A 'baker's dozen' of risks, with an upside tilt

Readers of this space know that every year in the first week of January, I publish a list of possible surprises for the coming year relative to our base forecast. I emphasize “possible” surprises, as the spirit of this exercise is not to throw a flock of black swans at the wall that have little likelihood of happening, but rather to focus on twists and turns that each have more than a 20% chance of actually occurring. Not our base case, but possible.

Some years the surprises weigh heavily to the upside, others to the downside. Our positioning in our multi-asset portfolios tends to run consistent with the perceived balance of risks outlined. When it has been skewed to the upside, we’ve been overweight stocks; in a few isolated instances when we’ve mostly seen negative possibilities ahead, we’ve been underweight stocks. 

This year, after reviewing my list of upside and downside risks with the entire Federated Hermes macro team, it’s best described as “A ‘baker’s dozen’ of risks, with an upside tilt.” This is fairly normal for a bull market, which needs a “Wall of Worry” as its essential fuel. Not surprisingly, our positioning is also balanced: a moderate overweight to stocks and a more modest overweight to cash/money markets, funded by an underweight to bonds.

First, to recap our base case outlook: bullish, with a year-end target of 7,000 on the S&P 500 (and a 2026 target of 7,500), which we think will be achieved by continued strength in the large-cap growth stocks being supplemented by a broadening out of performance to “everything else”: dividend-paying stocks, cyclical value stocks, small caps and emerging markets. This base case assumes close to full implementation of President Trump’s supply-side growth agenda, continued earnings improvements, particularly among small caps and “old economy” value stocks, and gradually lower interest rates from the Federal Reserve on the back of Trump’s deflationary policies (on balance). So far, so good.

Now let’s review the risks on both sides. We’re highlighting six for the downside list and seven for the upside, making the package a “baker’s dozen,” with an upside tilt.

Downside risks that could derail the Bull, at least temporarily:

1. Ugly sausage-making of the President’s agenda could challenge the post-election euphoria in the near term. As we listen to the endless array of senators and congressmen highlighting what aspects of a potential omnibus bill they like and which aspects they don’t, it strikes us that a lot of negotiating is already going on, with more to come. Given the Republicans’ razor-thin majorities in the House and Senate, practically each of these potential votes count, and what one wants is at times the opposite of what another wants. (As an example, the re-instatement of the SALT tax deduction seems to be a ‘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.) Given game-theory dynamics, it seems unlikely that either side will publicly back off their positions until the very final hour of the process. So, the weeks ahead are likely to be full of headlines around a deal being achieved, a deal being squashed and everything in between. 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.
2. Earnings might not come through. A lot of our market stance depends on earnings coming through solidly: $275 in 2025, $310 in 2026 and $350 in 2027. These forecasts imply a solid 12% annual growth pace, driven by strong economic growth, continued productivity gains driven partly by AI, lower corporate taxes, lower corporate operating costs resulting from the peel-back of the harsh Obama/Biden regulatory regime and improved cash flows driving buybacks. But there are plenty of reasons the earnings forecasted might not materialize: tariffs might disrupt supply chains, tax cuts might get scaled back in the omnibus bill, interest rates might stay higher for longer, etc. 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. The tone and guidance coming from these calls, on both the big tech side as well as the broader market, will be more important than usual.
3. The Fed could make (another) policy error. The Powell Fed has so far not instilled a ton of confidence in some of us. They were late, for sure, in starting the hiking cycle in 2022, misjudging how non-transitory the supply-constrained inflation beast actually was, resulting in a series of 75 basis-point hikes that nearly tanked the economy. Then they were late beginning the cutting cycle last summer, this time embarking (late) on 100 basis points of cuts in the back half of 2024; their tardiness provoked a brief swoon in the labor market. Their emphasis on backward-looking economic models built for perfect, academic worlds rather than real-time inputs tends to leave Powell’s Fed in a reactionary mode, raising 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. Ironically, the Fed’s higher rates are continuing to pressure the housing market, keeping owner-equivalent rents high, which is in turn keeping the inflation numbers artificially elevated. The Fed needs to escape this negative policy cycle, and our base case is they will, but only when “the data” comes in. In the meantime, there’s no guarantee, particularly since they now seem inclined to forecast fiscal policy direction under President Trump. (Again, a little ironic given their decision to ignore the demand stimulus impact of Biden’s $7 trillion fiscal bonanza which led to the inflation blowout even while the Fed was holding rates at 1%.)
4. The runoff of the massive demand stimulus of the Biden policy agenda could leave too big of a near-term hole to fill. Speaking of the $7 trillion in what, in most cases, was unneeded fiscal stimulus under Biden, a question still out there is what happens when this stimulus runs off? This runoff will be gradual (by some estimates, roughly a third of Biden’s spending spree has yet to hit the economy), but still will require offsetting stimulus from Trump’s upcoming supply-side-driven agenda; he is already talking about repurposing parts of Biden’s unspent stimulus funds to support his border/defense rebuild agenda. The timing of the one replacing the other could cause a few economic hiccups along the way, which could prove market unfriendly.
5. US bonds could have a ‘Liz Truss’ moment. One of the big events of 2022 that has started to fade into our collective memories was the crisis in the UK government bond market that occurred in a very short period of time when newly minted Prime Minister Truss tried to implement a massive supply-side tax cut, which might have undermined the solvency of some major UK pension obligations. Gilt yields shot 134 basis points higher, and the UK stock market plunged a scary 6% in just a few days. The crisis wasn’t resolved until Truss resigned and the promised policy change reversed. Although the US is not the UK for a lot of reasons, this alerted all of us to the “still alive” bond vigilantes. 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. 
6. Hubris within the incoming administration could lead to an overstep. Whenever one side wins big in our democracy, it seems it cannot help itself from falling prey to the natural human tendency toward hubris. This at times can lead to an overstep and explains why one of my favorite mottos in this business is “humility at the highs, confidence at the lows.” The good news is that Trump has been through the political wars before, and in all likelihood is more than aware of the risks of an overstep, either in policy or in one of his chess-playing negotiations. Ever the dealmaker, he’s also experienced at backing off and changing direction, at least some of the time. We’ll see. But an overstep is still possible in a variety of forms, either in letting the debt limit blow us up, a China trade war getting out of hand or a tax deal stalemate that leads 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.

