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Hello and welcome to another episode of the Odd Lots podcast.
I'm Joe Wisenthal and.
I'm Tracy Allaway.
Tracy, it's my favorite time of year.
Do you know what I was going to say, the exact same thing. I was going to make, the exact same comment.
It's Outlook season, twenty twenty five Outlook season, and our inboxes get flooded with various flavors of big picture outlooks, micro picture outlooks. Fifteen things to watch for within the industrial and trucking segments of the economy. Fifteen big questions we have.
For Here's a list of all the things Trump is going to make great again.
Yeah, all these things, and these are some of my favorite cell side notes to read every year, but they always make for a thoughtful something to do around this time of year.
Here's the big question. Do you go back and look at the twenty twenty three outlooks?
I never do.
I people always in our industry joke about that, they like, let's go back, and I've seen it happen twice.
But on a serious note, I know the analysts who produce these outlooks like it is their actual job to try to forecast the future. But like I find it so difficult, especially in the current context with so many uncertainties and the new administration coming in. I just I don't even know how you begin to, like try to figure out what the level of the S and P five hundred is going to be under those like very uncertain conditions.
Well, you know, most of the time stocks go up and the economy grows.
And that that would be your outlook is like, well, stocks are probably going to go up.
Stocks will go up with the economy will grow. In two and a half, three and a half. Anyway, we have much better guests.
Yes, we have people who actually do.
That and are really truly some of the best in the industry. And it is a real treat. We actually have them both together, which makes for an extraordinary opportunity. So I'm very excited. We have two guests, two of the perfect guests, I should say. We're gonna be speaking with Jan Hatziis, chief economist and head of Global Investment Research at Goldman Sachs, and David Coston, chief US equity
strategist at Goldman SACS. David and Jana, this is such a thrill to have you on both at the same time and just talk about what twenty twenty five is like, because there's obviously a lot to talk about. I don't know to start it with you Yan, like, actually, do you accept the premise that it's a difficult time. It feels difficult, it feels tricky, it feels like there's a
lot of questions and uncertainties. Do you accept the premise that it's an unusually tricky time to be making a short term or medium term forecast?
I think it is a difficult time just because there's more uncertainty than normal about the policy environment. So you have all the usual uncertainties around whether the consumer is going to continue to spend we think yes, where inflation that's going to continue to trend down X, any new shocks we think yes, Whether the Fed will still deliver cuts just based on the underlying trend in the economy.
And then you have to think about the potential impulses, both on the positive and the negative side, and obviously we'll get into those, but that just adds to the variability around the central forecast.
I have a lot of procedural questions when it comes to the outlooks. My first one is do you guys like talk to each other before you do your respective outlooks, because I imagine what the market does is obviously going to depend a lot on what the economy does.
There are I guess nearly a thousand people in the research department at Goma. Yan is the head of the research department, and within Macro probably one hundred people, and we are pretty coordinated. Every week have a conversation about what's happening in the different regions around the world economically, in commodities, in strategy and rates. So we're pretty coordinated at the macro level.
Do you ever disagree we do?
I do think that we spend a lot of time trying to get to the bottom of what the disagreement is about, and that often brings views more closely together. I think in the end we do try to present a coherent overall picture, but that doesn't mean that every nuance is exactly the same. I mean, I think there is sort of a spectrum between having just one view of the world where there's zero room for individual kind of creativity, and just having a bunch of people that
have independent views that are not coherent. You have to find a place somewhere in the middle. I think we're more towards the coherent side than what I see, you know in many other research organizations where it's really more individuals than a team effort.
We're going to get into all the actual details, but I kind of like asking some of these procedural questions. Okay, so you make an S and P. Five hundred forecast for the year twenty twenty five, you talk to clients, et cetera. You know, I can't imagine there are that many people in the investment industry. Maybe I'm wrong, And tell me if I'm wrong, who's like David says, the SMP is going to X, so that's what we're gonna
buy or we're gonna sell or et cetera. How do you view, like, what is your goal when you're talking to clients, when you're putting out a forecast for the S and P five hundred, and when you think about the value that you bring to clients from making these forecasts that Tracy and I love getting in our inboxes this time of year, Like, what are you hoping is the end fruit of that?
Well, there's a variety of customers or clients that we think about, and I would say framing the issues is probably the most important thing we do. Identifying investment strategies inside of the market is a big area of focus. We think about segmenting the clients of Goldman Sachs. We have hedge funds, mutual funds, pension funds, insurance companies, endowments, sovereign funds. Each of those constituencies are looking for something
a little bit different the mixed asset portfolio. On the part of number of endowments and pension funds, sovereign wealth funds, they're quite interested in the index level because they think about the alternatives between equities and credit, private credit, public credit, commodities, private equity, etc. And so those are issues for those
type of clients. If you're thinking about and when we talk to and interact on a daily basis with hedge funds and mutual funds, they're focused on oftentimes investment strategies inside of the market, and those are some of the reasons. But in terms of your specifics on how you think about the index level, that is something people think about broadly. Do they put more risk on or do they take less risk? Is the market going to pay for excitement or is it going.
