Reshuffling the cards

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2024 – another year to remember

2024 turned out to be another outstanding year for most equity markets (see Chart 1). Economic growth surprised to the upside – versus the U.S. recession that consensus was expecting – and major central banks finally started to cut interest rates. Against this backdrop and powered by a 67% surge of the Magnificent 7, the S&P 500 posted a total return of +25% in 2024. This was the first time since the late-1990s that the index had recorded back-to-back annual total returns of more than 20%. The strongest monthly performance was in November (+5.9%) after the U.S. election result. Equity markets also managed increases elsewhere. The STOXX Europe 600 rose by +9.6% and the MSCI Japan even advanced by +21.1% in local currency terms. Emerging markets grew relatively slowly, but the MSCI EM index still posted a solid gain of +8.0%.

Spurred on by the persistent excitement around artificial intelligence (AI), the Information Technology and Communication Services sectors globally showed the strongest performance of all GICS level 1 sectors with the corresponding MSCI ACWI indices both gaining 32% on a total return basis. Materials (-7.7%) was the only sector that recorded a loss in 2024 (see Chart 2).

Despite the general equity market buoyancy in 2024, there were bumps along the way. Geopolitics induced several market wobbles, particularly around April when tensions in the Middle East escalated. Moreover, it took longer for major central banks to commence their rate cutting cycles than many market participants had anticipated. There was also a brief but intense period of market turmoil in the summer as the combination of weak U.S. economic data and a BoJ rate hike led to the unwinding of JPY carry trades. Finally, equity markets slipped again after the Fed pivoted in a more hawkish direction in December: the Federal Open Market Committee (FOMC) delivered a third rate cut of 25bps, but its members’ dot plots signalled only 50bps of cuts for 2025. As a result, the S&P 500 saw its biggest daily decline following an FOMC decision since 2001 and broader equities have struggled to find a clear during the first trading days of 2025.

Concerns to monitor in 2025

Since the beginning of the year inflation concerns have risen again, reviving fears that the Fed and other central banks could have to keep rates higher for longer. Taken together with robust labour markets, expectations of higher public deficits and uncertainties around trade, such concerns had pushed long-end bond yields significantly higher around the globe (see Chart 3).

Consequently, it was a challenging start into 2025 for equities – particularly for more rate-sensitive segments. However, recent downside inflation surprises in the U.S. and the UK have allowed markets to take a step back a one-way trade on inflation and bond yields. Falling bond yields unleashed a significant equity market rally that brought the S&P 500 (+3.5%) clearly back into positive territory on a YTD basis and this was accompanied by a clear rotation back into the strongest performing sectors of 2024 (see Chart 4). The rally got further support from the start of Q4 2024 earnings season, with U.S. banks posting upbeat results that were largely driven by their capital market activities.

It is worth noting that European equity markets are faring better so far in 2025 – consider the STOXX Europe 600 (+4.1%), the FTSE 100 (+4.6%) and the CAC 40 (+6.1%). The DAX (+6.8%) has hit an all-time high with roughly one month until the German federal election (performance data as of January 22).

Q1 will bring several important political events. One big question will be how the new U.S. administration moves on tariffs, and which countries they focus on. Markets have reacted in various ways to recent tariff comments by President Trump and his incoming team, with continued uncertainty about the degree to which provocative statements will translate into actual policy.

The early German federal election is taking place on February 23. For investors, a key focus is the possibility of changes to the constitutional debt brake after the election, which in turn could enable a more expansive fiscal stance through more borrowing. But given that it usually takes a few months for a German government to be formed after coalition negotiations, that a policy change here currently seems unlikely (see below) and that it would take some time for any policy changes to be implemented, any easing in the debt brake in terms of implications is more likely be a story for 2026 or later.

In the meantime, central banks will stay in the spotlight in 2025. U.S. and Eurozone headline and core inflation rates are still lingering slightly above their 2% target levels and potential upward price pressures (e.g. from new tariffs) are looming. So another major question is whether the Fed and ECB deliver rate cuts according to market expectations, or whether this will be another year where market pricing proves too dovish.

U.S. exceptionalism still holds

Overall, we foresee a generally supportive equity market environment in 2025 with major economies showing moderate levels of economic growth. Earnings growth will therefore remain the primary driver for returns in the asset class. Against the backdrop of rising earnings across regions, we globally assume high single-digit returns on average for equities in the year to the end of 2025 (see Chart 5).

But we emphasize that this is still an uncertain situation: a fluid backdrop is characterised by plenty of cross-cutting themes which could trigger bouts of volatility. Interdependencies and reactions to changes in monetary policy and tariffs will have an impact on inflation, global trade and economic growth and thus determine equity markets’ trajectory. There will also be continuous reassessment of the political landscape in Europe and its fiscal policy implications, as well as of geopolitical developments.

