2025 Market Perspectives
December 20, 2024
Following Trump's election victory, the stock market extended its rally, fueled by optimism surrounding his promises of tax cuts, smaller government, and deregulation. These policies often appeal to markets for their potential to boost corporate earnings and stimulate economic activity. However, a closer look at historical data on tax and spending policies—along with their impact on the federal budget and S&P 500 returns—provides valuable insights into their effectiveness.
Republicans frequently advocate for tax cuts as a way to stimulate economic activity, boost corporate earnings, and ultimately increase tax revenues. However, historical data challenges this assumption. For example, during the Reagan era, tax revenues grew by 7.59% annually, but government spending grew by 6.85% per year over his eight-year term. Similarly, under Presidents Bush Sr. and Bush Jr., tax revenue increases of 4.70% and 2.78%, respectively, were outpaced by spending growth of 6.82% and 7.18% annually. In the Trump administration, tax revenue growth was a modest 2.13% annually, while spending surged by 13.01% per year. Conversely, Democratic administrations have generally seen higher revenue growth with more moderate increases in spending. Under President Clinton, revenues grew by 7.61% annually compared to a 3.08% rise in spending. Under President Obama, revenues grew by 3.66% annually, while spending increased by 2.74%. Most recently, under President Biden, tax revenues have increased by 7.99% annually, while spending has risen by only 1.63%. These patterns suggest that tax cuts alone may not always lead to higher revenues, as spending frequently rises in tandem.
My intent here is not political but to provide an objective analysis. Historical data shows that the Republican belief in lower taxes driving higher tax revenues has not always proven true. Since the Reagan era, tax revenues have grown at an average annual rate of 5.26%, while government spending has increased slightly faster at 5.67% per year. Regardless of political party, the data suggests tax revenues and government spending tend to rise over time.
Now, let’s look at the federal budget. While tax revenues and spending are important, the critical question is whether the government is running a budget surplus or deficit. Historically, the United States has run budget deficits, regardless of which party is in power, with the notable exception of the Clinton administration, when a budget surplus was achieved. On average, deficits have tended to rise under Republican administrations and decrease under Democratic ones. Given this persistent trend, the pressing issue is how to address the national debt, which currently exceeds $36 trillion. To make this more manageable, achieving and maintaining a budget surplus would be key. The stakes are high: if existing debt is refinanced at current interest rates, annual interest payments could exceed $1.6 trillion, consuming more than 20% of total government spending. This highlights the urgent need for fiscal discipline and sound financial strategies.
Balancing the budget is simple: it requires both increased taxes and reduced spending. Tax cuts, while politically appealing, only exacerbate the deficit. Without addressing both sides of the equation, paying down the national debt becomes impossible. A shift toward sound fiscal policy is critical. This is why aspects of DOGE’s plan to cut government spending appealing. However, the practicality of these proposals remains in question. For instance, while Elon Musk warned of “temporary hardship,” and Vivek Ramaswamy proposed slashing 75% of the 2.9 million federal workforce and cutting $2 trillion in spending, the feasibility of such measures is uncertain. Mandatory spending programs such as Social Security, Medicare, and Medicaid are politically untouchable, and interest payments on the national debt are unavoidable. Even eliminating all discretionary spending, including defense, would fall short of the $2 trillion target. The reality is that the only viable solution is to increase tax revenues. While spending cuts should play a role, a balanced and pragmatic approach, including tax reforms, is essential to addressing the fiscal challenges ahead.
Now, let’s turn to market performance. Historically, the S&P 500 has delivered positive returns regardless of government policies, with the notable exception of the Bush Jr. era. Below are the annualized returns of the S&P 500 during each presidency from Reagan to Biden:
Reagan: 9.36%
Bush Sr.: 11.92%
Clinton: 14.86%
Bush Jr.: -4.63%
Obama: 12.02%
Trump: 13.81%
Biden: 11.70%
These figures suggest little correlation between budget deficits and equity performance. Although budget deficits often bring up debates about the debt ceiling—threatening government shutdowns—these political standoffs seem to have minimal long-term impact on market performance. Achieving a balanced budget, however, would eliminate recurring debt ceiling debates and their associated uncertainties. While equity markets have historically weathered these challenges, removing such disruptions could foster a more stable fiscal environment for sustained economic growth.
As we approach the end of 2024, what lies ahead in 2025? While no one can predict the future, a few things are clear: the economy is in a strong position, supported by healthy GDP growth and low unemployment. However, this could be derailed by extreme measures taken by the new administration, such as drastic tax cuts, tariffs, and government spending. As for deregulation, I hold mixed views. In the short term, it may spark economic activity and result in positive market performance, but in the long run, it could have unintended consequences. Corporate innovation does indeed create growth opportunities, but deregulation may also allow some players to take advantage of a more relaxed system. I believe some regulations are necessary to maintain order in the market.
Geopolitical tensions, ongoing conflicts, and trade disputes—particularly with China—will continue to exert significant pressure on the global economy. China, now the world’s second-largest economy, is increasingly vying for the top spot, and its growing economic interdependence with the U.S. underscores the need for careful diplomacy. A trade war with China at this juncture seems unwise, especially since China is the second-largest holder of U.S. Treasuries. Retaliatory measures, such as tariffs or restrictions on U.S. companies, could disrupt global supply chains and harm multinational businesses. Both nations must engage in thoughtful negotiation to foster a stable, mutually beneficial economic relationship. At the end of the day, the U.S. and China need each other to maintain global economic stability.
Regardless of policies or geopolitical challenges, market performance is primarily driven by valuations and economic growth. When market exuberance takes hold, underlying realities can be obscured, causing even the most skeptical investors to join the rally. This sentiment has led some analysts to revise their S&P 500 targets upward, with projections as high as 7,000. If realized, such a target would push the S&P 500’s price-to-earnings (P/E) ratio to 26x, approaching the all-time high of 29x recorded during the dot-com bubble in 2001. Currently, the index trades at a P/E of 22x, well above its historical average of 17x. While this suggests a “risk-on” market, recent pullbacks and volatility indicate that investor sentiment may be moderating.
In summary, tax cuts do not necessarily lead to higher revenues, markets perform well regardless of political leadership, tariffs are likely to raise inflation, and a strong dollar has deflationary effects. Furthermore, dramatic cuts to government size and spending could lead to higher unemployment and slower growth. After two years of strong S&P 500 returns, I advise investors to remain cautious as elevated valuations and potential economic headwinds could present challenges in the coming years.
Regarding portfolio positioning, I recommend continuing to avoid long-dated bonds. As noted in previous comments, I’ve avoided bonds with maturities longer than one year since 2022. However, the yield curve is beginning to show signs of steepening, suggesting it may soon be a good time to reconsider fixed-income securities. If short-term rates come down, this could help normalize the curve without causing disruption. Historically, the average Fed Funds rate over the past 70 years is 4.68%, which aligns with the current rate. However, from an affordability standpoint—considering the federal government’s rising debt load—my calculations suggest that the average rate across the yield curve should be closer to 3.40%. Given the current 10-year Treasury rate of 4.57%, a Fed Funds rate of around 3.50% seems to represent a reasonable neutral or affordable rate. However, if long-term rates were to rise instead, we may face another year of negative returns in fixed income, with growth stocks underperforming as well. In this case, I would favor value stocks, hedge growth stock exposure, and continue avoiding long-dated bonds.
Wishing you a Merry Christmas and a Happy New Year! I look forward to reconnecting and getting back to work in 2025.
Alpha Capital Wealth Advisors, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
