Odd Lots - Goldman's Hatzius and Kostin on Markets and Macro in 2025

Episode Date: December 2, 2024

It's trite to say that there is a high degree of uncertainty right now, for macro forecasters and investors. It also happens to be true. The new administration is promising major policy changes in areas like tariffs, immigration, and the size and scope of government. But even beyond that, there is near-term uncertainty over the outlook for the labor market and inflation. Furthermore, we're in an era of high stock valuations, high market concentration, and the AI wildcard. So in light of all this, we talked to Jan Hatzius, the Chief Economist and Head of Global Investment Research, and David Kostin, Goldman's top equity strategist, about what they're looking for in the year ahead. Become a Bloomberg.com subscriber using our special intro offer at bloomberg.com/podcastoffer. You’ll get episodes of this podcast ad-free and exclusive access to our daily Odd Lots newsletter. Already a subscriber? Connect your account on the Bloomberg channel page in Apple Podcasts to listen ad-free.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a very big line. It's a lot. It's a firm. commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio.

That's vanguard.com slash audio. All investing is subject to risk Vanguard Marketing Corporation Distributor. Podcasts Radio News. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Alley. Tracy, it's my favorite time of year. You know what?

I was going to say the exact same thing. I was going to make the exact same comment. It's outlook season. It's 2025 outlook season. And our inboxes get flooded with various flavors of big picture outlooks, micro picture outlooks, 15 things to watch for within the industrial and trucking segments of the economy. 15 big questions we have for- Here's a list of all the things Trump is going to make great again.

Yeah, all these things. And these are some of my favorite sell-side notes to read every year. But they always make for a thoughtful, something to do around this time of year. Here's the big question. Do you go back and look at the 2023 outlooks? I never do. People always in our industry joke about that. Like, let's go back.

And I've seen it happen twice. But on a serious note, I know the analysts who produce these outlooks, like, it is their actual job to try to forecast the future. But like, I find it so difficult, especially in the current context with so many uncertainties and the new administration coming in. I just, I don't even know how you begin to like try to figure out with the level of the S&P 500 is going to be under those like very uncertain conditions. Well, you know, most of the time stocks go up.

and the economy grows about two and a half or three and a half or something. That would be your outlook is like, well, stocks are probably going to go up. Stocks will go up and the economy will grow in two and a half, three and a half. Anyway, we have much better guests. Yes, we have people who actually do this. And are really, truly some of the best in the industry. And it is a real treat. We actually have them both together, which makes for an extraordinary opportunity. So I'm very excited. We have two guests, two of the perfect guests, I should say. We're going to be speaking. with Jan Hotsias, Chief Economist and Head of Global Investment Research at Goldman Sachs,

and David Koston, chief U.S. Equity Strategist at Goldman Sachs. David and Yon, this is such a thrill to have you on both at the same time and just talk about what 2025 is like because there's obviously a lot to talk about. I don't know, I started with you, Jan. Like, actually, do you accept the premise that it's a difficult time? It feels difficult. It feels tricky. It feels like there's a lot of questions and uncertainties.

Do you accept the premise that it's a unusual? usually tricky time to be making a short-term or medium-term forecast? I think it is a difficult time just because there's more uncertainty than normal about the policy environment. So you have all the usual uncertainties around whether the consumer is going to continue to spend, we think, yes. Whether inflation is going to continue to trend down X any new shocks. We think yes. Whether the Fed will still deliver cuts just based on the underlying trend in the economy and then you have to think about the potential impulses both on the positive and the negative side and obviously we'll get into those. But that just adds to the variability

around the central forecast. I have a lot of procedural questions when it comes to the outlooks. My first one is, do you guys like talk to each other before you do your respective outlooks? Because I imagine what the market does is obviously going to depend a lot on what the economy does. There are, I guess, nearly a thousand people in the research department at Goldman. Yeah, is the head of the research department. And within macro, probably 100 people. And we are pretty coordinated. Every week have a conversation about what's happening in the different regions around the world economically, in commodities, in strategy, and rates.

So we're pretty coordinated at the macro level. Do you ever disagree? We do. I do think that we spend a lot of time trying to get to the bottom of what the disagreement is about and that often brings views more closely together. I think in the end, we do try to present a coherent overall picture, but that doesn't mean that every nuance is exactly the same. I mean, I think there is sort of a spectrum between having just one view of the world

where there's zero room for individual kind of creativity and just having a bunch of people that have, independent views that are not coherent. You have to find a place somewhere in the middle. I think we're more towards the coherent side than what I see in many other research organizations where it's really more individuals than a team effort. We're going to get into all of the actual details, but I kind of like asking some of these procedural questions. Okay, so you make an S&P 500 forecast for the year 2025. You talk to clients, et cetera. You know, I can't imagine there are that many people in the investment industry. Maybe I'm wrong and tell me if I'm

