2025 Market Forecasts, Interest Rates, and Economic Risks With Dr. David Kelly (EP.192)

0:28We all need to make smart decisions with our money. voices in economic and market analysis, Dr. David Kelly, Chief Global Strategist at J.P. Morgan Asset Management. If you're not familiar with Dr. Kelly's work, he is considered to be one of the go-to resources for financial professionals, helping cut through the noise of market headlines and focus on what truly matters for portfolios. In this episode, we're going to dive deep into how economic forecasts are built, how investors should interpret them, and what key themes are shaping the market landscape in 2025 and beyond. We cover everything from the role of forecasts in long-term investing, the potential impact of policy changes, and the risks and opportunities in today's market.

1:11Plus, Dr. Kelly shares his thoughts on rising interest rates, the national debt, and the ever-important question of global diversification. If you can't tell from this description, this conversation is packed with valuable insights for anyone looking to make more informed investment decisions. And as a reminder, you can find detailed show notes from the conversation at thelongterminvestor.com. And I'd also like to invite you to subscribe to my newsletter that comes out every other Wednesday with my latest work, free downloadable resources, and links to the most important things that I'm reading.

1:44To get to that newsletter, there is a link to subscribe in the episode description of your podcast app. So go there, subscribe now, and anytime you get one of those newsletters, hit reply and drop me a note. Tell me what you think. But enough from me. Let's get right to it. Here is my conversation with Dr. David Kelly.

2:06Dr. David Kelly, welcome to the Long-Term Investor. So glad to be here. Well, David, you put out some of the best work on markets, on the economy. It's something that everybody in the financial profession goes to anytime you're publishing. And I'm just kind of curious, we're in that season still where we're talking about forecasts. How does one go about making forecasts for the year? Well, I approach this as an economist and I've had a macroeconomic model of the U.S. economy, which I've been nursing and nurturing for the best part of 30 years. So what I try to do is look at the overall mosaic of data.

2:42There's not any one series, not like the unemployment rate or GDP growth. I try to look at it all, actually. And I have forecasts for some key variables like GDP growth or unemployment or inflation or corporate profits, but they all sort of feed into each other. And so you sort of build a picture of how the economy is progressing. And I think it's very important to have that broad view, looking at a lot of numbers, because then you're not too surprised by any one number. And very often one surprising reading, you know, say unemployment jumps up or falls sharply, it's not going to throw your forecast off that much.

3:15But it's really just working with a lot of data at the same time, because there's no series that's clean. There's no series that will tell you the full truth. And you just have to put it all together to try and get a picture of what's really going on. And when you put your forecasts out into the world, I realize that's your job to do this. But how do you feel like people should be using these forecasts in general? Like what purpose does the forecast serve? Generally, it helps keep people grounded, to be honest, because if you watch news shows on TV or particularly anything on the Internet, what they're trying to do is grab your attention by saying something crazy.

3:48and usually something crazy and negative. But that's usually not the truth. The truth is this is a kind of a boring economy. We're sort of in a post-cycle expansion. It's not like we're heading for a soft landing. We've actually had a soft landing for some time now. The economy is just sort of coasting along. But I think it's important for people to understand that and understand that we're not sort of on the edge of some economic cliff here. But also that people ought to really think carefully about the valuation of the stuff that they own. Because what's happened is we've had this very steady economy, but you can get some assets which get to push up to ridiculous prices by that.

4:24And so I think a lot of the risk is in markets, but not in the economy. What I want people to do is just look at the economy in a balanced, nonpolitical way and see it for what it is. But then also think a lot about where markets are given that economy. There's something I cannot wait to dig into a little bit more. But before I do, I want to note to everybody watching, to everybody listening, that we're recording the market is closed on January 30th. And so as we go through some of these conversations, we can't predict what's going to happen in the next two weeks that might change these. But I'm curious, David, there are a lot of potential policy changes that could impact a year like 2025.

