Solving for 2025

Solving for 2025

Anu Rajakumar: Neuberger Berman's Solving for 2025 publication outlines five themes expected to shape the financial markets in the upcoming year. It provides perspectives from the firm's senior investors on key questions such as what factors will impact the macroeconomic environment in 2025. Will equity market performance broaden out beyond the Magnificent 7? How will a more stable inflation and central bank outlook impact fixed-income markets? How can private market investors prepare for what appears to be a more robust deal-making environment?

To help answer those questions and more, I'm delighted to welcome back two of the publication's authors to the show, Erik Knutzen and Shannon Saccocia, who are the chief investment officers of Multi-Asset and Private Wealth respectively. Erik and Shannon, it's good to have you both back on the podcast.

Shannon Saccocia: Great to be here.

Erik Knutzen: Always great to participate.

Anu: So in the Solving for 2025 publication, the first two themes relate to the macro environment under the heading Going for Goldilocks, and the first theme suggests that 2025 could be a year of above-trend growth. Let's begin there. Erik, could you elaborate on some of those macro perspectives, and in particular, how industrial policy might contribute to growth?

Erik: Sure. As we look into 2025, while the politics may be evolving, industrial policy aimed at influencing production patterns will continue whether achieved via government spending and investment or tax policy, trade policy, deregulation, or other means. If inflation can be contained and we think it can, central banks can stand aside and allow economies to run a little warm.

That's a recipe for above-trend US GDP growth, and we think that can lift global growth more broadly. The debt and deficit implications and the question of whether capital is being well allocated may surprise investors by being manageable concerns in the coming year, even if that can loom larger as we look further out. Just to highlight some quick numbers, current consensus GDP growth expectations in the US are for about 1.8% real economic growth next year.

We already think that number should be probably 20, 30 basis points higher, and with the new administration's focus on growth including deregulation, continued areas of stimulus, and focusing on the more dynamic areas of the economy, we think that the US could experience real GDP growth in the 2-2.5% range next year, which is above long-term trend.

It is already expected that growth will improve in '25 in Europe and Japan, and with some of the significant policy announcements and efforts that the Chinese government and policymakers have proposed, we think that the risk of significantly worse growth in China is diminished. As we go into '25, policymakers are going to focus on improved economic growth for the coming year.

The second key component of our growth outlook is really expanding the soft landing by broadening real income growth. The incoming administration realizes that the most important goods that they need to deliver is improved real income growth and positive real income growth across the spectrum. That is going to be an important focus as we go into '25. That is also putting pressure on other governments to pursue similar policies. We think that will be a key element of the coming year.

Shannon: Yeah I think an important point, Erik, that you make is when you think about the stimulus that was put forth towards the consumer after the pandemic here in the United States. We really didn't see similar efforts outside of the United States. But interestingly, that tends to have a very short term impact. So we saw this huge boost in consumer spending as a result of the stimulus, but then there were questions as in our outlook last year about the sustainability of that consumer momentum.

And so this broadening out of real income growth is going to be critical. If you think about total labor force participation, it's actually been declining since the 1990s. But prime working age participation is at multi-decade highs over the course of the last couple of years. If you think about, what does that imply? It implies that number one, over 99% of businesses in the United States are actually small businesses, meaning they employ less than 500 people, 46% of private sector employees are employed by small businesses.

If you think about creating a more pro-business environment, if you think about creating an environment where smaller businesses feel just as excited and constructive on the economic environment as larger businesses do, then you start to really get not only that participation, but that real income growth for a larger percentage of the population, which creates a much more sustainable cycle of consumer spending and confidence than what we receive from a stimulus perspective.

Other countries are behind us because they didn't have that one-time lift on which to build, but I think the foundation that we have, and now this potential for this broadening out of income growth is really why, coupled with industrial policy, we think that we could actually achieve that above-trend growth next year.