To pay for boredom?
How do you think about shifting your portfolio to reflect those Those are basically the variety of conversations that we have on a daily basis.
So this time last year, I think we were still maybe not as much as earlier, but we were still kind of in recession expectation mode. And you know that obviously went on for like two years with the yield curve inversion and the surveys showing that the vibes were down, and everyone worried that consumer spending would eventually drop off and that sort of thing. And yet here we are,
tail end of twenty twenty four. Recession hasn't emerged. The Fed is now cutting rates, which presumably takes some of the pressure off. Yeah, you were one of the economists who I think got this right. You were in the soft landing camp. From what I remember when we spoke to you. What was it that you saw that kind of played out effectively in twenty twenty four.
I'd say the key to the soft landing call over the last couple of years was, I think to recognize that this is a very different business cycle that was much more driven by the pandemic and the post pandemic ambalanced US that emerged really in twenty twenty twenty one, and climbing out of a hole that was really a supply side hit is very different from squeezing down inflation
that had emerged because of an overheating. If you have an overheated economy and the level of activity is just too high and the level of demand is too high, to bring that back to normal, you almost have to have a decline in economic activity, which is almost the
definition of a recession. But if you're climbing out of a hole on the supply side, and supply chains go back to normal, libor force participation goes back to normal, we get an additional boost to supply from immigrants coming into the workforce, and you know, we'll get into some of these things. All of that means you can see declining inflation and increases in real output and employment at the same time time, and that's basically what we've been
seeing over the last couple of years. So for me, that's the most important difference. I think there was too much extrapolation from past business cycles, and too many people looked at when inflation is at five percent or six percent, there's always been a recession because those were much more demand driven cycles rather than supply driven cycles.
So we're recording this, by the way, on November twenty sixth. The S and P as of the moment I'm saying this is that six four point seventy two extraordinary gains, nearly twenty six percent gains from the start of the year.
I guess I'm not surprised.
David that, given this sort of easy mode disinflation that we had in twenty twenty four, that we've had such a great year for the stock marketing. You have a call of sixty five hundred for your your in twenty twenty five target, which is about a little over seven seven percent from where we are.
How come how much?
So it's gonna be it's gains, And you know, I think a lot of people would be happy with seven percent gains.
You do that for ten straight years of.
Age Shoe's thesis that stocks go up.
Yeah, Well, so how do you get there?
All right, let's talk about some of the building blocks for how we get there. Number one is earnings, and earnings are expected to grow in our model around eleven percent this year, meaning twenty twenty five looking ahead, and about seven percent in calendar twenty twenty six. We've got a couple of years of continued expansion in earnings. How do we get the earnings, Well, we can think about
sales growing roughly five percent. Most companies over time grow their sales and their revenues by roughly nominal GDP, so we'll call that around five percent, a little bit of a margin expansion, and that's going to lead to the growth rate. Now, the growth rate of eleven percent is a little higher than that. You have some issues around healthcare in particular. We are not expecting the write off of so much in process R and D, and so we
get very very specific about some things. But our models would show around eleven percent earnings growth for the coming year, and we are affecting that the multiple actually come down slightly. Currently, the market multiples around twenty or nearly twenty three times forward earnings market prices consensus as opposed to our earnings estimates, which is a little bit below consensus, and the idea of the multiple declining Joe of maybe twenty one and
a half times is our model. So the bottom line, how do we get there? You're looking at eleven percent earnings growth. By this time next year, the market will be pricing off of the twenty twenty six earnings. That's why we have to look out for two years. And the idea of a market multiple or multiple of around twenty one and a half times what is ultimately a twenty twenty six estimate supports six five hundred is it target?
So you're talking about earnings expansion. All of us presumably woke up to headlines this morning about Trump imposing tariffs on Some.
Of us checked the news last night before that.
Okay, well, I didn't I want to sleep early. I was blissfully unaware of global politics and trade policy. But anyway, presumably higher input costs would eventually feed into corporate earnings. I guess is that on your radar at all?
Well, it certainly should be. As far as China tariffs are concerned, I mean, we do expect a significant increase in China tariffs, and we're building in about a twenty percentage point increase in the average rate on US imports from China. I think it's also pretty likely that we'll get some additional tariffs outside of China. We're thinking auto tariffs, potentially on Europe and Mexico. And then of course there were some announcements or threats of broader tariffs on both
Mexico and Canada. You know, we'll have to see whether that ultimately happens. There is a renegotiation of the US Mexico or Canada trade agreement that will have to occur over the next couple of years. So I think there still will be a number of rounds before this actually gets finalize. But clearly tariffs are the in all of you, the biggest risk to what otherwise is quite a positive outlook. I mean, we're pretty optimistic on the US growth outlook
for twenty twenty five. We're you know, two and a half percent again, half a percentage point or a little more above the current Bloomberg consensus. But we're watching the tariff situation closely, and I'm sure there's going to be many twists and turns before all of this becomes totally clear.
