excluding volatile items such as autos and gas, sales increased 0.7%. However, not all sectors fared equally well. Building materials sales fell by 2% m/m and restaurant spending dipped by 0.3%, Yet employment in the industry continued to rise, suggesting that the drop in spending may be a temporary blip rather than a long-term downturn.

Housing, industry and labor: Generally healthy

The housing market performed well in December. Housing starts rose 15.8% m/m. (Multifamily starts jumped 62%, while single-family starts rose 3%). Still, high mortgage rates and rising inventories will likely constrain further improvement. One sign of possible softening: Building permits declined 0.7% m/m.

Industrial production came in better than expected, as manufacturing output increased 0.6%, up from 0.4% in November. But on a year-over-year (y/y) basis output was roughly flat, suggesting that on a longer-term basis, the U.S. manufacturing sector remains relatively stagnant, with no significant increase compared to a year ago.

The labor market looks generally healthy even as some data signals cooling. December nonfarm payrolls rose by 256,000, with job gains widespread across most industries outside manufacturing. Meanwhile, the unemployment rate decreased to 4.1% from 4.2%, while the labor force participation rate held steady at 62.5%, signs of a labor market in a reasonable state of balance.

The Job Openings and Labor Turnover Survey (JOLTS) delivered a mixed message. Openings are rising but hiring is declining. The quits rate fell to 1.9% from 2.1%, returning to this cycle's low, while the layoffs rate remained at a low 1.1%. Market participants welcomed the data, which suggest the labor market's cooling reflects a slower pace of hiring rather than increased layoffs.

Looking ahead to the January jobs report, we anticipate some negative impact from the California wildfires. Initial jobless claims nationwide rose by 6,000, to 223,000, in the week ending January 18, while continuing claims jumped to 1.899 million, marking a three-year high.

Crosscurrents affect our inflation outlook

As always, the labor market data critically informs the inflation outlook. Here the wage data are encouraging. In December, average hourly earnings grew by 0.3% m/m, down from the previous month’s 0.4% growth; y/y, it increased 3.9%. With a reacceleration in wage growth posing the biggest risk to an expected cooling in inflation, it will be important to monitor this data closely.

On the inflation front, several crosscurrents are at work. December core CPI, which excludes volatile food and energy prices, rose by 0.2% m/m and 3.2% y/y. But a 4.4% m/m surge in energy prices pushed up headline CPI, which rose 0.4% m/m and 2.9% y/y. Shelter inflation remains elevated at 4.6% year-over-year but is trending in a favorable direction, according to real-time data. Excluding shelter, core services inflation rose by just 0.2% m/m.

The December Producer Price Index (PPI) was softer than expected. The headline measure increased by 0.2% m/m and the core measure stayed flat on a monthly basis. That suggests a potential easing in upstream price pressures, which could translate into more moderate consumer price inflation in the future. As such, we continue to look for the Federal Reserve (Fed) to cut rates twice this year, once in the first half and again in 2H25.

But what is priced in?

All in all, we see a solid economic backdrop for investing over the coming quarters. What are markets pricing in on the growth and policy fronts? That’s a critical question. To answer it, we can glean different insights from interest rates, credit spreads and equity valuations. 

Rates: Government bond yields have been more stable after rising significantly at the end of 2024 and beginning of 2025, largely on concerns about the evolution of U.S. government policy.

Some market participants worry that the new administration’s tariff and immigration policies could prove inflationary. Notably, inflation breakevens have returned to the top end of their recent range and the term premium is at its highest level since 2015.

On balance, we continue to believe that President Trump’s bark will be worse than his bite. Inflation will remain contained, we believe, enabling the Fed to cut rates twice this year. Market pricing seems to be moving toward that view, after oscillating between pricing two extremes, very little monetary policy easing or a sharp cutting cycle.

Credit: We can learn more about what credit spreads have priced in from a macroeconomic perspective; reading the data from a policy perspective is less useful. U.S. high yield spreads seem a bit rich relative to the pace of manufacturing activity, but they look consistent with the rate of overall economic growth. Perhaps more importantly, given some underlying concerns about inflation, spreads are consistent with current market pricing of one-year forward inflation. The spread level also suggests a further easing in lending standards and contained defaults. That’s the good news.

But some credit metrics signal a less benign outlook. Estimates of what spreads should be based on cross-asset implied volatility are far higher than current levels. In addition, the credit default swap (CDS) basis is negative, as the spread on high yield CDS is higher than the spread on cash bonds. In short, some data suggests potential risks beneath the surface of the high yield market.

Equities: Stocks offer a third source of insight into what markets have (and haven’t) priced in. After a soft start to the year, stocks have enjoyed a healthy run, with only a brief late January sell-off. Valuations, which currently sit above our estimate of fair value and near the high end of their trading range in recent years, reflect a widespread optimism about profit growth. Equity investors may be proved too optimistic about earnings growth over the course of 2025.

Broadly, equity markets seem to be pricing in a better growth environment supported by significant deregulation in sectors such as energy and financials. At the same time, investors look to be fading the risk of a more-hawkish-than-expected set of tariff and/or immigration policies. 

Investment implications

As we remain constructive on the outlook for the U.S. economy, we maintain a pro-risk tilt in portfolios. U.S. equities have room to run, but we are extending our exposure across a range of capitalizations and styles to take advantage of an expected broadening in earnings growth. We also see opportunity in credit. Although spreads are tight, fundamentals remain supportive and all-in yields are attractive. Finally, higher yields and a positively sloped yield curve make us more constructive on duration. We expect that this will be more about trading the range rather than making an outright bet on duration.

Overall, our portfolios remain positioned to capitalize on the theme of U.S. exceptionalism. We do find opportunity in markets outside the U.S. but we believe that the Trump administration’s pro-growth agenda will lead domestic assets to outperform this year. 

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