Erik: I think Shannon hits some really important points here. I think what this highlights is that we have better visibility for positive growth in the United States. The key questions that we're going to be grappling with as we go through '25 is going to be, how does this translate into growth outside of the US? I think we have greater visibility on China, and they're still reserving some policy tools that they have that we'll see as the tariff discussions unfold. We have visibility into how Japan is going to continue to pursue growth, India and other parts of emerging markets.

I think a key question mark will continue to be Europe. How do they drive growth in this new global environment? And we're going to see a lot more in coming weeks with the situation in France and how they resolve their budget challenges with the election coming up in Germany and how they move, either positively or negatively, towards a more aggressive, least stimulative environment. I think that will unfold as we see 2025 come.

Anu: Yeah absolutely. We talked about the pro-business environment in the US, constructive macroenvironment, positive growth, and some uncertainty in different parts of the world, but generally a constructive environment.

Now, translating those insights into asset classes as we think about equities, the publication highlights an expectation for a broadening of equity markets and suggests that value in small-cap stocks might catch up with mega caps, which have run tremendously over the last number of months. Maybe, Shannon, if you could recap some of the key reasons for that viewpoint on equities and maybe share some specific indicators you're monitoring to identify this shift in equity markets.

Shannon: Sure, Anu. I think one of the things to just note is that we had a somewhat similar theme in our outlook last year, but I think the backdrop is different. And so if you think about what our concerns were coming into 2024, we were really concerned about the vulnerability of the valuations of those top 7-10 stocks within the S&P 500. And so we felt like there would need to be some semblance of mean reversion within that environment, given the fact that we expected some pressure on those valuations from additional capital expenditure into growth efforts, such as AI.

We have seen that. We have seen expectations come down for those earnings, and we've seen the delta between the other, say, 490, 493 stocks within the S&P 500. We've seen those earnings expectations ratchet higher.

Now, outside of the large cap space, however, it's important to note that we've also seen earning expectations for small-cap companies here in the US accelerate as well coming into this year. There are two things that we really thought about coming into 2024 that are somewhat similar. We expected there to be lower interest rates. We do anticipate that we're going to see lower interest rates, perhaps not as low as we thought we would coming into this year. And we also have seen continued disinflation.

Again, probably not down to the Fed's target, not down to those lower levels that we had anticipated, given the fact that growth has been more robust than anticipated, but we're seeing the opportunity for both of those things to impact smaller company earnings. More importantly, however, we've started to see this reacceleration in the economy, not only here in the US, but we're also seeing signs or glimmers of it outside of the United States.

And so if you think about the dynamic for broadening, number one, you need to have continued economic growth. I think we've set the stage for that. Number two, you need to have those earnings impulses in terms of lower rates and lower prices. We've set the stage for that as well. Number three, you need to have an opportunity for companies that haven't participated as much in the market rally over the last couple of years to get into the game. You think about financials, you think about industrials, you think about more cyclical parts of the economy. You spoke about value. Those are much better represented in the investable universes outside of the US than they are here in the US. They're much better represented in smaller capitalization than larger capitalization.

So if we anticipate this influx or impulse from industrial policy and we expect to see the fruits of reshoring, nearshoring, friendshoring really come to fruition in this period, those are the types of sectors that are going to benefit. We haven't even talked necessarily about regulation when you think about the opportunity in financials. So there are just a number of reasons that go well beyond the vulnerability of valuations and beyond mean reversion that lead us to an even stronger level of conviction as we move into 2025 for this broadening out.

Erik: Yeah you could see an environment in 2025 where you have a fairly tepid return for the S&P 500, which is dominated by this handful of mega-cap tech stocks, while the rest of the market actually turns in pretty good returns. That could be smaller company stocks. As Shannon said, we think it has the opportunity to spread to overseas stocks. It also could be the S&P 493, the S&P away from those Magnificent 7 stocks that could see very good results and strong growth in the coming year.