Our turiff's inflationary, because I could see it both ways. Right, on the one hand, they throw sand into the gear, so to speak, of the global economy, and that is in a costly process. Right, there's a readjustment et cetera. On the other hand, I think new Treasury Secretary nominee Scott Best and made some quotes they don't have to be per se inflationary, because yes, imports may cost more, but then you know, sort of a kind of it
struck me as sort of a monitor's framework. There's less money in households, and then that reduces demand elsewhere, and that brings prices lower, and so the overall price level or the rate of inflation doesn't change as much as an economist. Someone asks you our terriff's inflationary. How do you think through that question, I.
Would say tariffs raised prices, and we can see that very clearly from when they have been applied, including some of the China tariffs in the first Trump administration. They fed through to prices in the categories the relatively few categories where they were applied, and.
This is such achanical it's really good.
So yes, I would say that's quite clear. Whether that is ongoing inflation, that's much less clear because these are really price level effects. They're sort of like value added tax increases in various European countries. We've seen this time and time again. There's a one time increase in the price level, a one time increase in inflation, but the
inflation then drops out twelve months after. Assuming that there are no major second round effects through inflation expectations, then of course central banks would become a lot more concerned if you did see a big increase in inflation expectations, wages ongoing escalation, if there is a you know, tit for tat trade war that keeps going, obviously that would also have a longer tail, But initially it is a price level impact.
David, I'm going to ask what is possibly an unfair question, but can you pretend to be the entire stock market right now and tell me, like, what is happening today? Stocks are up about point four to oh percent off the back presumably of those tariff headlines we had, like a drop in Asia stocks overnight, but US stocks recover pretty quickly. What is it that investors see here?
Well, the biggest discussion point that I'm in having with portfolio managers has to do with the expectation that small business confidence is likely to increase sharply. That was the experience at the beginning of the first Trump administration. Actually, it started to happen between the election, and actually the inauguration that took place back in twenty sixteen early twenty seventeen,
it was a surge in small business optimism. And so the discussions are and around the expectation that portfolio managers have that this is going to be a repeat of the last administration, and there's a lot of enthusiasm the expectation that there's less sort of muscular antitrust environment, that there is an idea of small businesses investing, and that optimism is therefore likely to benefit a lot of companies whose customers are small and medium sized businesses, and that's
one of the investment strategies we have for the current year. We work with the individual analysts at Goldman and we've identified a group of stocks where more than fifty percent of their revenues are coming from small and medium sized businesses. And so there's investment opportunities that we look at on the back of the expectation of a more robust economic or more positive business environment. And again it's about the expectations,
the perception of what is like could happen. And so as back to your question, Tracy, that's the topic is that not necessarily the topic of today, not necessarily, but that broadly in the last couple of weeks has been the central topic right now that the last NFIB survey was around the thirteenth percentile versus history, so quite low, and the expectation of many as it's going to surge in the coming months.
You mentioned the regulatory environment one of your other themes for twenty twenty five, and this has come up a lot, as expectations of more liberal m and a regulatory environment, more deals being relighted. I think we can understand that you also are still bullish on the really big megacap stocks, and you said something in your twenty twenty five out
look that I kind of take an issue with. You said, like, the primary question for mutual fund managers over the last two years is whether they got the big megacap story right, which is true, but it's also true for arguably like fifteen years at this point, because really what we should have all been doing for the last fifteen years is just by Microsoft and Alphabet and Meta and really ignore
everything else. You're still bullish on them. What would have to change, What conditions would have to change such that the mag seven or whatever permutation is hot? Maybe one pops in and one drops out. What would have to change for these handful of stocks to not be the big winners of the market going forward.
So, Joe, the driver of these stocks over the past decade has been superior earnest growth, saparitor sales growth, superior earnest growth in terms of the comparison with the rest of the market, and so that has been a terrific
investment strategy for for a long time. The largest companies really driving the index well, our analysis would sugges just that most of the market, including the largest stocks, are trading around fair value right now, and that it is earning's growth in the coming year that's likely to drive the performance of the market. Well, the superior earnings growth of these largest stocks is likely to diminish, in our opinion, in the coming year. So let's put some numbers around that.
This year Counter twenty twenty four, the largest companies, the Magnificent seven as they're called. Those companies had thirty three percent expected. Well, now, Spectacles is the fourth quarter, but let's use that as a full year number. Earnings growth around thirty three percent, and that compares around three percent for the four hundred and ninety three remaining companies in the SMB five hundred. That's thirty percentage points excess growth rate.
