Adding more logs to the Yuletide fire

As we approach year-end and set up our clients' portfolios for 2025 and 2026, Federated Hermes' macro team yesterday shifted more funds out of Europe and Japan into the US and emerging markets. The moves reflect our bullish outlook on the domestic equity market post-election and a cautious view on international stocks. Europe, in particular, faces headwinds of slower economic growth, political uncertainty and the potential for increased defense costs and tariffs in the Trump presidency. In contrast, we expect US equities will benefit from tax cuts, deregulation and continued Fed rate cuts, reflected by our overweight allocation in large-cap value, small-cap value and small-cap growth. Our move yesterday from EAFE to US large cap growth neutralizes our only US underweight while taking EAFE to a significant underweight. Although we believe value and small cap will beat large-cap growth over the next two years, it seems clear that even the latter is likely to outperform Europe. For EM, the prospects for stimulus—particularly out of China—presents an enticing contrarian call.

This is a follow-through on our initial move out of international in early July, anticipating a Trump win would accelerate growth in the US to the detriment of Europe and Japan, while possibly serving as a catalyst for stimulus in EM. With these moves, we remain overweight equities by 400 basis points and money markets by 100 basis points, all funded by an underweight to bonds, which we see as having limited upside at current yields. Within equities, we remain tilted toward the broadening-out trade of domestic value and small caps, and are now neutral large-cap growth stocks. At the same time we are underweight international stocks but within international, heavily tilted toward EM.

Call it throwing another log onto the brightly burning Yuletide fire.

Readers of our last two market memos (Playing chess versus checkers and Equity market outlook for 2025 and 2026) have probably been expecting this, as it is the logical next move on the chess board.

To summarize our logic:

1. The US economy looks set to re-accelerate. While it was already running faster than other economies, the US under the second Trump presidency looks set to widen its lead. Given his landslide electoral victory and first-time experience, we think Trump's pro-growth agenda (lower taxes, less regulation, increased domestic energy production) is likely to be implemented more quickly than generally expected. So, our macroeconomic committee recently bumped our US growth forecast to 2.5% for 2025 and 3.0% for 2026 to account for the positive US policy shift.
2. Inflation is stabilizing near the Fed's 2.5% informal target. While still too high, it could be pulled lower by Trump's government cost-cutting efforts, lower taxes, lower regulatory costs and increased oil production. We anticipate fed funds to continue to decline gradually toward 3.0-3.5% by sometime in 2026, which with a more normal "term premium" would put the 10-year near present levels. The steeper yield curve, along with Trump's other policies, should support the broadening-out trade where we are overweight.
3. Europe, in particular, looks to be in a tough position. Trump will insist on more defense spending, worsening already tight fiscal budgets. He will also likely extract trade concessions. Political fragmentation looks set to freeze policy at a time when significant policy overhauls are needed. Longer term, Trump could be the catalyst toward the implementation of a Trump-like growth agenda in Europe, but the sausage-making is likely to be ugly, given the fragmented political environment. Forward growth in Europe looks likely to stall around 1%, giving European companies little help at the top line, even as regulatory burdens make corporate level and/or government level cost-cutting difficult.
4. Although US large cap growth stocks have already had a big run and are closer to fair value in our models, we prefer them to Europe's markets, which may be more of a value trap than a value opportunity. The US mega caps are unique across the world for their leadership in AI, their competitive moats, extraordinary growth and fortress balance sheets. Given their somewhat slowing growth and higher valuations, we don't expect them to outperform the broader US market as it grinds toward our 7,500 target. However, we do think they will likely outperform EAFE and hence have funded our "extra log" added to these stocks from our international positions.
5. Our add to emerging markets, also funded by sales of our EAFE positions, is something of a hedge. These are the cheapest stocks in the world and have been hammered most since Trump's decisive election win. However, unlike Europe, they are better poised to more quickly implement Trump-inspired reforms. China, in particular, is ruled by a powerful autocracy that could change the economic and even geopolitical trajectory with almost the waive of a hand. Massive fiscal stimulus, a domestic reform program and a rapprochement with the US could launch China, and more broadly the emerging markets, on a new growth path. We are not predicting this, but given the valuations, we are willing to fund this call out of a portion of our European underweight.

It's been a good year, for sure, and as we start wrapping the Christmas presents, investors have much to be thankful for. Trump's big win promises a renewed era of economic growth on top of the AI revolution that was already powering us forward; we've hit our longstanding S&P 6,000 forecast a year early; and still the broader market is loaded with relatively cheap small-cap, financial and cyclical stocks whose earnings look set to reaccelerate. Yes, a pullback is overdue and a scary blip down could happen at any time, probably driven by a bond event of some kind. For these, we have a cash cushion ready. But in the meantime, we are keeping the home fires burning and throwing a few more logs onto the hearth.

Merry Christmas and Happy Holidays to all! Look for our "Top surprises in the year ahead" memo early in the new year.