Anu: I think a constructive environment for equities, it sounds like. Maybe switching gears to fixed income next. Solving for 2025 suggests a shift in focus for bond markets from monetary to fiscal policy. Maybe Erik, back to you, if we can discuss that in a bit more detail and address some of the issues that you think will affect bond market volatility. And importantly, what does that mean for the fixed income opportunity set?

Erik: For more than two years, bond markets have really been dominated by inflation data and the responses of central banks. We think a reacceleration of inflation can be avoided next year, although, there's going to be a lot of headlines around concerns around inflation from tariffs and immigration and labor policy, et cetera.

But if that inflation remains reasonably contained, and we do think by the end of next year, core CPI in the US will be lower than we are now, still probably above central bank targets, but this will allow central banks to settle into a more focused approach to really debating, where's the neutral rate of interest? It's lower than here. Probably not as low as investors thought, say, a year ago. That will allow bond investors to shift focus to growth through the coming year and possibly deficits and the term premium question later in the year, and more likely into 2026.

The result will be moderately steeper yield curves from our expectation and a migration of bond market volatility from the short end of the curve to the intermediate and long parts of the curve. And what that tells us is we do want to continue to be moving away from cash as we do think short end yields will come down, it's likely that the FED's going to cut a couple of more times but there'll be a pause in there, and move out the curve, but the sweet spot really remains in that short to intermediate portion of the yield curve. Once you get out beyond the tenure point where we think we're about fair value right now, you're just going to get volatility without a lot of additional compensation.

So you know our themes as we go into '25 in the bond market is to really be focusing on that intermediate portion of the curve to take some credit exposure but credit spreads are pretty full. Valuations are full. Be ready to be nimble or opportunistic to take advantage of volatility or spread widening that happens in various parts of the credit market. Also take advantage of floating rate opportunities in areas like bank loans and collateralized loan obligations as investors can capture additional yield in an area where rates may not be falling at the short end as much as perhaps we thought.

Shannon: I think a great point that Erik just made is that being opportunistic, if we do see periods where credit spreads start to widen, because again, with our macro outlook being constructive, we're not as worried about the fundamentals, we're not worried about even pockets of increased defaults especially in higher quality credits but even in the top end of junk, if you will.

So what we're looking for is we're looking for those opportunities where we see that incremental spread widening. We feel confident and compelled to take advantage of that rather than being concerned that it's a reflection of macro weakness or something at a more fundamental level.

Erik: One element of that is that over the coming year, just as we said in equity, it is also possible and even likely that opportunities will move overseas in terms of the fixed income market. Now this is a lot about the dollar and the dollar has certainly been strong. We think that that dollar strength can continue for some time just as strengthened US assets more broadly can continue, but as we go through the next year and you start to see more convergence of economic growth expectations and relationships between non-US economies in the US, you could start to see the dollar soften.

It's important to note that in 2017, the first year of the Trump first presidency, the dollar actually weakened through that year after an initial rally. Frankly, to help industrial policy, the current administration wouldn't mind a little bit of a softer dollar, and that could lead to opportunities in areas like emerging market debt where there's pretty attractive yields on offer and also potentially in European fixed income assets as especially the central banks in Europe are going to need to cut probably more than in the US.

Anu: Great, thank you very much. You spoke about inflation potentially being contained, a lower rate environment. We briefly mentioned a more friendly regulatory environment as well. I want to transition to talk about the final theme in Solving for 2025, which relates to alternatives, where we suggest a potential surge in mergers and acquisitions.

Shannon, could you talk about some of the main drivers behind that trend and how investors can position themselves to benefit from this environment of an increased deal-making period of activity within private markets?

Shannon: Sure. So I think it's been an extraordinary period if you look at private market activity since 2000. It really has been multiple cycles in a very short period of time, and so one of the things that we really want to impart upon our listeners is that if you're just looking at this last four-year period as your private markets experience, you probably want to extend that time horizon and look at something that's more normalized. And normalized means that you have a pattern of realizations and distributions back to limited partners, and that is driven by, in many cases, M&A activity.