The possibility of a higher level of dispersion across stocks, styles, sectors, countries, and investment themes might therefore emerge as a central subject for equity investors in 2025. De-coupling monetary policy paths, uneven disinflation progress and technological change/innovation could drive regional business cycle divergence. After a period of very narrow stock market leadership, this could open up a broader spectrum of investment opportunities, providing a more favourable operating environment for active management.

The equal-weighted S&P 500 just posted its longest streak of daily advances with more than two thirds of its constituents having climbed since data begins in 1928.

There is also quite a chance of a convergence trade, given extreme relative positioning and valuations divergences across regions (see Chart 6).

For the time being, however, U.S. equities may remain the centre of gravity owing to their macro and earnings advantages relative to the rest of world, at least until there is more clarity on trade, fiscal and geopolitical developments. While one should closely monitor the potential disruptive effects from excessively high bond yields, the lack of an adequate quality substitute to U.S. equities is likely to keep investors loyal to them.

Continuing global growth is coupled with a healthy U.S. labour market. Together with a broadening of AI-related capital expenditure, and the prospect of stronger capital market and deal activity should allow for among best-in-class U.S. earnings growth rates (see Chart 7). Consensus numbers currently indicate a 14% YoY increase of aggregate FY2025 S&P 500 earnings, probably again driven by the mega cap Tech space.

While the U.S. exceptionalism narrative could face headwinds further down the road, opportunities are likely to outweigh the risks posed by U.S. policy changes. The longer-term benefits of extensive government investment, greater deregulation and a more business-friendly environment (e.g. additional tax relief) may be underestimated, along with the potential for unlocking significant productivity gains. Hence, our long-term focus is on Financials and those sectors that are likely to benefit from a growth-enhancing environment, such as IT, Consumer Discretionary and Communication Services. The latter three sectors account for around the half of the market capitalisation of the S&P 500.

At just over two years old, the current U.S. equity bull market (+68% in USD) is also still relatively young from a historical perspective. Since 1935, the average U.S. bull market has lasted 47 months, during which the S&P 500 has on average gained 137% (see Chart 8). While past patterns cannot serve as a blueprint for future performance, this provides one argument that concerns around already-exceptional performance are not necessarily justified. Note that historical data also shows that stock markets rarely slide into a bear market without a pronounced slump in GDP.

Can the DAX defy gravity once more?

Germany’s leading stock index, the DAX, rose by 19% in 2024 and recently reached a new all-time high. It therefore significantly outperformed most other European country indices as well as the STOXX Europe 600, defying the gloom enveloping the German economy. The performance was largely driven by a small group of companies: seven companies contributed more than 18ppts to the DAX return, with the five largest companies making up almost 45% of the index market cap. Concentration risks have therefore increased and the DAX has become more vulnerable to earnings shocks from a few large companies and the biggest sectors. 

To extend the index’s rally in 2025, DAX companies also need to fulfil market earnings expectations, as the index valuation has climbed over long-term average levels. Expected 2025 earnings growth of 11% YoY is higher than for its major European peers. As in the last few years, aggregate earnings delivery remains very dependent on the contributions of just three sectors: Consumer Discretionary (which is dominated by automobile companies), Financials and Industrials. This combination of sectors is expected to generate two-thirds of aggregate DAX earnings per share (EPS). Market expectations for these sectors are all above estimates for the respective sectors in the STOXX Europe 600. As such, they certainly appear ambitious.

While we feel that Financials should be able to clear expectations hurdles in the current macro and yield environment, the earnings outlook for Industrials is significantly less clear. This is because it could hinge on future developments in U.S.-European trade policy. Six of the eight DAX industrials generated more than 15% of their revenues in North America in 2023, one generated over 40%. The sector’s quarterly EPS growth has thus followed YoY growth in German goods exports to the U.S. closely since 2010. Hence any new trade restrictions would hit the sector hard, even if a stronger USD provides some FX tailwinds.

New tariffs on German automobile imports are one topic for discussion. But expectations of subdued volume growth in 2025 suggest that earnings recovery will hinge on better pricing and higher unit margins. This seems already quite challenging amid, given sluggish Chinese demand and potential U.S. tariffs. In this context, it is worth noting that German IT and Communication companies also have significant exposure to the U.S. and could be negatively affected if the new U.S. government decides to target areas outside of goods trading.