Upside risks not in our bullish outlook:

1. The planned omnibus 'Trump Agenda' bill gets passed faster than anticipated. Careful readers of our outlook will notice that the big jump in earnings really occurs in 2027. This is not an accident. It is based on the assumption that deregulation and DOGE cost-cutting will take time, that the border fix will take priority over the tax cuts and that the full “Trump Agenda” will be implemented over two years, not three months. If on the other hand, the President can herd the Republicans tightly, as he did on the recent House Speaker vote, and if the DOGE gets moving in the timeframe that Musk is talking about, it’s possible that most of the pro-growth agenda could be in place by the spring. If so, markets would probably rip higher.
2. ‘Tariff chess’ works out better than forecast. How the coming tariff wars work out is an unknown. The optimists, including ourselves, are assuming that much of the inflation pressure of higher tariffs is absorbed by the foreign suppliers, not the US consumers, and that the resulting increase in US investment at least offsets these negatives. In an upside scenario, the negotiations could go better than expected, and prove not a neutral for the US economy, but a net positive. This is certainly what the President’s team is aiming for. So, we’ll see. But there surely is a greater than 20% chance that the tariff war outcome is more positive than the relatively dim expectations of even the market bulls.
3. Inflation drops and the Fed’s forward (lower) policy path becomes firmer. Right now, most market pundits are running with the Fed’s latest forecast, which is for inflation to remain higher for longer resulting in fewer rate cuts ahead. So any downside surprise on inflation could provoke an up-move in markets. We see reasons to believe this could happen. First, the roll-off of the early months of 2024, which saw three straight months of 0.4% monthly Core CPI growth, is likely to bring the trailing year-over-year inflation numbers in. Second, a Mideast peace deal (see below), along with loosened federal constraints on oil and Liquefied Natural Gas (LNG) production, could bring oil prices, and inflation, down. Third, the overheated rental market could soften up as new supply comes on board, bringing down a key component of the recent higher inflation readings. Any combination of these that spark the Fed, and the economic consensus, toward a lower terminal rate on fed funds than the nearly 3.5% level currently being assumed, would be market positive.
4. The IPO/mergers market heats up. With a more pro-business, pro-US corporation regulatory regime on the way, it seems likely to us that after four years of lock-down, the capital markets for IPOs and for mergers and acquisitions could heat up quickly. That would boost animal spirits and valuations and lead almost certainly to higher levels of the market, particularly among the small-cap and financial stocks that have only recently begun to participate in the bull. This is an upside surprise that could come quicker than anticipated, since “tone at the top” matters so much within a regulatory bureaucracy. Already we’ve had the lead, left-leaning, anti-corporate regulators at the FTC, SEC, and now the Fed, resign. And Trump is not even in office yet…
5. Geopolitical risks decline in Ukraine and the Mideast. With Trump on the way, and a firmer hand overseeing the US military machine, it’s possible that the “intractable” wars in Ukraine and the Mideast might finally end. Already, peace deals seem to be stirring, and the President is not formally in charge yet. Settling both these wars unexpectedly quickly, while not in our base case, is actually possible. If so, it would spark global economic growth through the rebuild effort in both regions, along with lower commodity inflation. Markets would react positively.
6. The DOGE movement could go global. In my most recent December trip to Europe, the tone abroad was very different than during the years of the first Trump presidency. Instead of “How could you possibly vote for this guy?,” the broad sentiment seems to be more like, “I wish we had one of him.” The US is not the only G-7 economy being held back by excessive regulation and overreaching central governments; in fact, things are far worse abroad, particularly within the moribund European economy. With elections coming up in Germany and France, it’s possible we will experience a sudden shift towards a pro-growth agenda in the most unexpected of places, the European continent. That would be an unexpected boon to the global economy and to the many global US companies with operations there.
7. The US dollar could begin to soften. While US tourists abroad enjoy the present strong dollar environment, US exporters and US trade flows are negatively impacted by the current level of dollar strength. With the dollar approaching parity with the euro, it’s at least vulnerable to some form of a pullback. Dollar softening could be sparked by any number of the upside risks highlighted above, including unexpected European economic strength driven by supply-side reforms there and/or a Ukraine peace settlement, unexpected resumption of Fed rate cuts driven by lower US inflation readings or unexpected decline in US trade deficits resulting from Trump’s tariff negotiations, which would reduce the supply of US dollars abroad. Because negative net exports are a direct hit to GDP growth, a reversal here due to a weaker dollar would boost US GDP and earnings. Stocks would react positively.

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. 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.

Either way, the year ahead promises more volatility, we think, than 2024, which is often the case when expectations are elevated. So get ready; even bull markets have corrections. “A baker’s dozen” implies plenty of excitement in this new year.