Why would we see acceleration of M&A activity? Well, number one, certainly the regulatory environment seems to have-- or likely to loosen over the course of the next couple of years. It has been very difficult for acquisitions and mergers to occur over the last several years due to a more challenging regulatory environment. As that starts to loosen across multiple industries, across most industries likely, we do anticipate that that will create this catalyst for activity.

The other thing to think about is that we've had two really strong years in the public equity market. Going back to 2022, we saw the declines in the public equity market, and private portfolio companies did not want to take their marks down in accordance with what we saw in the public equity market. Now you've had two really strong years. There's probably a better comparable for those valuations, and so we anticipate that that will get people a little bit more comfortable from a valuation perspective.

There's also buyers that are looking to acquire companies given their expectations of a more constructive economic environment over the next couple of years. If you think about those things together, this backdrop of stronger equity returns, the likelihood that there is continued pressure from LPs to realize some of this value.

Then finally, on the fundraising front, funds need to be raised. This lack of realizations is delaying the raising of new funds. It certainly kept levels down from where larger private equity managers, in particular, would like to see them. Catalyzing all of that, I think this is the year where you start to see companies determine what their valuation is and go out there and try to find buyers.

Erik: This trend would also potentially support smaller company stocks in the public markets. It's another potential positive.

Shannon: Right I think this has been something where many CEOs and C-suites have been potentially holding off because they fear that, "Why would I go down this road if I'm going to hit this regulatory impasse and not be able to get the transaction done?" That feels a lot less likely as we move into this next couple of years, given the GOP suite.

Erik: One other note, something we've been talking a lot with clients about is the need to be able to be a liquidity provider in these markets. As this environment starts to improve, again, investors who can allocate to private markets can be in a strong position to take advantage of this better environment. This includes in areas of private equity and private debt but also in real estate where we're starting to see better fundamental overall environment as marks have been adjusted to reflect higher rates and now that's beginning to shift. Broader pricing is reasonable and fundamental economic supports are there. And so we're seeing a better overall environment for investing in private equity real estate as well.

Anu: Terrific. Now just to begin to wrap up here, I do want to acknowledge that the new incoming US administration is expected, as we've been discussing throughout this episode, to implement a more pro-growth set of policies and a lighter stance on regulation. I do want to just touch on this for a second. Shannon, what are some strategies that investors should consider for navigating what are likely to be a number of policy changes? What are some of the market implications there?

Shannon: I think when you think about regulation in particular, there are certain areas that are likely to benefit from looser regulation. We've talked already about mergers and acquisitions. That really does benefit financials if you think about the ability to be back in the game. From an investment banking perspective that certainly is going to be exciting for many folks who are investing, particularly in some of the larger banks.

If you look at energy, energy policy is certainly going to become perhaps more supportive. There is some offset with that in terms of policy around keeping energy prices lower, so you're going to have to be very selective within that space.

The other thing to really consider is that there is this question of tariffs on immigration. If you think about the potential, as Erik mentioned earlier, our expectation is, is that inflation will be contained. There are some caveats there if we do see sizable tariffs, particularly on goods. Goods deflation has actually been a big force in terms of the disinflation that we've seen over the last 18 months or so. That could reverse some of the success that we've seen at the headline in core CPI levels.

Immigration, too, has certainly helped us. You look at how wages hit their cap and have started to move down on a year-over-year basis, that's benefited from this influx of immigrants and workers that we've seen over the last couple of years. In 2025, I think more of this pro-growth, less regulatory touch, that's really going to benefit. I think as you move into 2026, that's when you have to start to think about, could there be implications from tariffs and from immigration that could potentially put the inflation theory that we have at risk?

Erik: I'd add, and these are important points that Shannon's making, that it is unlikely that we see a significantly reduced volatility environment. 2017 was actually a very low volatility year, followed by Volmageddon in 2018 and significant, significant additional volatility episodes, particularly around tariff announcements.

