Could inflation burst the stock bubble in 2025?

As a new year approaches, the world is preparing for a new administration in the US that is sure to shake up domestic policy and, consequently, the economy of the world's biggest superpower. Despite some testing economic and geopolitical conditions, 2024 has turned out to be an overwhelmingly positive year for the US stock market. Finding ever-higher highs of late, the two big indices (the S&P 500 and Nasdaq 100) are up 28% and 33%, respectively, and many expect them to grow further in 2025 under a dovish Fed and business-friendly Trump White House. In spite of the vigorous growth over the past 12 months and some isolated sectoral bubbles, there are still plenty of opportunities for further gains in a number of sectors.

There is, however, a potential threat to equities' success, and it's probably something many had forgotten all about: inflation. That's right, the risk of price pressure is on the rise following a series of rate cuts by the Federal Reserve. On top of that, Fed Chairman Jerome Powell has committed to continuing with monetary easing for the foreseeable future. So, what does this mean for long-term stock plays, and what factors beyond inflation should investors look out for when trying to shield themselves from any potential downside?

Take the lead

We've already identified the spectre of rising inflation as one of the biggest threats to the continuation of the stock market boom of the past year and a half, but the mechanism of how that works is more complex than it first seems. Of course, higher prices of goods and services mean ordinary investors will have less disposable income to buy stocks, but the rate of organic inflation will also influence the Fed's monetary policy in a sort of negative feedback loop. As inflation rises, Powell will be forced to consider interest rate hikes that will, in turn, make risk assets like stocks even less attractive.

Naturally, however, the US regulator will look at more than just price pressure data when making its decisions. For this reason, it is wise to stay ahead of key leading indicators like the labour market for hints at where policy could be headed. The latest non-farm payrolls and JOLT reports show that the jobs market is continuing to cool steadily while layoffs remain at multi-year lows and voluntary resignations hit new heights. Even in the face of an uptick in inflation, the Fed will be looking for a significant change in this dynamic before pivoting back to a hawkish stance. For now, the consensus seems to be that the labour market situation will allow for one more rate cut before a "wait-and-see" approach is adopted in 2025. While this will help buoy stocks in the short term, what happens in the new year is still anybody's guess, though watching the key indicators will help you be among the first to anticipate it.

Down to the detail

While price pressure is surely a core metric affecting the values of the stock market as a whole, it is fairly low down the list of factors influencing individual stock prices. Assuming there is no hyperinflation or market-wide black swan event, it's more than likely that we will see winners and losers in the equities markets in 2025: Some sectors and individual tickers will outperform, while others will lag behind.

One major determining factor in this will be the policies of the Trump White House. The incoming Republican has made clear his stance on oil, gas, cryptocurrencies and US-based carmakers, which means we can expect these industries to fare well over the next four years. With the appointment of Elon Musk as head of the new Department of Government Efficiency, Tesla can also be added to this list. Meanwhile, AI and semiconductor firms like Intel and NVIDIA are already enjoying an organic boom, as it were, but Trump's anti-China stance will see stateside chipmakers capitalise even more on this natural momentum.

Conversely, we would do well to prepare for further depression in previously hot sectors like green energy and renewables, which saw huge, unsubstantiated gains after Biden was elected in 2020 and are still reeling from the subsequent correction. Last but not least, the Q4 earnings season will undoubtedly give us strong clues as to the future fortunes of individual companies, and there's truly no better way to make an informed choice about which specific tickers you would do well to include in your long-term portfolios.

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