The stock market hopes for a significant interest rate cut and strong profit growth in 2025, but both are not possible. Wall Street and the Federal Reserve need to reach a consensus.
In short, analysts expect corporate profits to increase significantly in 2025, indicating strong future economy. Meanwhile, Federal Reserve officials are preparing for the first interest rate cut, in response to the slowdown in the job market and inflation. Clearly, the two cannot coexist, as Joe Mazzola, the head of trading and derivatives strategy at Charles Schwab, puts it, "There will always be a compromise."
Our view is that Wall Street may make concessions. First, let's take a look at the current situation.
The Federal Reserve is preparing to lower interest rates on September 18, which will be the first rate cut since March 2020, in order to curb rising unemployment and prevent further weakness in the labor market. According to the latest pricing in the futures market, the federal funds rate may fall to between 3% and 3.25% by December 2025. This means a rapid decline from the current level of 5.25% to 5.5%.
Meanwhile, investors are quite optimistic about profit growth. Analysts predict that the profits of the S&P 500 index will grow by over 15% in 2025, higher than the expected growth rate of 12.8% at the beginning of this year and the projected growth rate of 10.7% in 2024.
Mazzola believes that expecting such strong profit growth at the same time as eight rate cuts is "futile." After all, the reason why the Federal Reserve is cutting rates is because the unemployment rate is starting to rise and is expected to continue to climb, while inflation is slowing down. If consumers feel pressured due to the slowdown in the labor market, their consumption may decrease, thereby impacting corporate profits.
Jack Janasiewicz, Chief Investment Strategist at Natixis Investment Managers Solutions, also points out that the strong profit expectations are at odds with the recent decline in inflation.
In the end, if future data continues to show a weak US economy, Wall Street analysts will have to revise down their profit expectations for 2025.
The question is, when will this adjustment happen? Mazzola believes that analysts may start lowering expectations after the company releases its third quarter financial report in October. However, there is reason to lower expectations now. For example, executives from Goldman Sachs (GS.N) and JPMorgan (JPM.N) have hinted that the financial situation is deteriorating, especially in terms of trading and net interest income. The Chief Financial Officer of consumer lending giant Ally Financial has also warned that "credit challenges are intensifying" and borrowers are struggling due to "high inflation" and "recent deterioration in the job market".
Some well-known retailers, such as Walgreens and Target (TGT.N), have recently announced price cuts to alleviate long-term inflation pressures, which may prompt companies to lower profit expectations and quickly change Wall Street's optimistic outlook.
The stock market could also be impacted by this, especially considering the current market valuations are not low. The S&P 500 index trades at a price-to-earnings ratio of 20 times expected earnings in 2025, slightly above historical average levels. Therefore, even after recent market volatility, investor expectations for next year's earnings may still be overly optimistic.
Another potential variable is that Skyler Weinand, Chief Investment Officer of Regan Capital, believes that the Federal Reserve may not cut interest rates as frequently as the market expects next year. The Fed will only lower rates at each meeting in 2025 if the unemployment rate is well above 5% or if there is a major economic or market crisis. He predicts that the Fed may only cut rates five to six times.
In summary, there are concerns about profit or interest rate expectations, and this misalignment has not yet been reflected in stock prices.