And the coming year the expectations use consensus for a moment is around eighteen percent versus twelve percent. That's a six percentage point gap. So from thirty percentage points to six percentage points, and you look into twenty twenty six and that's going to narrow yet further until around four percentage points. So relative earnings growth is going to be the explanation in our view of a narrowing premium return.
And so if I put some numbers around that, very specifically, you had sixty three percentage points of outperformance excess return of the largest docks versus the market in twenty twenty three. It's running around twenty two percentage points this year, and our forecast next year is probably around seven percentage points. So the largest cap stocks likely to continue to perform in our view, but by a much much smaller margin than has been last couple of years.
I want to go back to what David was saying about animal spirits and maybe bringing yan and my question is going to sound very weird, but bear with me. Do animal spirits actually matter for the economy. And the reason I ask that is because you know, for the past couple of years, the surveys have been coming in terrible. You know, if you looked at the consumer sentiment surveys, it was like the worst economic period ever or in many, many years, but the economy kept.
Growing spending consumers.
Yeah, I mean, I agree you have to take a lot of these survey results with a large grain of salt. There is also evidence that even relative to the pre pandemic period, where it was already a mistake to extrapolate one to one from surveys into activity, that that relationship has gotten even looser. And I think you have to be particularly careful with surveys that ask how are you feeling,
as opposed to what are you doing? If you take them somewhat more objective surveys that ask about production and orders and inventories and employment, you can put a bit more weight on that, But if it's really pure confidence surveys, you do have to be pretty careful. I mean, I agree that the small business survey is likely to show very large increase over the next couple of months, but I would only feed a relatively small portion of that
into our expectations on actual capital spending. We do expect some lift up in terms of cap X in an environment that is viewed as friendlier from a regulatory perspective, where we'll probably also get a bit of additional tax cuts. I mean, it's mostly about extending the twenty seventeen tax cuts, but we do think there will probably be some additional fresh tax cuts. I think all of that is going to be supportive, but more at the margin. I don't
think it's going to be a massive pickup, you know. Overall, my basic view is the economy has been recovering at a generally better than expected pace, and I think that's going to continue. If we're looking at consensus service going into twenty twenty.
Five, and that's largely priced into the market, which is now trading around twenty three times forward earnings, which are historically a very high multiple, and that is reflective in our interpretation of the backdrop that Yan has described.
There's obviously a lot of policy uncertainty, and we'll talk more about it with the new Trump administ and its visions and how seriously it's going to take tariffs and deportations and rebuilding American manufacturing all these questions, there is a short term uncertainty, however, which is that there's still
some ambiguity about the trajectory of inflation itself. And at one point it looked like a December rate cut was going to be a total lock, and actually right now it looks like, according to the market, it's like a sixty forty scenario, So it's not guaranteed. There are still some lingering questions about the inflation trajectory. Question to both of you, which is a y sort of like where do you see this sort of short term push and
pull in terms of the rate trajectory? And then to David, how much when you think about valuation specifically, is it contingent on some of these questions about what's going on with the further cutting cycle and.
So forth on inflation. I think the underlying trends are looking quite favorable, and I base that not just on the actual price number, okay, but also on the rebalancing that we've seen in the labor market. And we're basically back to where we were in twenty nineteen in terms of the supply demand balance in the labor market, if not a little bit looser We've seen, for example, declines in the quit rate and in some of the surveys of labor shortages to levels that are a little bit
below where they were in twenty nineteen. We've seen deceleration in wage growth. All of that, to me says that this inflation process is on track. There is an upside risk again maybe more price level effect, but an upside risk from the terriffs. But X that, I think we're on a path back to around two percent by the end of next year, which then because of our terraff assumptions, becomes two point four percent in terms of our actual forecast.
But X that around two percent, and I think in that kind of environment, the Fed's going to say, you know, four and a half to four and three quarter, that's still a very high nominal funds rate, which will become a higher real funds rate as you go through next year. So I think they're still going to want to deliver several cuts. A December cut is all forecast, it's certainly
not a foregone conclusion. We'll get some important data before then, and then we have ongoing cuts as we go through next year, and we think ultimately will land in the low to mid threes for the funds rate, which is a bit below what markets are pricing now. But I would remind you that if you go back a couple of months, markets who are priced for terminal fed funds rate in the two point seven percent range, So that was clearly very low relative to you know, certainly what
we expected. Now. I think the market's price may be a little bit higher than is appropriate in our view.
So there's a lot of things happening on the back of your question and the idea of investment strategies around inflation. What's the source of the inflation that may occur, And we can think of US companies that are selling abroad
compared with US companies that are selling domestically. If you're concerned about tariffs and what that might be from a price level point of view, the risk of retaliatory tariffs is certainly there, and so owning companies whose customer base is in the United States, while of course long the supply chain, they may have increased the prices the idea of those type of stocks generally doing better. As part of our view, you can think about wage inflation as well.