5:02And before we get into those, I'm kind of curious, how do you feel like the economy in the market looks now? You know, what is our starting point? And then what sort of considerations and adjustments do you think through as you're putting out forecasts and just thinking about markets? Well, it's tricky. I mean, what you do is exactly that. You look at a baseline forecast of if nothing happened, if nothing changed in terms of policy, where would we be? And I remember last year in 2024, my forecast was actually 2-0-2-4. 2 % real GDP growth, zero recessions, the inflation rate coming down to 2 % and the unemployment rate holding at about four.

5:38Turns out that was pretty close to the mark, actually. The economy is just a little bit stronger. Inflation was a little bit higher than that, but not by much. And honestly, the baseline forecast, if we didn't make any big policy changes, is 2024 for 2025. It seems like we'd have a repeat because the economy's got enough momentum in terms of things driving consumer spending to keep that going and therefore keep growth going at about 2%. There's no particular shock outside of what we do ourselves. We can see that would cause the economy to go into recession. I do think that inflation would gradually come down.

6:10We're seeing shelter inflation, auto insurance inflation gradually ease off. That should bring inflation down to about 2%. And in unemployment, we've got good job growth, but we've also still got good labor force growth. And those are offsetting each other, keeping the unemployment rate about four. So it will be 2024 for 2025 if there weren't any shocks or policy changes impacting the economy. But of course, that's really going to be the story of 2025. Well, and so let's dive into maybe your viewpoints, or at least the framework for what you are thinking through as it comes to policy changes. And let's maybe start with what was supposed to be the sunsetting of the tax cuts and jobs acts.

6:47But generally, most people would agree it's going to get extended in some manner. How are you thinking through that, particularly as you go through these different models? Well, that's right. And I think I should preface this by saying that I really tried to leave politics outside the door when it comes to investment decisions. I mean, people have got strong political opinions and will continue to have them. But when I look at policies from the new administration and the new Congress, what are those things which affect our culture and our lives and a lot of other stuff? And what are those things that really affect the economy and financial markets?

7:17I focus on things that will affect the economy and financial markets. And that group is roughly the fiscal policy, which I'll talk about right now, which is the extension of the Tax Cut and Jobs Act of 2017 and any other tax cuts, but then also immigration, deregulation, and trade policy are all very important. But getting to your question on fiscal policy, I think we will, first of all, see a full extension of the tax cuts in the Tax Cut and Jobs Act, because if we didn't, you would actually be putting some fiscal drag on the economy in 2026. Now, yes, I think that it does make the debt and the deficit worse.

7:50The deficit's already close to$2 trillion. I think if we just extended the Tax Cut and Jobs Act in 2017, all those tax cuts, we'd stay at$2 trillion. has slowly rise all the way to about$2.5 trillion in the middle of the next decade. So I think that's almost a given with a Republican control of the House and the Senate and the White House that we'll see all those tax cuts extended. But over and beyond that, there were various promises that the president made on the campaign trail, removing the income tax from TIPS, overtime and Social Security, cutting the corporate income tax rate for domestic production from 21 % to 15%, putting in a new R &D tax credit, or allowing the full expensing of R &D and equipment purchases for domestic production, a tax break on auto purchases.

8:35You add it up, it's a lot. And I don't think we're going to get it all. But I think you'll get some of it. The way this is going to work is there's one bill that's going to go through Congress this year. It's the omnibus reconciliation bill for the 2026 budget. That is the vehicle upon which all these tax cuts are going to have to be placed, because it's the only financial bill that can go through the Senate and not be blocked by a filibuster. You'd get one bite of this apple every year. And so that's what's going to happen. Over the course of the spring and the summer, people are going to be putting in their own pet tax cuts onto this bill.

9:06It will therefore, I think, increase the debt. There'll be some efforts, some of them real, some of them not so real, to try to cut spending to pay for this or to try to use perhaps tariff revenue to pay for some of this. But net net, I think it will expand the deficit and imagine some fiscal stimulus in 2026 and beyond. So I think we will get bigger deficits, but also a stimulus to consumer spending, a stimulus perhaps to corporate profits or an increase in corporate profits, of tax profits because of a tax cut. So it will basically be stimulative in 2026, adding a little bit to growth, but also adding a little bit to inflation.