wrong. Who's like, David says the S&P is going to X, so that's what we're going to buy or we're going to sell, et cetera. How do you view, like, what is your goal when you're talking to clients, when you're putting out a forecast for the S&P 500 and when you think about the value that you bring to clients from making these forecasts that Tracy and I love getting in our inboxes this time of year? Like, what are you hoping is the end fruit of that? Well, there's a variety. of customers or clients that we think about. And I would say framing the issues is probably the most important thing we do. Identifying investment strategies inside of the market is a big area of focus. We think about segmenting the clients of Goldman Sachs. We have hedge funds, mutual funds,

pension funds, insurance companies, endowments, sovereign wealth funds. Each of those constituencies are looking for something a little bit different. The mixed asset portfolio on the part of number of endowments and pension funds, sovereign wealth funds. They're quite interested in the index level because they think about the alternatives between equities and credit, private credit, public credit, commodities, private equity, et cetera. And so those are issues for those type of clients. If you're thinking about and I talk to and interact on a daily basis with hedge funds and mutual funds, they're focused on oftentimes investment strategies inside of the market. And those are some of the reasons. But in terms of your specifics on how you think about the index level, that is something

people think about broadly. Do they put more risk on or do they take less risk? Is the market going to pay for excitement or is it going to pay for boredom? How do you think about shifting your portfolio to reflect those? Those are basically the variety of conversations that we have on a daily basis. So this time last year, I think we were still, maybe not as much as earlier, but we were still kind of in recession expectation mode. And, you know, that obviously went on for like two years with the yield curve inversion and the surveys showing that the vibes were down and everyone worried that consumer spending would eventually drop off and that sort of thing. And yet here we are tail end of 2024. Recession hasn't emerged. The Fed is now cutting rates, which presumably

takes some of the pressure off. Jan, you were one of the economists who I think got this Right. You were in the soft landing camp, from what I remember when we spoke to you. What was it that you saw that kind of played out effectively in 2024? I'd say the key to the soft landing call over the last couple of years was, I think, to recognize that this is a very different business cycle that was much more driven by the pandemic and the post-pandemic imbalances that emerged really in 2000. in 2021 and climbing out of a hole that was really a supply side hit is very different from squeezing down inflation that had emerged because of an overheating. If you have an overheated economy and the level of activity is just too high and the level of demand is too high, to bring that back to normal, you almost have to have a decline in economic

activity, which is almost the definition of a recession. But if you're climbing out of a hole on the supply side and supply chains go back to normal, labor force participation goes back to normal, we get an additional boost to supply from immigrants coming into the workforce, and we'll get into some of these things. All of that means you can see declining inflation and increases in real output and employment at the same time. And that's basically what we've been seeing over the last couple of years. So for me, that's the most important difference. I think there was too much extrapolation from past business cycles.

And too many people looked at when inflation is at 5% or 6%, there's always been a recession because those were much more demand-driven cycles rather than supply-driven. cycles. So we're recording this, by the way, on November 26th, the S&P, as of the moment, I'm saying this, is that 6,004.72, extraordinary gains, nearly 26% gains from the start of the year. I guess I'm not surprised, David, that given this sort of easy mode disinflation that we had in 24, that we've had such a great year for the stock market, you have a call of 6,500 for your end 2025 target, which is about a little over 7.7% from where we are. How come? How much? So it's going to be, it's gains. And I, you know, I think a lot of people would be happy with a 7% gains.

You do that for 10 straight years. It's Joe's thesis that stocks go up. Yeah, but like, so how do you get there? All right. Let's talk about some of the building blocks for how we get there. Number one is earnings. And earnings are expected to grow in our model around 11% this year, meaning 2025, looking ahead. And about 7% in calendar 2026. So we've got a couple of years. And we've got a couple of years of continued expansion in earnings. How do we get the earnings? Well, we can think about sales growing roughly 5%. Most companies over time grow their sales and their revenues by roughly nominal GDP, so we'll call that around 5%. A little bit of margin expansion, and that's going to lead to the growth rate. Now, the growth rate of 11% is a little higher than that. You have some issues

around health care in particular. We are not expecting the write-off of so much in-process R&D, and so we get very specific about some things. But our model, would show around 11% earnings growth for the coming year. And we are expecting that the multiple actually come down slightly. Currently, the market multiples around nearly 23 times forward earnings. Market prices consensus, as opposed to our earnings estimates, which is a little bit below consensus. And the idea of the multiple declining Joe to maybe 21 and a half times is our model. So the bottom line, how do we get there? You're looking at 11% earnings growth. By this time next year, the market will be pricing off of the 2026 earnings. That's why we have to look.

look out for two years. And the idea of a market multiple or multiple of around 21 and a half times what is ultimately a 2026 estimate supports 6,500 is a target. So you're talking about earnings expansion. All of us presumably woke up to headlines this morning about Trump imposing tariffs on... Some of us checked the news last night before I went to sleep. Okay, well, I didn't. I went to sleep early. I was blissfully unaware of global politics and trade policy. But anyway, Presumably, higher input costs would eventually feed into corporate earnings. I guess is that on your radar at all? Well, it certainly should be as far as China tariffs are concerned.

