Profiles of the Future: Our 2025 Macro Outlook

There seems to be a widespread view that inflation will remain “sticky” or re-accelerate in 2025. Even the Fed expects inflation to moderate slower in 2025, with the median policymaker expecting core PCE inflation to only reach 2.5% in the December 2024 Summary of Economic Projections (SEP) and not back to 2% until 2027. The central tendency of the FOMC projections skews from 2.5-2.9%, giving us a sense of the Committee’s bias. 

We find this amusing, as early in the hiking cycle, we had great difficulty convincing colleagues that inflation was a problem. How the tables have turned! No doubt Trump’s election heightened investor concern about prices perking back up. 

However, we could envision a scenario in which the Fed’s preferred core inflation gauge dips below 2% sometime in 2025. While many inflation re-accelerationists cite their worries on the last three months’ stickier inflation readings, beneath the headline print, the stickiest and largest single inflation component—shelter—has recorded one of its softest prints in over three years.

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On the surface, annual outlooks peer into the near future.

But, beneath the surface, outlooks often play to the market’s present preoccupations.

A year ago, we heard almost nonstop that the U.S. consumer was running out of savings, putting America on the precipice of a downturn in 2024. Today, we hear nearly nothing about this.
Instead, we’re inundated with Trump-related macro fears. Indeed, some consider the Trump threat so severe that it could put the Fed on hold in 2025 or even force the central bank to pivot and hike!

In recent years, for our annual outlook, we have developed different methods to address the problem of investors being susceptible to viral macro ideas. We’ve suggested spending less time prophesying and more on myth-busting, narrative-bursting, and meme-mincing. The common thread in all our annual exercises is that misconceptions about the present, not forecasts, are the main issues that plague investors and their portfolios.
Arthur C. Clarke, best known as a science fiction writer, also wrote a book on approaches to foresight. (Clarke, A. C. (1971). Profiles of the Future: An Inquiry Into the Limits of the Possible. Bantam Books.)

Clarke begins by saying, “It is impossible to predict the future, and all attempts to do so any detail appear ludicrous within a few years.” His book, he says, has a more “realistic aim”: “not to try to describe the future, but to define the boundaries within possible futures must lie.”
Science fiction writers and readers, he says, are best suited for the task because you must have “sufficient imagination to assess the future realistically,” a key trait of those attracted to the science fiction genre.

How can science fiction help us, macro investors? The ability to imagine alternative futures might be key to anticipating them. It might also be a way of preventing yourself from being captivated by the most popular views that are captivating the media and markets at the moment.
Science fiction presents alternative futures. We’d like to entertain possible futures that may surprise markets in 2025. Below is less a forecast and more an exercise in creative thinking, asking ourselves to investigate plausible outcomes. Here are our top plausible picks for 2025:

Core inflation may come in at or below the Fed target in 2025.

There seems to be a widespread view that inflation will remain “sticky” or re-accelerate in 2025. Even the Fed expects inflation to moderate slower in 2025, with the median policymaker expecting core PCE inflation to only reach 2.5% in the December 2024 Summary of Economic Projections (SEP) and not back to 2% until 2027. The central tendency of the FOMC projections skews from 2.5-2.9%, giving us a sense of the Committee’s bias.

We find this amusing, as early in the hiking cycle, we had great difficulty convincing colleagues that inflation was a problem. How the tables have turned! No doubt Trump’s election heightened investor concern about prices perking back up.

However, we could envision a scenario in which the Fed’s preferred core inflation gauge dips below 2% sometime in 2025. While many inflation re-accelerationists cite their worries on the last three months’ stickier inflation readings, beneath the headline print, the stickiest and largest single inflation component—shelter—has recorded one of its softest prints in over three years!

Moreover, the recent overall core inflation print was driven by a pickup in used vehicle prices in core goods, which could be easily reversed in the months ahead. If core goods return to their long-run average trend, even if shelter remains at current rates, core CPI could still return to 2.5% by 2025 year-end (see the gold line Figure 1). And, if shelter moderates back to its long-run average trend as suggested by falling new rents, core CPI would reach the Fed’s 2% target in 2025 (see the turquoise line Figure 1).

Bonus points: a core CPI at 2% year-over-year would suggest that the Fed’s preferred inflation gauge, core personal consumption expenditures (PCE), would be even below that given the historical 30-40 basis points gap between the two measures.

The unemployment rate could end 2025 at 4.4% or above

After a mid-summer scare due to slowing job growth, most investors forgot and moved on to the re-acceleration story, especially in light of the run-up in the equity market. But is there more weakness in the labor market than meets the eye?

Perhaps. From a statistical perspective, it’s rare for the three-month average unemployment rate to stay flat (±0.1 percentage points) over 12 months outside of recessions since 1960 (see Figure 2). In other words, the unemployment rate is likely going up or down.

History suggests that the unemployment rate has often (70% of the time) moved down throughout an expansionary period before bottoming and picking up quickly preceding a recession. While our base case call is not for a recession, there are more reasons supporting a slight pickup in the unemployment rate than a falling one like bond investors foresee.

First, nonfarm payroll jobs growth has clearly slowed from its 250k pace in 2023 to about 173k in the last three months. Further, while permanent layoffs only accounted for 20% of the total unemployed population in the summer of 2024, its share has now increased to 30%—not a severe warning sign but indicates accumulating weakness in the labor market. Lastly, the quarterly census of employment and wages (QCEW) report for Q3 also suggests that previous payroll data could be softer than expected. Under a scenario with job growth slowing to 130k and the labor force participation rate returning to its levels in the summer of 2024, the unemployment rate would still rise to 4.4% by December 2025.

