A Growth Mindset

For more than two years, inflation news was the prime mover of market prices; we think last week confirmed that a new dynamic is in play.

Following the consumer-prices shock of 2021 and 2022, markets were driven (if not fixated) on inflation and policy rate outcomes. While that story remains lodged in the minds of many investors and commentators, our analysis of the principal components driving current returns suggests that the market now assigns more importance to changes in GDP growth expectations.

Last Wednesday’s unexpectedly high U.S. inflation data was a significant test for this analysis, and the market took it largely in stride. That underlines our view that investors need to shift from an “inflation mindset” to a “growth mindset” to understand current dynamics.

Shifting Bond Market Volatility

Ashok Bhatia applied this logic to the bond market at the start of this year.

For the past three years, bond market volatility has been concentrated in the short end of the yield curve, because those are the bonds most affected by changing expectations for inflation and policy rates. In 2025, Ashok argued, the long end of the curve would express the volatility instead, as the market focuses on fiscal policies and their impact on interest rate and growth expectations.

Changes in inflation expectations remain important. However, it would take a severe and sustained pivot to rising inflation to return the market to the “inflation mindset” of 2022 and 2023, where it exerts a direct impact on the expected path of policy rates. Instead, inflation data is now parsed for what it contributes to long-term nominal growth expectations and long-dated real yields.

A Weak Growth Outlook Concentrated Equity Market Performance in 2024…

That brings us to the equity market. Nominal GDP growth is a key determinant of corporate earnings growth; and long-dated real yields are a key component of the discount rate applied to corporate earnings. Over the past 18 months, U.S. nominal GDP growth has been slowing as both inflation and real GDP growth have declined; today, it is running at about 5%. The 10-year real yield, however, has been rising; it stands at around 2.1%, which is the sort of level we were used to before the Global Financial Crisis of 2008, when nominal GDP growth was running at 6% or more.

That, together with the artificial intelligence theme, helps to explain the exceptional concentration of equity market performance in U.S. mega-cap technology stocks over the past 18 months. A rising discount rate combined with declining nominal growth led to relatively weaker broad equity market performance during 2024. That weaker broad performance was obscured, however, because the same dynamic forced a huge wave of capital to concentrate in U.S. mega-cap tech stocks—the one place where earnings growth seemed unstoppable.

… A Strong Growth Outlook Is Now Broadening Performance

Coming into 2025, the growth story has become more optimistic. Investors now appear to expect the gap between nominal growth and the long-dated real yield to close, as real GDP growth accelerates, inflation remains well-behaved and the real yield declines.

Much of that optimism is rooted in the outlook for the U.S. economy, where the consumer is confident, unemployment is declining, wages are rising and the Manufacturing Purchasing Managers’ Index (PMI) is surprising to the upside.

But this is not just a U.S. story. China’s 5% GDP growth rate for 2024, driven by a rebound in industrial output and retail sales in the fourth quarter, suggests stimulus measures are bearing fruit there, too. Europe’s PMIs have also been surprising in the upside, showing activity expanding at the fastest rate in six months. France’s government has managed to pass a slightly looser version of its budget and Germany’s “debt brake” is a live issue in the run-up to next weekend’s elections, raising the prospect of additional fiscal support.

The result, since the start of the year, has been notable outperformance from U.S. value stocks, Industrials, Financials, higher-quality U.S. midcaps and, especially, European equities. This is the broadening performance trend that we anticipated in our Solving for 2025 outlook and that made us “positive on equities but cautious on the S&P 500” in December.

Set Aside the Inflation Mindset and Adopt the Growth Mindset

If the driver of all that is the market’s growth mindset, it follows that the biggest risk to a continuation of this trend is a deterioration in the growth outlook rather than the inflation outlook—and we think it is particularly important to underline that observation now.

We have already mentioned rising wages and U.S. core inflation remaining sticky in the short term. Gold is trading at an all-time high. Surveys suggest that even longer-term consumer inflation expectations are stuck above 3%, and market inflation expectations are creeping upward. Most prominently, seemingly every commentator worries about the inflationary impact of tariffs.

And yet, aside from the prospect of tariffs, none of those things have knocked equity markets off course. And note that the sell-off triggered by President Trump’s tariff announcements was accompanied by falling bond yields—affirming, as Joe Amato wrote last week, that their growth implications are far more important for market prices than their inflation implications. The same pattern greeted the DeepSeek news three weeks ago, which was a potentially disinflationary development and a threat to earnings growth projections.

We think the initial sell-off following Wednesday’s inflation release was quickly erased for the same reason. Investors know that January’s inflation data has a seasonal tendency to overshoot, but we see the growth mindset at work here, too.

It is hard, given all that happened over the past three years, but in our view every investor must set aside the inflation mindset and adopt the growth mindset. Until you do, it will be impossible to see your way through the risks and opportunities of the year ahead.