I mean, we do expect a significant increase in China tariffs, and we're building in about a 20 percentage point increase in the average rate on U.S. imports from China. I think it's also pretty likely that we'll get some additional tariffs outside of China worth thinking auto tariffs potentially on Europe and Mexico. And then, of course, there were some announcements or threats of broader tariffs on both Mexico and Canada. You know, we'll have to see whether that ultimately happens. There is a renegotiation of the U.S.-Mexico or Canada trade agreement that will have to occur over the next couple of years. So I think there still will be a number of rounds before this actually

gets finalized. But clearly tariffs are the, in our view, the biggest risk to what otherwise is quite a positive outlook. I mean, we're pretty optimistic on the US growth outlook for 2025, where, you know, 2.5%. Again, half a percentage point or a little more above the current Bloomberg consensus, but we're watching the tariff situation closely, and I'm sure there's going to be many twists and turns before all of this becomes totally clear. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy.

Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income.

So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Eating well shouldn't be complicated. but somehow it turns into recipes, prep, clean up, and half your Sunday gone. Factors solves all that. These are fresh, ready-to-eat meals designed by dieticians, delivered to your door, and ready in just minutes.

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Hurry, this offer won't last long. Go to FactorMeals.ca and use code Fit. That's 11 meals, free shipping, and free sides for life, but only with the code fit at FactorMeals.C.A. Factor, Canada's number one ready-to-eat meal delivery service. Are tariffs inflationary? Because I could see it both ways, right? On the one hand, they throw sand into the gears, so to speak, of the global economy, and that is in a costly process, right? There's a readjustment, et cetera. On the other hand, I think new Treasury Secretary nominee Scott Besson made some quotes. They don't have to be per se inflationary because, yes,

imports may cost more, but then, you know, it struck me as sort of a monitor's framework. there's less money in households, and then that reduces demand elsewhere, and that brings prices lower. And so the overall price level or the rate of inflation doesn't change as much. As an economist, someone asks you our tariffs inflationary. How do you think through that question? I would say tariffs raise prices, and we can see that very clearly from when they have been applied, including some of the China tariffs in the first Trump administration. They fed through to prices in the categories, the relatively few categories where they were applied. This is a chart in your outlook that's really good.

So, yes, I would say that's quite clear. Whether that is ongoing inflation, that's much less clear because these are really price level effects. They're sort of like value-added tax increases in various European countries. We've seen this time and time again. There's a one-time increase in the price level, a one-time increase in inflation. But the inflation then drops out 12 months. after, assuming that there are no major second round effects through inflation expectations, then of course, central banks would become a lot more concerned if you did see a big increase

in inflation, wages, ongoing escalation. If there is a tit for tat trade war that keeps going, obviously that would also have a longer tail. But initially, it is a price level impact. David, I'm going to ask what is possibly an unfair question, but can you pretend to be the entire stock market right now and tell me, like, what is happening today? Stocks are up about 0.40 percent off the back, presumably, of those tariff headlines. We have like a drop in Asia stocks overnight, but U.S. stocks recovered pretty quickly. What is it that investors see here? Well, the biggest discussion point that I'm in having with portfolio managers has to do with the expectation that small business confidence is likely to increase sharply. That was the experience at the beginning of the first Trump administration. Actually, it started to happen between the election and actually the inauguration that took place

back in 2016, early 2017. It was a surge in small business optimism. And so the discussions are around the expectation that portfolio, managers have, that this is going to be a repeat of the last administration. And there's a lot of enthusiasm, the expectation that there's less sort of muscular antitrust environment, that there is a idea of small businesses investing. And that optimism is therefore likely to benefit a lot of companies whose customers are small and medium-sized businesses. And that's one of the investment strategies we have for the current year. We work with the individual analysts at Goldman,

and we've identified a group of stocks where more than 50% of their revenues are coming from small and medium-sized businesses. And so there's investment opportunities that we look at on the back of the expectation of a more robust economic or more positive business environment. And again, it's about the expectations, the perception of what is like it happened. And so with respect to your question, Tracy, that's the topic. Is that not necessarily the topic of today? Not necessarily, but that broadly in the last couple of weeks has been the central.

topic. Right now, the last NFIB survey was around the 13th percentile versus history, so quite low. And the expectation of many is that's going to surge in the coming months. You mentioned the regulatory environment. One of your other themes for 2025, and this has come up a lot as expectations of more liberal M&A regulatory environment, more deals being green lighted. I think we can understand that. You also are still bullish on the really big mega-cap stocks. And you said something in your 2025 outlook that I kind of take issue with. You said like the primary question for mutual fund managers over the last two years is whether they got the big mega cap story right, which is true.

But it's also true for arguably like 15 years at this point. Because really what we should have all been doing for the last 15 years is just by Microsoft and alphabet and meta and really ignore everything else. You're still bullish on them. What would have to change? What conditions would have to change such that the Mag 7 or whatever permutation is hot, maybe one pops in and one drops out? What would have to change for these handful of stocks to not be the big winners of the market going forward?