We have companies where labor costs are relatively low. And when I talk about labor costs, I think of the wage, not just wages, salaries and bonuses and stock based compensation and healthcare benefits, which of course in the US are born by the corporate sector. And there are companies where that's quite low, relatively low labor intensive companies is compared
with high labor cost companies. And think that's a area again we're looking for strategies, investment strategies around these different macro themes that Yan has described and we talk about in our teams at Gobenzachs.
One thing I'm wondering as we enter another Trump administration. You know, Joe and I and other journalists, we have it kind of easy where we either see the headlines at night before we go to bed, or if we're saying people, we see them in the morning when we wake up, and all we have to do is write them up. Basically what Trump is saying. When you wake up and see the headlines in the morning, how like reactive is your work to some of the stuff coming
out of Donald Trump's mouth? And I guess the count true social account yeah, And I guess the consensus right now is you should take Trump seriously, but perhaps not literally. And I guess my question is like when does that change.
Well, it certainly changes once you have actual government policy that can be implemented. During the transition. Of course, that's not the case. So in terms of changing our forecast, you know, the hurdle now would be quite a bit higher than once we actually were back in the second
Trump administration. In terms of providing a comment on some of these announcements or tariff threats, yeah, there's a lot of demand for that, and so we did write a comment on yesterday's announcements around the Canada, China, Mexico tariffs, but ultimately said, some of this is very consistent with what we had been assuming, namely the China tariffs, and maybe even a little bit lower than what ultimately is
likely to materialize. But then on Mexico and Canada, we would take this with more of a grain of salt because there will be a whole process around that renegotiation. And ultimately we did have some similar tariff threats in the first Trump administration on Canada and Mexico, which ultimately didn't materialize because NAFTA effectively just became USMCA, but not with a huge number of changes.
Think about it in terms of horizon arbitrage. There is lots of price noise that happens every day. And then there's investment themes that may be less connected with the administration, whether it's Donald Trump, Joe Biden, what have you. The idea of artificial intelligence AI that everyone talks about, well, that's really less affected by some of the government policies.
It may be depending on the policies that get implemented, but the idea of more productivity growth, or idea of more efficiency, or the infrastructure build out relating to AI, those are some of the themes that are probably independent of the administration. These are the things that are having in the technology world. And that's a discussion point that I look at with portfolio managers who may have an investment horizon that may be three to five years out.
What stocks should they own, how should they position their portfolio as compared with maybe some more focusing on the day to day announcements of tariffs, which may be implemented, may not be Maybe that may be variable.
One thing I would just say is that on tariffs, this is to a large extent up to the president and up to the White House. So it does deserve more attention than some other policy pronouncements, which require Congress to hash out a reconciliation bill and ultimate tax legislation. So it is important to focus on the things when there are announcements that are effectively under the control of the White House.
The Treasury Secretary nominee has, according to report, been pitching Trump on this idea three three threes, improved growth via deregulation, smaller deficits, and more barrels of oil. Let's set aside the oil for a second. Do you see any prospect of a meaningful change in the spending trajectory? And do you see any meaningful opportunity for further pickup in trend growth from more favorable regulatory environment.
So I think these are aspirational goals. They're both pretty ambitious. I mean both a three percent of GDP federal deficit. That's not what we're expecting. That's not what the Congressional Budget Office is expecting. I mean, we think it's going to be closer to six percent. Probably maybe we can bring that down. Bringing it down to three percent would
be certainly very desirable. I think we will ultimately need to bring it back down to something like three percent, and to bring the primary deficit, the x interest federal budget deficit back down to somewhere around zero, depending on where growth and real interest rates ultimately balance out. But that's going to be a process that's going to require an enormous amount of effort, and.
That would take real political effort to cut into very sensitive, veryos spending.
Right.
That's right, because such a large chunk of government spending is basically entitlement programs, defense, and debt service. That doesn't leave a lot of discretionary non defense spending that's maybe a little bit easier to cut than some of those other categories. You know, fifteen percent or so of total federal spending is you know, non defense discretionary, so a relatively small share. And that then leaves the tax side, and you know, obviously there's no desire to deliver a
sizeable tax cut, certainly not with this administration. So it's going to be very difficult. On the growth side. We're on the optimistic side of at least the economist consensus if you take the federal reserve, the media, and longer term GDP growth rate is one point eight percent. We're at two point one percent. You know, maybe that can be lifted somewhat. Getting to three again would be very
difficult urely, given the demographics. If you have the labor force grow at only a pretty slow pace, you know, not a lot of natural population growth because of low birth rates, and probably much lawer immigration. So even if you're a productivity optimist, and I would say I'm on the more optimistic side as far as productivity is concerned, getting to three will be difficult.
