Trends In Equity Markets

The mood in markets is shifting as we approach 2025. The S&P 500 is hovering above 6,000, a level that puts its multiple around 23 times forward earnings. Unfortunately for the market’s various bull theses, the 15+ year run in the S&P has been so furious that large-cap dividend yields are now less than one-third of the yield on 10-Year Treasuries. That’s no bargain. Nevertheless, we favor an overweight to equities relative to bonds because positive catalysts abound. To name a few, there is the very real prospect that the corporate income tax could fall from 21% to 15%. Additionally, we are believers in the theory that the incoming Trump Administration will fuel a merger and acquisition (M&A) wave.

A major beneficiary of that wave could and should be Financials, for two reasons. One: who does the M&A underwriting? That’s the bullish part for the dominant investment banks. Two: the group itself may see consolidation, owing to the count of banks in the U.S. numbering 4,000. There is a distinct possibility that the next four years are characterized by a gobbling up of some of the regionals as the handcuffs come off this country’s largest financial institutions. Positive spirits in this specific sector should be supportive of Value mandates, which tend to own those names.

While many investors seem to have forgotten that a Value run of outperformance came strongly in 2022, recency bias has many investors focusing on Growth’s dominance over the last 24 months. Many market participants, by and large, cling to outdated narratives and ignore how Growth names were pummeled along with meme stocks and NFTs just a few years ago. We believe the undercurrent of market leadership in Value remains intact, despite the ruthless dominance of Growth after 2022’s beatings.

Consider too the age-old tug of war between large and small caps, because we think change is afoot. The 10-week correlation between the Russell 1000 and Russell 2000 dipped to -0.26 this summer. Normally, these two broad U.S. equity benchmarks run at a correlation above 0.9 as a matter of course. The last time a correlation breakdown occurred of any magnitude similar to this was around the turn of the millennium, just before small caps embarked on a 14-year run of outperformance.

While no historical analogy is perfect, we find this “rhyme” compelling. Big stock market leadership changes need some ruction, some big change in the system. Maybe the election was that thing. To say the power of K Street lobbyists, who represent the country’s largest corporations, may take a hit from 2025–2029 is an understatement. It suggests that small and mid-caps could be positioning for a new phase of outperformance, particularly as corporate America grows more comfortable with putting a target on them for M&A.

“Big stock market leadership changes need some ruction, some big change in the system.”

Opportunities Beyond the U.S.

Outside the U.S., we and others have discussed to the point of exhaustion the blowout in French bond yields relative to German bunds. We concede that our argument here—suggesting this tension could lead to bullish outcomes for European equities—is not a guarantee. Policy makers may fail to react swiftly or decisively.

Nevertheless, we highlight this scenario because episodes of sovereign stress have, on occasion, prompted reforms or interventions that later lifted equity markets in what were formerly “peripheral” European countries such as Greece and Spain. Nowadays, France and Germany themselves are problem children. At the very least, knowing that political sclerosis appears to be the lay of the land in those two countries, can inform our hedging strategies. Given the complexity of Europe’s policy machine, there’s no straight line from sovereign yield spreads to equity rallies, but experience suggests sentiment is so in the tank that 2025 might just witness rewards for lonely contrarians.

European and Japanese Equities: Diverging Fortunes

Still, you can’t be overweight in everything. This is a bull market that wants to own U.S. equities first and foremost. Europe remains an underweighted show-me story.

Japan offers a more straightforward set-up. Corporate governance reforms, an emphasis on improving return on equity and tangible steps toward better shareholder alignment have made the region more appealing. Gone are the days when Japanese corporations were slow to raise dividends or authorize buybacks. Now, as they increase shareholder payouts, investors can identify opportunities in a market that once was criticized for complacency.

The yen carry trade fiasco of summer 2024, which forced leveraged speculators to the sidelines, took us by surprise. However, what’s done is done; we hypothesize that any players who were caught over-exposed to the yen carry trade have already been taken out. The pain at the time was acute, but it’s over. What’s not over is the bull thesis for the country: a societal push for improved capital allocation, better operating metrics and more robust earnings quality. Most seers inside WisdomTree Research pick Japan as their favorite for EAFE mandates.

China also provides a noteworthy and controversial backdrop. On a cost of capital thesis, the five-year sovereign in China has slipped to 1.62%, a yield positively Japanese in spirit, owing to a near-consensus view that Japanification will be China’s conundrum in the coming decades.