So, Joe, the driver of these stocks over the past decade has been superior earnings growth, superior sales growth, superior earnings growth in terms of the comparison with the rest of the market. And so that has been a terrific investment strategy for a long time. the largest company is really driving the index. Well, our analysis would suggest that most of the market, including the largest stocks, are trading around fair value right now and that it is earnings growth in the coming year that's likely to drive the performance of the market. Well, the superior earnings growth of these largest stocks is likely to diminish, in our opinion, in the coming year. So let's put some numbers around that. This year, calendar 2024, the largest

companies, the Magnificent Seven, as they're called, those companies had 33% expected, well, now expected because of the fourth quarter, but let's use that as a full year number. earnings growth around 33%, and that compares around 3% for the 493 remaining companies in the S&B 500. That's 30 percentage points excess growth rate. And the coming year, the expectations, views consensus for a moment, is around 18% versus 12%. That's a six percentage point gap.

So from 30 percentage points to six percentage. points and you look into 2026, and that's going to narrow yet further until around four percentage points. So relative earnings growth is going to be the explanation in our view of a narrowing premium return. And so if I put some numbers around that, very specifically, you had 63 percentage points of outperformance, excess return of the largest stocks versus the market in 2023. It's running around 22 percentage points this year. And our forecast next year is probably around seven percentage points. So the largest cap stocks likely to continue outperform in our view, but by a much, much smaller margin than has been the last couple of years.

I want to go back to what David was saying about animal spirits and maybe bring in Yan. And my question is going to sound very weird, but bear with me. Do animal spirits actually matter for the economy? And the reason I ask that is because, you know, for the past couple of years, the surveys have been coming in terrible. You know, if you looked at the consumer sentiment surveys, it was like the worst economic period ever or in many, many years. But the economy kept growing. Spending, consumer spending kept growing, yeah.

I mean, I agree. You have to take a lot of these survey results with a large grain of salt. There is also evidence that even relative to the pre-pandemic period where it was already a mistake to extrapolate one-to-one from surveys into activity, that that really, relationship has gotten even looser. And I think you have to be particularly careful with surveys that ask, how are you feeling, as opposed to what are you doing? If you take the somewhat more objective surveys that ask about production and orders and inventories and employment, you can put a bit more weight on that. But if it's really pure confidence surveys, you do have to be pretty careful. I mean, I agree that the small business survey is likely to show very large increase over the

next couple of months, but I would only feed a relatively small portion of that into our expectations on actual capital spending. We do expect, you know, some lift up in terms of CAPEX in an environment that is viewed as friendlier from a regulatory perspective, where we'll probably also get a bit of additional tax cuts. I mean, it's mostly about extending the 2017 tax cuts, but we do think there will probably be some additional fresh tax cuts. I think all of that is going to be supportive, but more at the margin. I don't think it's going to be a massive pickup. Overall, my basic view is the economy has been recovering at a generally better than expected pace, and I think that's going to continue if we're looking at consensus surveys going into 2025.

And that's largely priced into the market, which is now trading around 23 times forward earnings, which is historically a very high multiple. And that is reflective in our interpretation of the backdrop that Jan has described. There's obviously a lot of policy uncertainty, and we'll talk more about it with the new Trump administration and its visions and how seriously it's going to take tariffs and deportations and rebuilding American manufacturing, all these questions. There is a short-term uncertainty, however, which is that there's still some ambiguity about the trajectory of inflation itself. And at one point, it looked like a December rate cut was going to be a total lock. And actually, right now, it looks like, according to the market, it's like a 60-40

scenario. So it's not guaranteed. There are still some lingering questions about the inflation trajectory. Question to both of you, which is a, Jan, sort of like, where do you see this sort of short-term push and pull in terms of the rate trajectory? And then to David, how much when you think about valuation, specifically, is it contingent on some of these questions about what's going on with the further cutting cycle and so forth? On inflation, I think the underlying trends are looking quite favorable, and I base that not just on the actual price numbers, but also on the rebalancing that we've seen in the labor market. And we're basically back to where we were in 2019 in terms of the supply demand balance in the labor market, if not, a little.

bit looser. We've seen, for example, the clients in the quit rate and in some of the surveys of labor shortages to levels that are a little bit below where they were in 2019. We've seen deceleration in wage growth. All of that, to me, says that the disinflation process is on track. There is an upside risk, again, maybe more price level effect, but an upside risk from the tariffs, but X-that, I think we're on a path back to around 2% by the end of next year, which then because of our tariff assumptions becomes 2.4% in terms of our actual forecast, but X-that around 2%. And I think in that kind of environment, the Fed's going to say, you know, 4.5% to 4.3 quarter percent, that's still a very high nominal funds rate,