Let's talk about immigration, because, as you pointed out, you know, tariffs are largely under the purview of the president. Maybe immigration is a little bit different. What's been the impact of immigration on the economy from the past, you know, three or four years or so, and how do you see that unfolding going forward, given that we don't really know what's coming. We could have mass deportations, or we could have something you know, around the edges, or maybe nothing happens.
So it's been very important in boosting growth and nevertheless
bringing down inflation. So it's obviously a very controversial topic from a political perspective, But if you just look at the economics, if you bring more people into the workforce, especially at a time of very serious labor supply constraints, and in particular, very serious labor supply constraints at the bottom end of skill distribution in twenty twenty one twenty two in areas like bars and restaurants, you know, in other areas like that construction, having that large influx of
people has boosted growth and probably at the margin also helped to bring down inflation. At least has helped to bring down wage inflation in some of these areas to levels that are more sustainable. Now there is already a deceleration in the immigrant inflow if you look at it on a you know, month on month kind of annual rate perspective. In late twenty twenty three, we were running
above three million at an annual rate. Are now probably a little bit between one and a half and two million, and that is likely to you know, come down further, even before you see an additional tightening of restrictions on people coming in and increased deportations. You know, we'll see how large the deportations are ultimately going to be. If you go back to say the Obama administration, we were
averaging something like four hundred thousand per year. You know, I think it's probably going to be higher than that, but whether it's going to be dramatically higher than that that I think is still less clear. Yes, it is up to the executive branch, it's up to the president. But unlike with tariffs, there are going to be a lot more logistical issues around deportations and moving immigration to much lower levels or into negative territory than with tariffs.
With tariffs, it's administratively relatively easy. So if I'm thinking about, you know, supply the sort of growth negative tariffs on the one side, and then immigration on the other, I'm more worried about tariffs than I am about immigration.
David, you mentioned you know we're talking, you talk to clients, and one of the dominant conversations Scott Bessant gets named Treasury Secretary nominee. Maybe his three percent deficit to GDP goal is very aspirational. Maybe some of his growth ambitions are aspirational, But it strikes me that, like, ultimately he does not strike me as some sort of like major shake up, We're going to totally rethink how the economy works.
Guy.
He sort of has a traditional macro background, seems to have very good understanding when you talk to clients. How far does that go, you know, in terms of thinking, being able to think long term and avoiding the noise of the day to day headlines. The fact that Scott Bessont is likely going to be the Treasury secretary, the fact that, according to reports that just hit the headlines, someone fairly mainstream like Kevin Hassett is going to be running a ne EC. Is this the kind of thing
that just makes investors? Do they get comfortable when they hear these headlines?
What are those chats like?
I would say that is a pretty good characterization of how portfolio managers are thinking about it right now. Based on his background. Number of people myself included known him for some period of time as a portfolio manager, and
he's viewed again perception as sort of more mainstream. Of course, a lot of the policies will depend on the president, and so it'd be up to the treasure Secretary and the other cabinet members to carry out those policies, and that remains asion indicated that some uncertainty around what those ultimately will be.
So one of the reasons we'd like to talk to you is because you go out and talk to other people too. Your clients, portfolio managers. As you just mentioned, what are some of the more interesting questions that you are getting this year and what's maybe different to this time in twenty twenty three.
Well, it's much more around policy and much less around the underlying path of the economy. I mean, I think where again, going through beyond the policies which we've discussed a little bit of the concern around higher inflation. It's certainly true that the last couple of prints have been a little bit higher. We talked about it earlier. I'm not super concerned about it, but it wouldn't be shocking if we saw the next few months a little bit
of upward pressure. First quarter has been a sort of seasonally higher sequential inflation period, I think partly because seasonal adjustment is difficult, especially post pandemic, and there is some residual seasonality which we may see again. So there are definitely questions around inflation. There are questions around, you know, the longer term neutral funds rate. Our star know to what extent has it risen relative to the pre pandemic period.
You know, our view is that it probably never was quite as low as many people thought in twenty eighteen twenty nineteen. We were never that sold on the secular stagnation story, and you know, it might not be quite as high as many observers now think. I mean, we're still in the low to mid threes and nominal terms, low to mid ones in real terms, but there's certainly a lot of discussion around that. There's a lot of discussion around Europe and the impact potentially of higher tariffs
or maybe just the trade policy uncertainty. You know, in advance of any actual tariff increases on Europe, what is that doing to an economy that's already pretty soft. And it's an area where we're actually well below consensus. We have a zero point eight percent forecast for EU area growth in twenty twenty five, which is four or five tenths below the Bloomberg consensus or the ECB and and a lot of that is around trade policy uncertainty, which
seems to have a particularly negative impact in Europe. So definitely another big topic of conversation.