I think that even while we describe an environment that is overall fundamentally supportive of investing for long-term assets, it is still going to be a volatile environment. That will have to do with policy announcements and perceptions or concerns around policies, whether it's tariffs, immigration, or geopolitical shocks in the known environment, as well as unknown potential shocks, so ensuring that portfolios are robust to volatility. And that can include, of course, good diversification, but it can include exposure to assets which are sensitive to inflation and are good diversifiers and uncorrelated strategies.

Shannon: Just to add, Erik, I think we would be remiss if we didn't acknowledge that volatility is also an opportunity which your group spends a lot of time thinking about in terms of being able to take advantage of that volatility, looking at the fundamentals and making those active management decisions aligned with our views.

Erik: Absolutely.

Anu: That is a perfect place where I think we can wrap up this episode, but I can't let you both go today without a quick bonus question, which I know is always Erik's favorite part of every episode that we record together. Today's question really invites a moment of career reflection, Erik and Shannon as the chief investment officers of Multi-Asset and Private Wealth respectively at Neuberger Berman. You're both esteemed leaders and senior investors. So with that in mind, I would love for each of you to share some of the most impactful career or life advice that you've received or perhaps advice that you've offered to others, reflecting on your own professional journeys.

Erik: Just to remind the audience, these are not scripted. We are genuinely surprised by these. I did turn this around against Anu one time and gave her a question, but I don't think I'm going to get away with that this time.

I think that as a lifelong investor, the best advice I got early in my career is to help investors continually focus on the fact that if they can truly maintain a long-term investment horizon, then that gives them an edge against many investors in the marketplace. There are few sustainable edges that investors can gain. It's hard to have information edges, it's hard to have other ways to take advantage of situations in the market, but maintaining that long-term focus and finding ways to use that in your favor, whether that's taking on liquidity being a funding source, being more opportunistic and nimble in volatile times, I think is very valuable.

It was very valuable advice I got early in my career and I reflect on often and share often.

Anu: It's a marathon, not a sprint, right? [chuckles]

Erik: Exactly.

Shannon: I would just say that one of the things that I've learned is that investment management is an incredibly humbling occupation. Being open, particularly in my world with private clients, being open to admit that you're wrong, showing some vulnerability and showing that you're learning from the mistakes that have occurred, even if they were "black swans" or outside of your purview, I really think that it makes you not only a more genuine partner for your clients, but I also think it allows you to grow over time in an environment where you are paid to be right, but unfortunately, we are often wrong.

Anu: We are all human at the end of the day. Thank you so much for sharing those sentiments and for your comments today on the themes that, again, have been outlined in the Solving for 2025 publication, which for our listeners, is available on our website, www.nb.com/solving.

We discussed a lot of really important topics today. The anticipation of above-trend growth in the coming year, opportunities assuming a broadening of equity markets, not just in the US and small caps, but also outside of the US, the potential impact of fiscal policy on bond markets, where Erik highlighted our interest in the intermediate portion of the curve and opportunistic fixed income, the multiple catalysts that we think will provide a ripe environment for private markets and uptick in M&A activity.

And of course, some of the expectations that we may see with the change in US administration beginning in January, 2025, but as you both highlighted, the potential for continued volatility and ensuring that portfolios are constructed with that volatility in mind.

Erik and Shannon, thank you again for being on the show and for the great conversation as always.

Shannon: Thank you Anu.

Erik: Pleasure.

Anu: To our listeners, thank you for tuning into Disruptive Forces in Investing this year. We wish you all a very enjoyable holiday season and look forward to continuing the dialogue in 2025. If you've enjoyed what you've heard today, you can subscribe to the show from wherever you listen to your podcasts, or you can visit our website, nb.com/disruptiveforces for previous episodes as well as more information about our firm and offerings.