which will become a higher real funds rate as you go through next year. So I think they're still going to want to deliver several cuts. A December cut is our forecast. It's certainly not a foregone conclusion. We'll get some important data before then. And then we have ongoing cuts as we go through next year and we think ultimately will land in the low to mid threes for the funds rate, which is a bit below what markets are pricing now. But I would remind you that if you go back a couple of months, markets were priced for terminal Fed funds rate in the 2.7% range. So that was clearly very low relative to, you know, certainly what we expected. Now, I think the market's price may be a little bit higher than is appropriate in our view. So there's a lot of things happening

on the back of your question and the idea of investment strategies around inflation. What's the source of the inflation that may occur? And we can think about U.S. companies that are selling abroad compared with U.S. companies that are selling domestically. If you're concerned about tariffs and what that might be from a price level point of view, the risk of retaliatory tariffs is certainly there. And so owning companies whose customer base is in the United States, while, of course, along the supply chain, they may have increased the prices. The idea of those type of stocks generally doing better is part of our view. You can think about wage inflation as well. We have companies where labor costs are relatively low. And when I talk about labor costs,

I think of the wage, not just wages, salaries, and bonuses and stock-based compensation, and health care benefits, which, of course, in the U.S. are born by the corporate sector. And there are companies where that's quite low, relatively low labor-intensive companies, as compared with high labor-cost companies. And I think that's a area. Again, we're looking for strategies, investment strategies, around these different macro themes that Jan has described. And we talk about in our teams at COVID-Sax.

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to some of the stuff coming out of Donald Trump's mouth? And I guess the- True social account. Yeah. And I guess the consensus right now is you should take Trump seriously, but perhaps not literally. And I guess my question is, like, when does that change? Well, it certainly changes once you have actual government policies that can be implemented

during the transition, of course, that's not the case. So in terms of changing our forecast, you know, the hurdle now would be quite a bit higher than once we actually were back in the second Trump administration. In terms of providing a comment on some of these announcements or tariff threats, yeah, there's a lot of demand for that. And so we did write a comment on yesterday's announcements around the Canada, China, China, Mexico tariffs, but ultimately said some of this is very consistent with what we have been assuming, namely the China tariffs and maybe even a little bit lower than what ultimately is likely to

materialize. But then on Mexico and Canada, we would take this with more of a grain of salt because there will be a whole process around that renegotiation. And ultimately, we did have some similar tariff threats in the first Trump administration on Canada and Mexico, which ultimately didn't materialize because NAFTA effectively just became USMCA, but not with a huge number of changes. Think about it in terms of horizon arbitrage. There is lots of price noise that happens every day. And then there's investment themes that may be less connected with the administration, whether it's Donald Trump, Joe Biden, what have you, the idea of artificial intelligence, AI that everyone talks about. Well, that's really less affected by some of the, you.

government policies. It may be depending on the policies that get implemented, but the idea of more productivity growth or idea of more efficiency or the infrastructure build out relating to AI, those are some of the themes that are probably independent of the administration. These are the things that are happening in the technology world. And that's a discussion point that I look at with portfolio managers who may have a investment horizon that may be three to five years out, what stocks should they own, how should they position their portfolio as compared with maybe some we're focusing on the day-to-day announcements of tariffs, which may be implemented, may not be, that may be variable.

One thing I would just say is that on tariffs, this is to a large extent up to the president and up to the White House. So it does deserve more attention than some other policy pronouncements, which require Congress to hash out a reconciliation bill and ultimate tax legislation. So it is important to focus on the things when there are announcements that are effectively under the control of the White House. The Treasury Secretary nominee has, according to reports, been pitching Trump on this idea. 3-3s, improve growth via deregulation, smaller deficits, and more barrels of oil. Let's set aside the oil for a second.

Do you see any prospect of a meaningful change in the spending trajectory? trajectory, and do you see any meaningful opportunity for further pickup in trend growth from more favorable regulatory environment? So I think these are aspirational goals. They're both pretty ambitious. I mean, both a 3% of GDP federal deficit, that's not what we're expecting. That's not what the Congressional Budget Office is expecting. I mean, we think it's going to be closer to 6% probably.

Maybe we can bring that down. Bringing it down to 3% would be certainly very desirable. I think we'll ultimately need to bring it back down to something like 3%. And to bring the primary deficit, the ex-interest federal budget deficit, back down to somewhere around zero, depending on where growth and real interest rates ultimately balance out. But that's going to be a process. That's going to require an enormous amount of effort.

And that would take real political effort. to cut it to very sensitive areas of spending, right? That's right, because such a large chunk of government spending is basically entitlement programs, defense, and debt service. That doesn't leave a lot of discretionary non-defense spending. That's maybe a little bit easier to cut than some of those other categories. You know, 15% or so of total federal spending is, you know, non-defense discretionary. so a relatively small share.

And that then leaves the tax side. And obviously there's no desire to deliver a sizable tax cut, certainly not with this administration. So it's going to be very difficult. On the growth side, we're on the optimistic side of at least the economist consensus. If you take the Federal Reserve, the median longer term GDP growth rate is 1.8%. We're at 2.1%. maybe that can be lifted somewhat.

