Heading into 2025, the global economy appears to have reached a balance: Moderate growth, disinflation and continued monetary easing could all bode well for markets, complemented by the potential for greater deregulation. But, with looming uncertainty in the U.S. around the policies of an incoming Trump administration, as well as their potential impact, Morgan Stanley Research says that finding the right window for opportunity will be key in the next year.
“Fixed-income markets may benefit in the first half of 2025 as modest growth and lower inflation prompt additional interest rate cuts,” says Serena Tang, Morgan Stanley’s Chief Global Cross-Asset Strategist. “In the second half of the year, relative value should shift toward equities if policy supports a meaningful pickup in mergers and acquisitions. But timing the rotation will be everything. Investors should consider overweighting equities in their portfolios 2025, with U.S. and Japanese stocks likely to be the most attractive, along with spread products within fixed income.”
Policy Uncertainty
In the U.S., an easing of specific regulatory requirements or changes in their enforcement may count among the more immediate policy changes having a positive impact on companies and markets. For example, a pickup in M&A activity, with positive implications for equities, is one possible result from the new shape of power in Washington.
Also, Congress now seems likely to extend provisions of the Tax Cuts and Jobs Act that were set to expire at the end of 2025, including lower tax rates for individuals and corporations and larger exemptions. This could lead to a modest increase in the deficit, while avoiding the tighter fiscal outcome that could have resulted if the tax cuts had disappeared.
New tariffs and tighter immigration restrictions, meanwhile, have the potential to restrain U.S. growth. The impact of these expected policies will depend on their implementation and timing. Morgan Stanley economists point out that tariffs can slow economic activity with a lag of two or three quarters. Therefore, tariffs could become a drag on U.S. growth in late 2025 and in 2026. Restrictions on immigration, which may make labor market conditions less favorable, are also expected to have a negative impact in the latter half of 2025.
“There’s an array of alternative policy outcomes that could drive more positive or more negative macroeconomic impacts,” says Morgan Stanley’s Global Head of Fixed Income and Thematic Research Michael Zezas. “We’re watching for signals from key policymakers.”
Major policy changes are often announced quickly and achieved more slowly, so the current benign macroeconomic conditions may persist well into 2025 without significant disruption. Still, investment outcomes are going to depend on the substance of new policies, the rigor of their implementation and their sequencing.
Once again, timing may be key. If potential tax cuts come first, it could lead equities higher, but if tariffs are the initial priority on Day 1, concern about inflation and corporate margins may come to the fore.
Weighing Equity Valuations
Morgan Stanley’s midyear investment outlook noted that equity valuations were already stretched. Stock valuations have since increased more—but with good reason.
Back in May, global stock valuations1 were just shy of the 80th percentile. Now that ACWI P/E ratio, at 18.3 times forward earnings, has pushed above the 80th percentile, touching a post-pandemic high. A similar trend is evident in corporate credit, where investment grade and high yield spreads are the tightest they have been in 25 years.
What justifies valuations that are richer than average, though, is a set of fundamentals that are better than average. Markets have grown more certain that the U.S. economy and company fundamentals are sound, and this could send valuations yet higher six months from now if investors see that those fundamentals are sustained.
What to Consider for Your Portfolio
Morgan Stanley recommends overweighting equities in the U.S. and in Japan, where central bank policy has steered their economies through soft landings, but the outlook moves European equities to neutral. Europe is growing more slowly than the U.S., and it’s exposed to tariff risks and further slowing in China, which faces continuing deflationary pressures. Emerging-market equities are still out of favor, and any potential increase in trade tensions would only make them less attractive.
In fixed income, U.S. Treasury yields may continue to decline as the Federal Reserve cuts rates further than what markets have priced. Our economists expect Fed rate cuts to be on hold by midyear, however. And corporate credit in 2025 may also be a story of two halves. The moderating environment in the first half may sustain corporate credit, but the story changes in the second half as equities may outperform. Morgan Stanley strategists believe that leveraged loans offer the best balance of risk and reward, ahead of investment grade and high yield bonds, and the U.S. market is more attractive than Europe.