9:39You mentioned tariffs. I'm not sure that everybody totally understands how tariffs work, as well as what their impact can be on different economic participants. And tariffs are really a big part of the campaign language this election season. Can you explain a little bit about how tariffs work and their impacts on different parts of the economy? Yeah. So a tariff is an import tax. So you put a tax on imports coming into this country and it's normally on goods rather than services because that's just much easier. But all the goods that come into this country, you know, if we put tariff in those, the government raises a certain amount of revenue.

10:13But the prices that consumers pay for those goods, of course, goes up and that adds to inflation. But also when you put up those tariffs, people want to cut back on their spending on those goods because they can't afford to buy as much of them. So they tend to buy fewer goods. And sometimes over the long run, they will buy domestically made goods instead of the imported goods. And so you get some domestic substitution, which also further reduces our imports, of course, reducing also the tax revenue. That's how it works in sort of step one. But step two is you just put a tax on imports from other countries.

10:46they will put a retaliatory tax on you. And so then that's a real problem for exporters, because suddenly they can't export as much stuff or their goods are more expensive in foreign markets. The foreign consumers don't want to buy them. So they end up not being able to sell as much of the commodities and manufactured goods that they produce. And so the government may or may not provide subsidies to try and help them out. They certainly did under the first Trump administration, and that could cost some revenue. Meanwhile, while you've got a higher cost to import, higher cost to export. So trade diminishes overall, which tends to slow down the global economy.

11:19Economists don't like tariffs because in the long run, tariffs are a negative sum game. You get less trade, you get less economic growth, you get higher inflation. But also in the long run, it makes you less productive because sometimes it just does make sense to make something somewhere else. I mean, the dollar is too high. I will admit that. And I think we should do something about bringing down the value of the U.S. dollar. But are we really going to be manufacturing vast quantities of shirts and clothing here back in the United States? Or would it always be cheaper just to manufacture those overseas and import them and then use our labor to make more expensive items here and trade?

11:55Generally, countries flourish with strong trade and tend to stagnate if trade goes down. So I'm not in favor of tariffs, but that's roughly how they work. Well, that's really a nice, clear, concise explanation. And again, this doesn't have to be political. This is just economics. This is just, you know, what I was taught in school in general. You know, I think that over the years, of course, we've seen a realignment of political parties in a funny way. But generally speaking, people who believe in free enterprise don't believe in tariffs. So there had been a consensus in this country that tariffs really weren't a very good idea.

12:29And now the consensus on both parties seem to be much more willing to embrace tariffs than than was the case before. Well, and since the election, as the market is digesting some of these proposals, some of the promises that were made on the campaign trail, knowing full well that not everything gets implemented that's promised, but we've seen a pretty decent jump in long-term treasury yields. We've seen a jump in mortgage rates. I'm curious if you can share why you believe that this has happened and maybe how you might handicap long-term rates going forward? Well, yes. So if you think about the, and we haven't talked about deregulation yet, and we'll probably get to that.

13:06But if you think about the other policies, tariffs will tend to push up prices, cause you higher inflation. Fiscal stimulus in 2026 will also cause higher inflation. If you restrict immigration, and of course, we have to see how this plays out. But if you were to shut the door on all immigration, for example, as a hypothetical, which is not going to happen, but if you shut the door on all immigration, we'd suddenly have a huge labor shortage. because more than half of the jobs created in the United States in the last four years are now being occupied by people who were not born in this country.

13:35So if you have a huge labor shortage, you end up with higher wages. So all of it adds a little bit to inflation. Now, higher inflation pushes up long-term interest rates anyway, because you're going to lend somebody some money and the money is going to be worth less when you receive it later. You need a higher interest rate. You get a higher yield. Higher inflation means higher yields. But it also sends a message to the Federal Reserve. If you go back to last September, the Federal Reserve thought they would cut interest rates four times this year. And now they're down to saying they're only going to cut interest rates two times this year.