David, and take a stab at the same question.
Sure, there's a variety of things that portfolio managers are focused on right now, and the first is something you reference earlier, Joe, which is the idea of the largest stocks in the market are now representing more than a third of the S and P five hundred equity capitalization. So the question is, you know, how does one position in that. You look at the mutual fund community, for example, seventy five percent of mutual funds are lagging their benchmark.
It's not a criticism, it's just the data so far and those companies. What's been consistent about those funds has been they have been underweight these positions in the largest stocks, and so the idea of perhaps having an index weight for the largest companies and then choosing to generate alpha or seek alpha in the rest of the market is probably the better strategy. That's number one. That was something that the twenty five percent of the mutual funds that
are outperforming have tended to tended to do. That's number one. Number two, relating to Yon's observe as, it's a perpetual question of well, what about these global markets Europe, Asia, China, Japan,
Is this their opportunity to outperform the US. The relevant evaluation metrics are really really eye catching, which is that the multiple forward pe multiple for the US equity markets now roughly twenty three times, and it's about thirteen times for Europe and Japan and China is even lower than that. And so that question is well for a decade, it's still been the US. Is this the time? Is the valuation gap so significant that the opportunity set at the
lower end of the valuation scale? Does that represent good opportunities? So I'd say those are two major questions. The third question that is highly debated is on AI and the idea is of the huge capital investments that some of the hyperscalers and other companies making these investments, what will the ROI turn on investment be of the AI that they're making, And so that is a question that's and
flowed over the course of the year. A lot of the companies who are involved in the infrastructure build out have done particularly well. Those pe multiples have expanded and the share prices have done better than the growth rate in the underlying growth of earnings, and so our focus has been on companies in the third phase. As we think about it, the third phase of AI infrastructure build out.
First phase is Navidia's own kind of unique story. The second phase is the infrastructure and the third phase is the companies we think of whose revenues will be enhanced by AI, and a lot of the software companies and their price return this year have basically matched the earnings growth trajectory, and so the opportunity does exist there in some cases for a multiple expansion, So that would be an area of focus. So those are some of the topics that are debated with fund manager right now.
Tracy.
First of all, it feels like international out performance is always one year away.
Or oh, I know, we're always waiting for EM.
We're always waiting for EM and Japan and Europe. One day they're going to have their day. But also to refor it's another shops performers. But I always love looking at the via AML hedge fund survey and one of the things they ask is what's the most crowded trade? And it's always big tech, and it's always big tech that wins. And I think about how glad I am that I'm not a portfolio manager, and how sick to my stomach of it have to be did the big source of l F I just have to ride the
most crowded trade? Anyway, I'm glad I don't have that job where I have to just do the same trade as everyone else to outperform.
We're all glad to Yeah. Well, actually, speaking of jobs, Joe and I came up with a contrarian trade idea based on AI, which is by Europe as a beneficiary of productivity enhancing technology hormachical because their productivity is really low. Would that work? You guys should see the expression on David's face.
Right, he looks like he did bit into a lemon.
No one likes our contrarian ideas.
It could work.
I think maybe you used to think about it in terms of M and A activity. The idea of the companies in the stays much higher profit margins, and the idea, I guess Tracy your hypothesis is perhaps their margin expansion would be potentially enhanced by the adoption of AI. That one question is on the source of the potential margin enhancement. Is that labor driven and you have more efficiency therefore fewer jobs. Is that sort of a orthogonal to what
the objective are? Has seem a lot of the European governments, and so I think there's some debate around that. Could it be a trade?
I'm not a buyer Goleman isn't going to set up that index.
Just do you have ai macro thoughts? And to my mind there's potentially two ways it could go down. One is just the macro impact of all the capital spending. Does it move the dial at all in any sort of categories that are important on the top level. But I guess more importantly, you know, looking a few years out when you think about productivity, when you think about labor growth, are we at the stage yet where you can make interesting predictions about the impact of this stuff.
So on the near charm impact, we generally have not viewed that as all that large. I mean, these are huge numbers in a very small part of the economy, but in terms of boosting you know, near term growth, it's very difficult to get anything more than you know, a very small sort of tenth of a percentage point or something like that. And in terms of the broader impact on potential growth, I think we're also still probably
several years away. But then we're actually pretty optimistic when it comes to sort of late twenty twenties, early two thousand and thirties, and a little over a year ago we raised our long term potential growth estimate for the US by four tenths of a percentage point. We were at one point eight percent for the sort of years
around two thousand and thirty. We're now two point two percent, which is no, that's a pretty sizable boost, and it's really driven by the fact that AI can replace a lot of the tasks, not necessarily the jobs, but the tasks within certain jobs that are being done, you know, at sort of low and mid levels of white collar work at the moment, and that is ultimately going to
be productivity enhancing. Of course, it does mean some labor market upheaval, although we would emphasize that the labor market impact is going to occur over a period of time and there will also be new jobs that will be created. So historically, when you go back, it's actually not that easy to find instances of technological unemployment that were visible,
you know, in the overall economy. Typically when you have large increases in productivity growth, those are actually typically low unemployment periods rather than high unemployment periods, even though at the individual job level or industry level you might see quite a lot of job destruction. But overall we're optimistic over the longer term, but in the short term it's probably still going to be more limited.
