US, Europe face economic and market risks this year

The US economy entered the year on an upswing, but it faces plenty of question marks in 2025.
GDP registered 3.1% annualized growth in the third quarter, and 2.7% is expected for the fourth quarter.
But it’s unclear whether those kinds of numbers will continue. On the consumption side, things look pretty good. Wealthy Americans have opened their wallets to keep consumer spending humming.
A tax cut may well be coming, which should stimulate growth. But that also would risk lifting prices excessively. Already the Federal Reserve has had trouble pushing inflation all the way down to its 2% target. The central bank’s favored inflation indicator rose 2.4% year-on-year in November.
Without spending cuts to match tax cuts, the budget deficit would continue to soar. And spending is more likely to rise than fall. The deficit totaled $1.83 trillion last year, or 6.4% of GDP. That acts as a drag on the economy by crowding out private investment and boosting inflation.
Then there are tariffs. Increases of up to 60% have been threatened, but it’s unclear what will ultimately happen. Theoretically, they could boost the economy by protecting U.S. companies from cheaper imports.
Tariff impacts on small company
Tariffs could particularly help smaller companies, because they aren’t as dependent on imports as their larger brethren, the thinking goes. If smaller- and mid-size companies thrive more than large companies, that could boost their stocks. This would mean a broader stock market rally.
The problem there is that smaller companies can be just as dependent on imports as larger ones. Bicycle makers, for example, acquire crucial parts overseas. Already, the Russell 2000 Index of small-cap stocks has slid 10% since late November.
There is also talk that higher tariffs could help shrink the budget deficit. Say the US imposed a new 5% tariff on all foreign goods, and imports dropped by 25%. This would bring the government $117 billion of revenue.
That may sound like a lot of money, but it represents only 6% of the $1.83 trillion budget deficit. So tariffs wouldn’t do much to slash the deficit. Also, they are inflationary by definition. And if there is mass deportation of immigrants, that too could elevate inflation by curbing the supply of workers.
Outlook for the Fed
As for the Fed, given the economy’s strength and inflation’s resilience, the central bank may not go much further than the 100 basis points it’s already sliced off rates.
Interest-rate futures point to just one 25 basis point cut this year. And there is even talk among economists that the Fed’s next move may be a rate increase. That could be bad news for the stock market.
Looking at the eurozone economy, it expanded at an annualized rate of 1.5% in the third quarter. While that beat expectations, it obviously trailed far behind the US. The European Commission predicts that the economy grew 0.8% last year and will expand 1.3% this year.
“As inflation continues to ease and private consumption and investment growth pick up, with unemployment at record lows, growth is set to gradually accelerate over the next two years,” said EU Economy Commissioner Paolo Gentiloni.
But he also injected a dose of caution. “Structural challenges and geopolitical uncertainty weigh on our future prospects.” Those challenges include low productivity and inadequate innovation. Geopolitical uncertainty includes the Ukraine war.
What’s ahead for stock markets
Turning to stock markets, in the US the picture is mixed. Analysts forecast that S&P 500 earnings rose 11.7% in the fourth quarter from a year earlier and will climb 14.8% for all of 2025, according to FactSet. But keep in mind that analysts are often way too optimistic.
Valuations are stretched, with the S&P 500 forward price-earnings ratio at 21.5, well above the five-year average of 19.7 and the 10-year average of 18.2. So after two straight years of 20%-plus gains for the S&P 500, it may face some difficult sledding.
European stocks have lagged their US brethren for the last 15 years. During that period, some experts have repeatedly said it’s time for European stocks to outperform, but they haven’t.
This year might be more of the same for European stocks, given the weakness of the continent’s economy compared to the US. A weak economy means weak earnings. Also, any US tariff increases could hit Europe particularly hard.
So for both US and European markets this year, buyer beware.