We’re bullish, but brace for a ‘baker’s dozen’ of downside risks: 2025 market outlook

Equities investors can look forward to a largely bullish run for US stocks in 2025. Yet, investors would be loath to ignore a raft of potential downside risks during a Trump administration, stemming from a likely fractious Congress, a recent history of Fed policy missteps and unrealised corporate earnings, that could “derail the bull”, warns Federated Hermes’ CIO for equities Stephen Auth.

The global investment firm takes an overall optimistic view on US equities, anticipating a year-end target of 7,000 on the S&P 500 (and a 2026 target of 7,500) – adding at least a 1,000 points to the index, which currently sits a little under 6,000 – driven by continued strength in the large-cap growth stocks and a broadening out of performance to “everything else”: dividend-paying stocks, cyclical value stocks, small caps and emerging markets.

However, Auth does posit at least six potential downside risks that could temper any equities upswing.

• A fractious US Senate and House, given the Republicans’ razor-thin majorities in each and increasingly polarised views between and within the parties, could see key fiscal and economic legislation held hostage to political brinksmanship. Auth cited the reinstatement of the SALT tax deduction – ‘must have’ for the New York and California Republican delegations and a ‘must not have’ for some of those from the low or zero-tax states.“[The] weeks ahead are likely to be full of headlines around a deal being achieved, a deal being squashed and everything in between,” Auth wrote. “With the market hanging on the presumption of a full implementation of the Trump agenda, and the entire agenda probably being stuffed into one bill, the sausage-making exercise might be particularly unsettling in the near term.”
• Auth warns that forecast company earnings may not materialise, potentially impacted by a number of projected scenarios: for instance, promised tariffs disrupting supply chains, tax cuts being scaled back in the omnibus bill, and the potential for interest rates to stay higher for longer.“We think the earnings risks might be front-end loaded over our three-year time horizon, so we’ll have our antenna up high and fully tuned during the first quarter earnings season that is almost upon us.”
• Auth takes a dim view of the Fed’s recent policy activities, challenging its tardy response to the necessary hiking cycle in 2022 and more recent cutting cycle, as well as “backward-looking economic models built for perfect, academic worlds rather than real-time inputs”.Fed Chair Jerome Powell’s “reactionary mode”, he said, “[raises] the risk of yet another policy error ahead”.“Our present concern is that they keep rates too high for too long given the ongoing inflation rate, which seems lodged somewhere around 2.5% to 3.0%; the fed funds rate currently is a full 150 to 200 basis points above that. Worse, they might panic over a bad inflation read and hike rates, provoking a sell-off.”
• The runoff from the Biden presidency’s “unneeded” $7 trillion fiscal stimulus will, according to Auth, “could leave too big of a near-term hole to fill” for the Trump administration, and will demand some level of offsetting stimulus from the incoming administration. The timing of this stimulus could cause a “few economic hiccups along the way, which could prove market unfriendly”.
• Auth also warns of the “still alive” threat of bond vigilantes. He cited the UK’s 2022 bond market crisis (triggered by then Prime Minister Truss’s supply-side tax cut), which could befall the US.“If something goes wrong in the omnibus negotiations and/or we get an unexpected inflation spike, the bond market could react and take yields above 5.0%. If that happens, we’d expect equities to sell off, at least temporarily. “
• Trump has no shortage of outward confidence. Following the Republicans’ 2024 election sweep, the incoming Trump administration’s hubristic tendencies will no doubt be in overdrive. Auth warns that this over-confidence could lead to dangerous “oversteps”.Whilst noting that Trump’s prior experience through “political wars” should make him “more aware of the risks of an overstep”, ultimately, “an overstep is still possible in a variety of forms”. This could come in the form of a debt limit blowout, an “out of hand” China trade war or a tax deal stalemate leading to an “automatic, growth-killing tax hike”.“None of this is in our base case, but it likely passes the 20% probability hurdle and needs to be on our downside risk list.”

Auth also weighs up several “upside risks” not factored into its moderate bullish outlook, including fast passage of the omnibus Trump Agenda bill, delivering a “pro-growth agenda” by Spring, a considerable payoff from a successful “tariff war”, and a softening of the US dollar.

Ultimately, Federated Hermes sums up 2025 market as “a ‘baker’s dozen’ of risks, with an upside tilt.”

Resultingly, it has adopted a moderate overweight to stocks and a more modest overweight to cash/money markets, funded by an underweight to bonds.

“As we survey this risk landscape, we see a pretty balanced outlook, with a positive skew. With our multi-asset portfolios overweight stocks and money markets and underweight bonds, we are ‘barbelled’ against both sides of the risk scale,” Auth said.

“In our base case scenario, our big overweight to US stocks, particularly the laggards of last year, should produce a positive outcome, and an even better one if some of the upside surprises listed above come through. On the other hand, should one or more of the shorter-term downside risks occur, our cash position provides a buffer to add to stocks on a significant pullback.”