Getting to three, again, would be very difficult, especially given the demographics. If you have the labor force grow at only a pretty slow pace, not a lot of natural population growth because of low birth rates and probably much lower immigration. So even if you're a productivity optimist, and I would say I'm on the more optimistic side as far as productivity is concerned, getting to three will be difficult. Let's talk about immigration because as you pointed out, you know, tariffs are largely under the purview of the president. Maybe immigration is a little bit different. What's been the impact of immigration on the economy from the past, you know, three or four years or so? And how do you see that unfolding going forward, given that we don't really know what's coming. We could have mass deportations or we could have something, you know, around the edges or maybe nothing happens. So it's been very important in boosting growth and nevertheless bringing down inflation. So it's obviously a very controversial topic from a political perspective. But if you just look at the economics, if you bring more people into the workforce, especially at a time of very serious labor supply constraints,

and in particular very serious labor supply constraints at the bottom end of skill distribution in 2021, 122 in areas like bars and restaurants, you know, and other areas like that, construction, having that large influx of people has boosted growth and probably at the margin also helped to bring down inflation, at least has helped to bring down wage inflation in some of these areas to levels that are more sustainable. Now, there is already a deceleration in the immigrant inflow. If you look at it on a, you know, month on month kind of annual rate perspective. In late 2023, we were running above three million at an annual rate. We're now probably a little bit between one and a half and two million.

And that is likely to, you know, come down further, even before you see an additional tightening of restrictions on people coming in and increased deportations. You know, we'll see how large the deportations are ultimately going to be. If you go back to, say, the Obama administration, we were averaging something like 400,000 per year. I think it's probably going to be higher than that. But whether it's going to be dramatically higher than that, that I think is still less clear.

Yes, it is up to the executive branch. It's up to the president. But unlike with tariffs, there are going to be a lot more logistical issues around deportations and moving immigration. to much lower levels or into negative territory than with tariffs. With tariffs, it's administratively relatively easy. So if I'm thinking about supply the sort of growth negatives, tariffs on the one side

and then immigration on the other, I'm more worried about tariffs than I'm about immigration. David, you mentioned, you know, you talked to clients in one of the dominant conversations. Scott Besson gets named Treasury Secretary nominee. maybe his 3% deficit to GDP goal is very aspirational. Maybe some of his growth ambitions are aspirational. But it strikes me that, like, ultimately, he does not strike me as some sort of, like, major shakeup. We're going to totally rethink how the economy works, guy.

He sort of has a traditional macro background, seems to have very good understanding. When you talk to clients, how far does that go? You know, in terms of being able to think long term and avoiding the noise of the day-to-day headlines, the fact that Scott Bessent is likely going to be the Treasury Secretary, the fact that according to reports that just hit the headlines, someone fairly mainstream, like Kevin Hassett, is going to be running NEC? Is this the kind of thing that just makes investors? Do they get comfortable when they hear these headlines? What are those chats like? I would say that is a pretty good characterization of how portfolio managers are thinking about it

right now, based on his background, a number of people, myself included, known him for some period of time as a portfolio manager. And he's viewed, again, perception as sort of more mainstream. Of course, a lot of the policies will depend on the president. And so it'd be up to the Treasury Secretary and the other cabinet members to carry out those policies. And that remains, as theon indicated, some uncertainty around what those ultimately will be. So one of the reasons we'd like to talk to you is because you go out and talk to other people, too, your clients, portfolio managers, as you just mentioned. What are some of the more interesting questions that you are getting this year and what's maybe different to, you know,

this time in 2023? Well, it's much more around policy and much less around the underlying path of the economy. I mean, I think we're again going through beyond the policies which we've discussed a little bit of the concern around higher inflation. It's certainly true that the last couple of prints have been a little bit higher. We talked about it earlier. I'm I'm not super concerned about it, but it wouldn't be shocking if we saw the next few months a little bit of upward pressure. First quarter has been a sort of seasonally higher sequential inflation period, I think partly because seasonal adjustments difficult, especially post-pandemic.

And there is some residual seasonality, which we may see again. So there are definitely questions around inflation. there are questions around, you know, the longer-term neutral funds rate, our star, you know, to what extent has it risen relative to the pre-pandemic period. You know, our view is that it probably never was quite as low as many people thought in 2018, 2019. We were never that sold on the secular stagnation story. And, you know, it might not be quite as high as many. observers now think. I mean, we're still in the low to mid threes and nominal terms, low to mid ones in real terms. But there's certainly a lot of discussion around that. There's a lot of

discussion around Europe and the impact potentially of higher tariffs or maybe just the trade policy uncertainty in advance of any actual tariff increases on Europe. What is that doing to an economy that's already pretty soft? And it's an area where we're actually well below consensus. We have a 0.8% forecast for Euro area growth in 2025, which is four or five tens below the Bloomberg consensus or the ECB. And a lot of that is around trade policy uncertainty, which seems to have a particularly negative impact in Europe. So definitely another big topic of conversation. David, do you want to take a stab with the same question? Sure. There's a variety of things that portfolio managers are focused on right now. And the first is something you referenced earlier,

which is the idea of the largest stocks in the market are now representing more than a third of the S&P 500 equity capitalization. So the question is, you know, how does one position in that? You look at the mutual fund community, for example, 75% of mutual funds are lagging their benchmark. It's not a criticism, it's just of the data so far.

