Next Year, Investors May Be Surprised by a Major Inflation Surprise. Here's How the Pros Are Preparing

The coming year could bring a mix of factors likely to sustain inflation above the Federal Reserve's 2% target, defying investor hopes for a significant easing in price pressures and prompting only gradual rate cuts from the central bank.

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Chief among these influences are President-elect Donald Trump’s tariff and immigration proposals. While the specifics of these policies won’t become clear until after his inauguration in January, some market participants remain cautiously optimistic that inflation might stay contained and that Trump’s rhetoric is a negotiating strategy.

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However, there’s a risk that investors are underestimating the likelihood of persistent above-target inflation, which has been a trend since 2021. The construction industry, for example, is already bracing for challenges such as a diminished immigrant workforce and new tariffs that could elevate building costs.

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Similarly, retailers are encouraging consumers to buy now to avoid potential price hikes, while companies like Polaris Inc., which operates a factory in Mexico, might incur millions in tariff-related costs. These expenses could be passed on to consumers, though Polaris’ CEO Michael Speetzen indicated the company remains in a “wait-and-see” position.

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Goldman Sachs economist Jan Hatzius estimates that Trump's proposed tariffs could raise core inflation, as measured by the Fed's preferred personal-consumption expenditures (PCE) index, by nearly 1% if implemented. Inflation traders have noted this projection and adjusted their expectations for the consumer price index (CPI), anticipating the headline rate to stay above 2% through October 2025. This follows predictions of a November CPI uptick, due for release this Wednesday.

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Meanwhile, Nuveen, an investment manager overseeing $1.3 trillion in assets, is reevaluating its base-case scenario of a soft landing, which assumes the U.S. avoids recession and inflation declines. While Nuveen projects core PCE inflation will dip to the mid- to low-2% range in 2025 from October’s year-over-year rate of 2.8%, the firm acknowledges risks that it may not reach the Fed’s 2% target.

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Anders Persson, Nuveen’s chief investment officer for global fixed income, warns of the possibility that the Fed might need to reverse course and hike rates again if the economy falters, leading to a stagflationary scenario with elevated inflation and sluggish growth. While this isn’t their baseline view, Persson is confident inflation will remain above 2% over the next year, partly driven by tariffs and immigration policies.

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Persson advises investors to focus on fixed-income assets, which offer a favorable risk-reward balance and attractive return potential. If stagflation materializes, equities would struggle, making cash the best-performing asset class.

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As of Monday, fed-funds futures traders anticipated one to four rate cuts in 2025, following a projected quarter-point reduction next week that would bring the fed-funds rate to 4.25%-4.5%.

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Trump’s trade and immigration policies could pose additional economic risks, forcing the Fed to navigate inflation concerns while supporting growth. His proposals include mass deportations of undocumented immigrants, a 10% tariff on Chinese goods, and a 25% tariff on imports from Mexico and Canada. Analysts warn that further tax cuts could exacerbate the national deficit, potentially hindering long-term economic growth.

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The Fed targets 2% inflation to ensure stable purchasing power for households, a benchmark adopted by major central banks worldwide. While the Fed hopes inflation will naturally decline, the risk lies in prolonged above-target inflation destabilizing public expectations. Evidence suggests that persistent inflation influences consumer and business psychology, fostering an environment where higher prices and wage demands become normalized. This could lead to a wage-price spiral if another economic shock occurs.

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Recent Fed forecasts predict inflation will decline to 2% by 2026, but skepticism remains. For instance, if November’s CPI data or revisions to previous months indicate higher-than-expected inflation, it could alter policymakers’ outlook for rate cuts in 2025. Economist Derek Tang of Monetary Policy Analytics highlights that businesses and consumers are adapting to higher inflation, preparing for price increases and seeking wage gains, which could amplify inflationary pressures.

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Despite these concerns, the interplay between inflation and growth could still yield positive outcomes for certain markets. For example, the stock market has thrived in 2024, even as the Fed delivered only two rate cuts instead of the six or seven anticipated at the year’s start. This highlights the resilience of equities in an environment where inflation expectations remain somewhat anchored.

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At Insight Investment, portfolio manager Nate Hyde expects structural factors to exert upward pressure on inflation but believes tighter Fed policy could counteract these risks. Hyde is confident in the medium-term disinflationary trend but acknowledges that the trend has stalled temporarily. To mitigate inflation risks, he recommends shifting from dollar-denominated fixed-income assets to euro-denominated securities, where inflationary pressures are less pronounced. Additionally, Treasury Inflation-Protected Securities (TIPS) could be a valuable hedge in an environment of persistently higher inflation.

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Ultimately, while inflation is unlikely to reach the structural highs of the past, investors must remain vigilant. Elevated inflation paired with steady economic growth could provide opportunities, but unexpected shocks or policy missteps could derail this outlook. As the U.S. navigates a complex economic landscape in 2025, the interplay between inflation, growth, and policy decisions will be pivotal.

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