14:03And indeed, if you listen to the January meeting from the Federal Open Market Committee, it's not even clear that they're intending to cut interest rates two times this year. They have to be cautious because if inflation is higher, they're not sure they should be easing monetary policy anymore. So it's both in terms of directly what inflation does to long-term interest rates and also indirectly because of what inflation means for Federal reserve policy. And you mentioned deregulation earlier. How does that play into all of this? Well, deregulation can reduce inflation. But for example, there's a lot of talk about deregulating energy.

14:36And so if you have fewer restrictions on energy production, you might end up with greater U.S. production of oil and natural gas, which will push down energy prices, which of course is disinflationary. There are perhaps other areas. Financial markets could benefit from deregulation If you, for example, reduce the regulation on banks making loans or how much capital they have to hold, you could get more economic growth and that could possibly give you more growth and less inflation. So those things are positives of deregulation. But I think we need to pause and think a little bit about what deregulation means.

15:09So there's some things that aid financial markets. There's some things that might be good for the economy. But also, we're in a very weird time here in terms of technology. And you could argue that with completely new industries, such as social media or AI, there is actually a need for not blanket crude regulation, but actually rather intelligent regulation to try to limit the ability of these things to manipulate society in a way that's not a great idea or cause bubbles in markets. So everything that we regulate tends to reduce risk to some extent. If you deregulate, you may get more economic growth.

15:46You may also get lower inflation. but you also run the risk of a blowup. I mean, if you think about the crises that we've had so far in the 21st century, the housing crisis in 2008, the great financial crisis, was arguably caused by not enough regulation in the mortgage industry. You could argue that the pandemic had a lot to do with not being careful enough in terms of, obviously in this case, the Chinese, in terms of regulating their research into viruses, which is a catastrophic mistake. In 9-11, maybe, you know, not regulating the people who are getting on board planes. I mean, if you think every piece of this, right, in each case, it's sort of a failure of regulation.

16:22So there is a cost to a blanket deregulation, which I think we need to think about. We're perhaps not very good at regulating in a intelligent way, but every step in terms of deregulation can add to growth, maybe reduce inflation, but also may carry some risk with it. I really like the way that you frame up the thoughtfulness with that. I think a lot of people sometimes digest those terms in very black and white manners, but the nuance and the shades of gray can make a big difference. Another topic that people really seem to treat with black and white vigor is the national debt. It's always a common question that I get in my inbox, that I get from families, friends, clients.

17:00How do you think investors ought to think about the U.S. national debt? I think for as long as I've been studying U.S. economics, people have been worried about the national debt and talking about it as being unsustainable. But of course, it's grown over these years and it has been sustained. And I think it's sustained because people like to invest in government securities and government bonds, and they trust the United States will pay its bills over time. And they can't think of a safer long-term investment. I think that's allowed us borrow a lot over time. But I do worry about the size of the deficit.

17:33So we're running right now close to$2 trillion. It's very hard to see how you bring them down in a significant way without major cuts to spending or major increases in taxes or both. And so I think most likely, given our political system, the debt will continue to rise for some time, maybe for years into the future. At some stage, it could cause a crisis. And that is, of course, very worrying because if at any point global financial markets just believe that the U.S. will not pay on its debts, You could have a big spike in interest rates and a big shutter on an earthquake for the global financial system.

18:05But for the moment, I think that day is still somewhat distant. But I think we have to think about, first of all, in terms of policy, so long as we maintain Federal Reserve independence, I think that's very important in terms of maintaining the credibility of the U.S. federal government. And so long as we are somewhat careful in terms of how we extend the Tax Cut and Jobs Act of 2017 and don't allow just balloon deficits going forward, that gives us extra years in which to get our act together. So I think policy decisions made at this point are very important. In the end, I don't know what the percentage is.