And those companies, what's been consistent about those funds, has been they've been underweight these positions in the largest stocks. And so the idea of perhaps having an index way, for the largest companies, and then choosing to generate alpha or seek alpha in the rest of the market is probably the better strategy. That's number one. That was something that the 25% of the mutual funds that are outperforming have tended to do. That's number one. Number two, relating to Jan's observation, it's a perpetual question of, well, what about these global

markets? Europe, Asia, China, Japan, is this their opportunity to outperform the U.S.? The relevant valuation metrics are really, really eye-catching, which is that the multiple, forward PE multiple for the U.S. equity markets now roughly 23 times, and it's about 13 times for Europe and Japan and China is even lower than that. And so that question is, well, for a decade, it's still been the U.S. Is this the time? Is the valuation gap so significant that the opportunity set at the lower end of the valuation scale, does that represent good opportunity?

So I'd say those are two major questions. The third question that is highly debated is on AI. And the idea is of the huge capital investments that some of the hypers and other companies making these investments, what will the ROI return on investment be of the AI that they're making? And so that is a question that's ebbed and flowed over the course of the year. A lot of the companies who are involved in the infrastructure buildout have done particularly well. those PE multiples have expanded and the share prices have done better

than the growth rate in the underlying growth of burnings. And so our focus has been on companies in the third phase as we think about it. The third phase of AI infrastructure buildout. First phase is Navidia. It's own kind of unique story. The second phase is the infrastructure. And the third phase is the companies

we think of whose revenues will be enhanced by AI and a lot of the software companies and their price returned this year have basically matched the earnings growth trajectory. And so the opportunity does exist there, in some cases, for a multiple expansion. So that would be an area of focus. So those are some of the topics that are debated with fund managers right now. Tracy, first of all, it feels like international outperformance is always one year away or two years. Oh, I know. We're always waiting for EM. We're always waiting for EM and Japan and Europe. One day, they're going to have their day.

But also, not to reference another shop performance, but I always love looking at the B of AML hedge fund survey. And one of the things they ask is, what's the most crowded trade? And it's always big tech. And it's always big tech that wins. And I think about how I'm glad I am that I'm not a portfolio manager and how sick to my stomach it would have to be that the big source of alpha, I just have to ride the most crowded trade. Anyway, I'm glad I don't have that job where I have to just do the same trade as everyone else to outperform. We're all glad, Joe. Well, actually, speaking of jobs, Joe and I came up with a contrarian trade idea based on AI, which is by Europe as a beneficiary of productivity enhancing technology.

Farma, chemical. Yeah, because their productivity is really low. Would that work? You guys should see the expression on David's face right now. He looks like he just bit into a lemon. No one likes our contrarian idea. Yeah, it could work. I think maybe you should think about it in terms of M&A activity and the idea of the

companies in the United States much higher profit margins. And the idea, I guess, Tracy, your hypothesis is perhaps their margin expansion would be potentially enhanced by the adoption of AI. There you go. That, you know, one question is on the source of the potential margin enhancement, is that labor-driven and you have more efficiency, therefore fewer jobs? Is that sort of orthogonal to what the objective are, assuming a lot of the European governments? And so I think there's some debate around that. Could it be a trade? I'm not a buyer.

Goldman isn't going to set up that index. John, do you have AI macro thoughts? And to my mind, there's potentially two ways it could go down. One is just the macro impact of all the capital spending. Does it move the dial at all in any sort of categories that are important on the top level? But I guess more importantly, you know, looking a few years out, when you think about productivity, when you think about labor growth, are we at the stage yet where you can make interesting predictions about the impact of this stuff?

So on the near-term impact, we generally have not viewed that as all that large. I mean, these are huge numbers in a very small part of the economy. But in terms of boosting near-term growth, it's very difficult to get anything more than, you know, a very small sort of tenth of a percentage point or something like that. And in terms of the broader impact on potential growth, I think we're also still probably saying. several years away, but then we're actually pretty optimistic when it comes to sort of late 2020s, early 2030s. And a little over a year ago, we raised our long-term potential growth estimate for the U.S. by four-tenths of a percentage point.