I can't wait to be a prompt engineer, generating AI written podcasts. That's our future.
We can already are. Yeah, we're already data providers.
Yeah, that's true, David. I just have one more question, which is whose ideal was it to write the Equity Outlook through the lens of lessons learned from the Art of the Deal.
Well, last year we referenced Taylor Swift. We said the subtitle of the report was all you need to do is stay invested, and that was the strategy for calendar twenty twenty four. And a reference to your first question of this podcast, you asked, do anyone look back and see what we wrote in you do here? We certainly do and think about it as a report card. What was the impetus for the Art of the Deal and why we titled that or subtitled that for our twenty
twenty five outlook. Part of it is the M and A environment and the idea that our forecast is for a twenty five percent increase in M and A in calendar year twenty twenty five. That's part driven by our forecast of the use of cash of corporate America S and P five hundred companies will spend about four trillion dollars of cash next year, and a good portion of that we have a twenty percent gain or increase in
the cash devoted to M and A activity. So that was one of the impetuses that thought about the Art of the Deal. And then it is remarkable and for all the listeners of the Outloud's podcast, I would suggest you go back and read the report. Read the book. The Art of the Deal was written or co ghost written perhaps by Donald Trump thirty seven years ago, and many of the characterizations of the transactions in his whole
thought process was pretty interesting. So we went back revisited that in my first edition copy for when I was way back in the day, and that was the impetus for why we thought about that as an organizing structure for our Outlook report.
Do you have a first edition?
Are you used to nineteen eighty seven?
Wow? Oh wow, I'm gonna have to go read it. I should read it. I will read it.
Yeah, I haven't read it either. Isn't there a sequel as well? Oh?
There's many many books.
Yeah, we did references.
There's the art of the comeback that he wrote ten years later nineteen ninety seven, and a whole sequence of books that he's written.
Oh my gosh.
Okay, David and Jon, thank you so much for coming on out launch. This is a true treat to have you both and maybe I don't know, let's make it an annual tradition.
We'll do it again next year.
Thank you, Thank you exciting us.
Thank you so much. That was Thank you, Tracy. That was a real treat. That was really fun having David and On together.
I know, I wonder if they've ever done an external appearance together, like.
An external media appearance.
Yeah, that's what I mean.
I guess we could have asked them.
I'm sure they have spoken to clients.
Yeah.
But there was, you know, just one random thing that stuck out from me that I hadn't realized, like I knew it or I had a good idea in my mind that the reason big tech companies have done so well is because they're earnings juggernauts. Right. There's other things that go on flows and there, but like, they make so much money and they're so large, and yet they still put up like thirty percent numbers.
It's insane. But I had not realized like.
A quite how wide that gap has been and over the last two years between their earnings growth and everyone the other four hundred ninety three stocks, and b that the consensus is for a major shrinking in that gap going into twenty twenty five.
Yeah, that's right. Well. The other thing I was thinking was the differentiation between different Trump policies as well, and like maybe dividing them up by how much is under the purview of the president versus like what things need congressional approvement and where there are those sort of political limits and guideposts in place. I guess like that seems a reasonable way to view some of these risks. I still think there's a lot of stuff up in the air.
Yeah, And you know, it seems to me and we sort of joked in the beginning that like the GDP usually grows like two and a half three percent and stocks usually go up, And that's true. And it seems like even with the sort of some of the unorthodox or heterodox economic views of the incoming Trump administration, the impacts right now expected to be marginal. Right, so even tariffs aren't expected if they go through as expected, aren't expected to have a radical change to say the inflation
trajectory or whatever. And you know, it seems like what people are anxious about, what you're talking about, maybe some clients are talking about, is the idea of like genuine policy uncertainty. And that means not a debate about ten percent versus twenty percent tariffs, which is, you know, you shave some percents off GDP, you shave some earnings off, and life goes on, versus like the seeming potential for some gen andly radical rethink of how we do business with the rest of the world.
Yeah, totally. And I think that's like that's a.
Po's the big one, right, it seems plausible. Yeah.
Yeah, Well, in the meantime, sign up for our twenty twenty five investment outlook titled GDP normally increases two to three percent and stocks normally go up.
This way, we're gonna title our newsletter on Mondays.
Out Let's do it all?
Right?
Shall we leave it there?
Let's leave it there.
This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway and.
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