18:38Right now, the debt is about 100 % of GDP. It could well go to 130 % of GDP 10 years from now. I don't know what that threshold is, but I do know that the location of that threshold depends on the trust people have in the US federal government. So maintaining our institutional integrity and the independence of the Federal Reserve and maintaining some semblance of an attempt to bring the budget into balance, I think those are all very important to put off the day at which the federal debt becomes a more serious problem. But even if we don't have a crisis, I do think that the level of federal debt, the amount of money the government has to borrow every year from global financial markets probably will keep long-term interest rates higher.

19:17So years ago after the great financial crisis, I think it was Mohamed El-Erian coined the very apt phrase that we were in a new normal. Well, we're back to the old normal in terms of higher long-term interest rates. And I think we will stay here. I think the new normal will not return because we just have got too much government debt and too much government borrowing to be able to borrow money that cheaply. I don't think we'll see those very low long-term interest rates again in our lifetimes. Well, does that have to be a bad thing? No. I do think that you have to try and stabilize the debt at some level.

19:47So oddly enough, as the debt gets bigger, you can still run a bit of a deficit and the debt to GDP ratio can stabilize. So you don't need to get the deficit down to zero. I mean, the deficit is the amount that you're spending exceeds your taxes in every given year. You don't need to get that down to zero. If we get that down to about four or 5 % of GDP, then the debt to GDP ratio could stabilize and you could live with that. It's not perfect, but it's okay. What's a problem is if you run a deficit of six or seven or 8 % of GDP and you keep doing that, particularly in good times, it could lead to a financial crisis.

20:18It could also leave you much less well able to deal with the crisis if it occurs. And, you know, we have seen economies where the central bank basically lost its independence, was printing money whenever the government said that they could print money. And it turns out very ugly. I mean, if you think about South American countries, you know, it's sort of the road to Argentina when the central bank loses its independence. So it's very important to maintain that independence, to try and maintain stable inflation and to have some level of discipline in terms of how big we live these deficits get.

20:48Well, and I'm going to continue to dig in here because I think it's just such a misunderstood topic in general. But as long as the Fed remains independent, the question is never really, can we pay our bills? It's more a question of, do we choose to? Because between the Fed and the Treasury, we can print the money necessary to pay our bills. But if politicians, we still have this debt ceiling that's antiquated and not really relevant to the way markets work. But really, I think when rates rise and please, I mean, tell me if you think differently, a lot of that, the fear of investors entrusting us, I think has more to do with will our politicians make good choices?

21:24Will they choose to honor their debts versus can we actually pay them? These are all dollar denominated debts. We can pay them. It's just a matter of how it happens. Is that a fair way to look at it? That's absolutely correct. I mean, there are decisions that we make on taxation all the time. For example, if you wanted to raise more money, you could do something on the step up and basis for capital gains or on estate tax or the higher levels of income tax. Or you could try and do stuff on the supply side to save people, you know, instead of being able to retire with full Social Security at 67, maybe you gradually add that up to 70.

21:56None of these things are popular, but there are things that you could do on both the spending side and the tax side to balance the books. The problem, as you rightly say, it's a political problem. In the November elections, I saw an awful lot of commercials, far more commercials than I wanted to see. But I saw commercials attacking one side as being eager to raise your taxes and another side as eager to cut entitlements and cut spending on Medicare and Medicaid. I didn't see anybody run a commercial saying, I'm going to cut the deficit by making tough choices and my opponent won't. Those ads were not run.

22:28And that's the problem. We vote against people because they're going to raise taxes or cut spending. But in fact, the only way to balance a budget will be to raise taxes and cut spending. Certainly not politically popular and certainly something we're not going to solve overnight. It's a topic that I have no doubt will continue to be discussed on podcasts like these and in meetings and in social conversations. But more timely, and maybe this will come and go over time, is the Magnificent Seven and the fact that it makes up such a large portion of United States markets. That has been something, I think, throughout 2024 that was brought to the forefront of a lot of headlines.