We were at 1.8% for the sort of years around 2030, we're now 2.2%, which is, no, that's a pretty sizable boost. And it's really driven by the fact that AI can replace a lot of the tasks, not necessarily the jobs, but the tasks within certain jobs that are being done at sort of low and mid levels of white-collar work at the moment. And that is ultimately going to be productivity enhancing. Of course, it does mean some labor market upheaval, although we would emphasize that the labor market impact is going to occur over a period of time. And there will also be new jobs that

will be created. So historically, when you go back, it's actually not that easy to find instances of technological unemployment that were visible in the overall economy. Typically, when you have large increases in productivity growth, those are actually typically low unemployment periods rather than high unemployment periods, even though at the individual job level or industry level, you might see quite a lot of job destruction. But overall, we're optimistic over the longer term, but in the short term, it's probably still going to be more limited. I can't wait to be a prompt engineer generating AI written podcast, Joe. That's our future. We kind of already are. We're already data providers. Yeah, that's true. David, I just have one more question, which is,

whose idea was it to write the equity outlook through the lens of lessons learned from the art of the deal? Well, last year we referenced Taylor Swift, and we said the subtitle of the report was, all you need to do is stay invested, and that was the strategy for calendar 2024. In reference to your first question of this podcast, you asked, does everyone look back and see what we wrote in the previous year? We certainly do and think about it as a report card. What was the impetus for the art of the deal and why we titled that or subtitled that for our 2025 outlook?

Part of it is the M&A environment and the idea that our forecast is for a 25% increase in M&A in calendar year 2025. That's part driven by our forecast of the use of cash of corporate America. S&P 500 companies will spend about $4 trillion of cash next year and a good portion of that. We have a 20% gain or increase in the... the cash devoted to M&A activity. So that was one of the impetus that thought about the Art of the Deal. And then it is remarkable. And for all the listeners of the Outlawouts podcast, I would suggest, you go back and read the

report, read the book. The Art of the Deal was written or ghost written perhaps by Donald Trump 37 years ago. And many of the characterizations of the transactions and his whole thought process was pretty interesting. So we went back, revisited that, my first edition copy for when I was way back in the the day. And that was the impetus for why we thought about that as an organizing structure for our outlook report. You have a first edition or you used to? In 1987. Wow. I'm going to have to go read it. I should read it. I will read it. Yeah, I haven't read it either. Isn't there a sequel as well?

Oh, there's many, many books. You think he stopped at one? We did reference. There's the art of the comeback that he wrote 10 years later, 1997, and a whole sequence of books that he's written. Oh, my gosh. Okay. David and Jan. Thank you so much for coming on oddlots. This was a true treat to have you both. And maybe I don't know, let's make it an annual tradition. We'll do it again next year. Thank you, Dr. Thank you for inviting us. Thank you so much. That was great. Thank you. Tracy, that was a real treat. That was really fun having David and Jan on together. I know. I wonder if they've ever like done an external appearance together like that before.

Or there's external media appearance. Yeah, that's what I mean. I guess we could have asked them. I'm sure they've spoken to clients together. Yeah, but that was really cool. You know, just one random thing that stuck out from me that I hadn't realized. Like I knew, or I had a good idea in my mind that the reason big tech companies have done so well is because they're earnings juggernauts, right? There's other things that go on, flows, et cetera, but like they make so much money and they're so large and yet they still put up like 30% numbers. It's insane. But I had not realize like, A, quite how wide that gap has been over the last two years between their earnings growth and everyone the other 493 stocks. And B, that the consensus is for a major shrinking in

that gap going into 2025. Yeah, that's right. Well, the other thing I was thinking was the differentiation between different Trump policies as well and like maybe dividing them up by how much is under the purview of the president versus like what things need congressional approval and where there are those sort of political limits and guideposts in place, I guess. Like, that's, seems a reasonable way to view some of these risks. I still think there's a lot of stuff up in the air. Yeah. And you know, it seems to me, and we sort of joked in the beginning that like the GDP usually grows like two and a half, three percent and stocks usually go up. And that's true. And it seems like even with the sort of some of the unorthodox or heterodox economic views

of the incoming Trump administration, the impacts right now expected to be marginal, right? So even tariffs aren't expected, if they go through as expected, aren't expected to have a radical change to say the inflation trajectory or whatever, and et cetera. You know, it seems like what people are anxious about, what you're talking about, maybe some clients are talking about, is the idea of, like, genuine policy uncertainty. And that means not a debate about 10% versus 20% tariffs, which is, you know, you shave some percent off GDP, you shave some earnings off and life goes on versus like the seeming potential for some genuinely radical rethink of how we do business with the rest of the world.

Yeah, totally. And I think that's like, that's a plausible thing. That's the big one, right? It seems plausible, yeah. Yeah. Well, in the meantime, sign up for our 2025 investment outlook titled GDP normally increases two to three percent and stocks normally go up. That's where we're going to title our newsletter on Monday when this comes out.

Let's do it. All right. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Allaway. And I'm Joe Wisenthall. You can follow me at the stalwart. Follow our producers, Carmen Rodriguez, at Carmen Armin, Dashel Bennett at Dashbot and Kale Brooks at Kail Brooks. Thank you to our producer, Moses, Ondom. For more Odd Lots content, go to Bloomberg.com slash oddlots. We have transcripts, a blog, and a daily newsletter. And you can chat about all of these topics, including macro, including markets 24-7 in our Discord. Discord.

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