The last two times China’s intermediate-term bonds sunk to levels near the current quote were in 2008 and 2020, both of which were panic years. Those were great entry points for MSCI China and bottom callers see today’s market valuations as pricing in the challenges of slower growth and the threat of Trump’s 100% tariffs on Chinese-made goods.

All the emerging markets flows in the ETF industry have concentrated into ex-China strategies. This could signal a contrarian long position for China bulls but also reflects unease with the long-term case for allocations to China. Our team sees China as fit for the most tactical minded investors who are skilled at surfing the shifting sentiment waves. A meaningful overweight allocation is reliant on improving Sino-U.S. relations.

China and Global Market Dynamics: Risks, Reforms and Sentiment Shifts

U.S. inflation, or lack thereof, will continue to dominate the market’s focus in the coming 12 months. Many of us associate China with mass production of low-cost basic goods like clothing. The prospect of a follow-through on tariffs should be deathly frightening for portfolios that are positioned for a disinflationary U.S. CPI thesis, right?

Well, in the foreground, China’s productivity gains and the deployment of AI could keep price pressures more contained than skeptics believe. AI adoption is profoundly deflationary. It reduces labor intensity, trims material wastage and makes supply chains more efficient. As businesses integrate advanced robotics, machine learning and data analytics, they can often maintain or even lower prices.

We can game out the comings and goings of Trump’s foreign policy on the consumer price dynamic. It feels like tariffs are the only thing the market wants to think about on the inflation front, as if a demographic shift isn’t Policy Number One for the incoming president. If the Trump Administration does deport several million people, the initial reaction in markets will be labor shortages in industries like meatpacking and farming, along with attendant price rises at the grocery store. Additionally, concepts such as inflation in childcare are logical and rational for 2025 outlooks.

However, there are other effects on big chunks of the economy, many of which are notably deflationary. For example, this country’s emergency rooms are notoriously overrun. That pressure on healthcare costs should abate, as should rents, overflowing school budgets and general municipal services, as an unknown number of people are sent to their country of origin. The list goes on.

It is hard to see fruit and vegetable prices not rising, and it’s hard to see the cost of a babysitter not rising, but then again, maybe there will be respite on the hospital tab or this year’s conversation with the landlord. If rental vacancies start to pop higher, which is what happens when millions of people leave the country, suddenly we may just get some red ink splashed on the housing components of CPI.

Market Sentiment and Fundamentals in Focus

Something that worries us about the stock market is sentiment, as measured by the Conference Board survey, which is extremely bullish. A record gap exists between respondents who expect stocks to rally in the coming year and those who think they’ll either remain steady or decline, in data going back to 1987. Such lopsided optimism can signal a frothy environment that is ripe for a rotation.

Instead of following the crowd, we remain anchored by fundamentals and historical performance data. Our research on capital allocation—using Ken French’s database—demonstrates that top-decile share repurchasers earned 13.1% annually from July 1963 to September 2024, while top-decile share issuers managed an annualized return of only 4.8%. This difference intensifies during market panics, when diluted shareholders punish companies for ill-timed issuance. The fading of Kamala Harris’s proposed 4% buyback tax hike is a relief, reinforcing the appeal of companies that embrace disciplined, shareholder-friendly strategies.

As we move into 2025, we consider how all these elements interact. Sentiment is hot, but we must read the signals carefully. Valuations are full, but not every corner of the market is equally frothy. Correlations are breaking down, hinting at new leadership. AI adoption could help mitigate inflationary fears, as could a population-based resolution to the housing and healthcare crises.

Across these complexities, we focus on fundamentals: value, quality and metrics-based indications that management is shareholder-friendly. One way of finding this is a screen for stock repurchase programs. History suggests that disciplined, factor-based approaches can thrive when investors stop taking past regimes for granted and open their eyes to changing conditions. In that sense, we approach 2025 armed with a healthy skepticism, a nod to history’s lessons and the conviction that careful positioning can turn challenges into opportunities.

Adapting to Currency and Global Market Dynamics

With a sharp divergence in economic prospects between the U.S. and other developed markets, interest rate differentials should continue to support the U.S. dollar in 2025, relative to other developed markets currencies. Add the near-term support of the imposition of higher tariffs and King Dollar is likely to push head another year despite elevated valuations.

Emerging markets currencies could be more idiosyncratic. The Chinese yuan could struggle relative to the U.S. dollar as tariff debates heat up, while the Indian rupee and Brazilian real could be better supported as they fall outside of direct tariff focus while offering attractive carry.