The U.S. consumer will continue to spend

Consumer spending is a consequence of income, savings, wealth, and borrowing. On all counts, the consumer looks good, but if the labor market continues to cool, the best years of the cycle of consumer income growth may be over.

However, slower job growth doesn’t necessarily mean a severe pullback in consumer spending, as traditional economic theories suggest. Faithful readers might remember that our favorite gauge to measure consumer spending is our consumer power index, which measures consumer spending power based on labor market conditions (aggregate employment × wages per hour × hours worked per week). Historically, consumer power growth has averaged 3.6%, fueling an average real GDP growth of 2%.

Based on our consumer power series, even if we assume job growth slows to 100,000 per month and nominal wage growth returns to the long-run average (~2.8%), consumer power will remain above its long-term average growth rate (see the gold line in Figure 3), supporting the case for on-trend real GDP growth.

Further, the consumer can coast on wealth gains and borrowing capacity for longer than investors expect. Household net worth has increased by 50% since Covid-19, the fastest growth rate in the past four expansionary cycles.

There is now scope for dovish surprises from (some) central banks

As a consequence of the above three, central banks could surprise markets yet again. As of today, the bond market expects 1.5 rate cuts in 2025. Could we envision three or more? Easily! Our Taylor Rule approach means inflation only needs to slow down to 2.4% and the unemployment rate to 4.3% by December 2025—the minimum possible solution—and the optimal fed funds rate would be 3.3%, which implies at least four cuts in 2025.

Beyond the Fed, the Bank of England (BoE) is poised to surprise the most (see Figure 4). The bond market only foresees two cuts for the BoE in 2025. However, inflation in the UK could moderate much faster than the market expects, with services inflation recording its softest reading in October in over three years.

There’s a strong case for lower longer-term yields in 2025

Like the inflation story, many investors think a future with lower longer-term bond yields is far-fetched. We’re less confident. In our view, the most likely scenarios to play out in the next 12 months include lower longer-term yields (see Figure 5). Soft landing? Moderately lower yields. Garden-variety recession? Materially lower yields. Productivity boom? Lower yields due to softer inflation. A severe recession? Materially lower yields. You get the picture.

Indeed, the same hopes that fuel the reaccelerating inflation scenario animate the higher long-term yields, possibly also fueled by fiscal-related issues driving up the term premium. Instead, with inflation trending back to 2% due to the above-mentioned reasons, we could easily foresee the scenario where lower inflation breakevens (expectations for long-term inflation) would send yields lower (see Figure 6).

Asset returns could look great in 2025. Yeah, we said it

Most of the commentary on asset prices completely lacks imagination. “Spreads are too narrow. Valuations are rich.” Can we envision a scenario in which credit spreads tighten? Yes. Can we imagine one in which P/Es get more stretched? Yes.

Two factors overwhelmingly drive bond returns: the path of rates and the path of credit spreads. We have already established a scenario in which yields rally more than markets expect, inflation moderates, the economy avoids a recession, and the Fed cuts more than is priced in.

What about credit spreads? With spreads at their tightest in the current cycle, it might be hard to envision spreads narrowing further. However, there is a historical precedent—spreads were tighter, and valuations were more stretched in the late 1990s “soft landing.” Consequently, if we plot the returns on various asset classes based on our forecast for short-term and long-term Treasury yields, assuming spreads would tighten to their levels in the 1990s, duration and risk assets would outperform (see Figure 7).

Equities, too, have scope to rally further. When we envision consumer spending, nominal growth, and corporate profits, we find a plausible case for the S&P 500 to top 7,000 in 2025 (equivalent to a 15% price return). Sprinkle in a Fed moving to neutral, the fact that equities generally rally outside of recessions, and the carrot of tax cuts and easing regulatory environment, we wouldn’t rule out an upside scenario so quickly due to valuations (see Figure 8).

US dollar strength will remain regardless of political rhetoric

There are almost too many moving parts driving the dollar to enumerate. On the one hand, if the Fed shocks the market with dovishness, the dollar likely sells off (see Figure 9).

However, the factors driving the dollar over the last decade might remain intact. U.S. growth remains exceptional, especially relative to peers (the euro area, U.K., and Canada all look weaker). Further, the U.S. remains the home of innovation and continues to attract global capital, keeping the dollar well bid.

The bottom line is that it’s not too far-fetched to envision inflation moderating, central banks being more dovish, and bond yields rallying. If that scenario occurs without a recession, equities may yet have an upside, and credit spreads could remain tight or narrow further.

Arthur C. Clarke chalked up many failed predictions not due to the wrong facts or model but a lack of imagination about what could happen in the future. He advised: “One can only prepare for the unpredictable by trying to keep an open and unprejudiced mind—a feat which is extremely difficult to achieve, even with the best will in the world.”

Is the “profile of the future” we’ve outlined plausible, or will the truth in 2025 be stranger than fiction?

Happy Holidays and best of luck in 2025!
The Payden Economics Team

© 2024 Payden & Rygel All rights reserved. This material reflects the firm’s current opinion and is subject to change without notice. Sources for the material contained herein are deemed reliable but cannot be guaranteed.