Although the DAX is significantly more sensitive to global than domestic growth, domestic German developments still matter. Hence Germany’s snap elections on February 23 carry some risks. On the upside, as noted above, a new government could reform the constitutional “debt brake” and increase fiscal spending. This could stimulate economic growth and boost domestic and international investors' confidence in German equities. However, the conservative CDU and CSU sister parties, likely to head any new coalition, have committed to retain the debt brake in their recently published election manifesto. Furthermore, any changes to the constitution need a two-thirds majority in the federal parliament. Current polling suggests there is a chance that the AfD and BSW could win more than one-third of the seats in the new Bundestag and effectively block any constitutional changes. Such an outcome could dash all hopes for significant fiscal easing during the next couple of years. and probably weigh on risk sentiment.

The DAX NTM P/E ratio of 14.2 is currently 10% above the 10- year median (see Chart 9) with its relative valuation having significantly risen since the summer.

It is meanwhile trading at a 2% premium to the STOXX Europe 600 which is more than 2 standard deviations higher than the 10-year median discount of -12%. Also, the equity risk premium has declined significantly as of late. At 3.1 ppts it sits at a level last seen in 2010 (see Chart 10).

All in all, the fate of the DAX will depend on external factors. It should do well in our base case scenario of robust global growth, declining interest rates and slightly lower bond yields. But a range of adverse scenarios (e.g. trade disruptions, higher political uncertainty globally and disappointing fiscal dynamics in Germany) could materialise soon. Since valuations have normalised over the last year, they now provide less crumple zone to the downside. The outlook for the DAX is quite cloudy at the moment although one clear prediction is possible: volatility will rise. Last year the volatility index VDAX exceeded the critical level of 20 on just three trading days in the whole year (see Chart 11).

Q4 2024 earnings season update

The Q4 2024 earnings season is now well underway. As in Q3, hurdle rates have come down noticeably over the past three months, with aggregate S&P 500 Q4 2024 earnings growth estimates revised down by -2.1ppt since the beginning of October. Nine out of eleven sectors have seen downward revisions to consensus Q4 EPS growth estimates with Materials (-16ppt), Energy (-13ppt), Healthcare (-10ppt) and Industrials (-6ppt) having experienced the strongest cuts.

Given apparently accelerating economic momentum during Q4 and typically positive Q4 seasonality, this current assessment appears quite conservative. Better-than-expected Q4 earnings delivery could therefore result in a reassuring U.S. earnings season.

Seven sectors are expected to deliver positive YoY earnings growth for Q4 2024: Financials (+26% YoY expected), Communication Services (+23%), IT (+15%), Consumer Discretionary (+13%), Healthcare (+12%), Real Estate (+11%) and Utilities (+10%). By contrast, Energy (-31%) is expected to take the clear lead in terms of YoY Q4 earnings declines (see Chart 12).

On an aggregate basis consensus forecasts are currently pointing to a +10.7% YoY increase in S&P 500 earnings in Q4 2024 on +4.1% higher revenues. This would mark the six consecutive quarter of positive aggregate earnings growth for the index. The Magnificent 7 (Mag 7) are expected to see 22% YoY earnings growth in Q4, with the group now having beaten consensus expectations for seven straight quarters. While some broadening in terms of earnings contributions is observable, the gap between the Mag 7 and the rest of S&P 500 remains wide with S&P 500 ex Mag 7 earnings forecast to grow by only 5.3% YoY in Q4 (see Chart 13).

In line with a sluggish European economic environment, STOXX Europe 600 earnings expectations for Q4 2024 have been trimmed down by 9.2ppt since October and now suggest an earnings increase of 1.5% YoY (which, if achieved, would be the third consecutive quarter of positive YoY earnings growth). 

Consumer Discretionary (-45ppt), Materials (-27ppt), Real Estate (-21ppt) and Utilities (-20ppt) EPS growth forecasts have experienced the strongest reductions.

On a YoY basis all STOXX Europe 600 sectors except Consumer Discretionary (-25% YoY), Energy (-18%) and Consumer Staples (-1%) are currently expected to deliver positive earnings growth figures in Q4 2024. Real Estate (+77% YoY), Materials (+29%), Industrials (+19%) and Healthcare (+10%) are expected to deliver double-digit YoY earnings growth rates (see Chart 14).

Q4 2024 revenues of the STOXX Europe 600 in aggregate are expected to rise by +1.6% YoY. We believe that European earnings are more at risk than the U.S., despite considerably reduced earnings expectations, given the contrast between resilient U.S. expansion in Q4 and quite soft activity momentum in Europe.

In addition, European FY2025 consensus numbers are currently indicating a more pronounced earnings growth acceleration than in U.S. This seems overly optimistic – even after excluding potential trade issues and China uncertainty from the equation – given the significant real GDP growth spread that is expected to continue between the two regions. Therefore, we emphasize that U.S. earnings may continue to outperform European ones for the time being.