S&P 500 Midyear 2025 Outlook: Navigating a New Regime of Slower Growth, Fiscal Dominance, and Monetary Transition

Earlier on in the year before the tariff disruption we held the view that no recession was in sight and that the CPI would by noisy but still lower by year end. However, despite mounting concerns over slowing real GDP growth, elevated Treasury issuance, and political uncertainty surrounding US fiscal and trade policy, the S&P 500 remains structurally supported by resilient earnings, moderating inflation, and the powerful gravitational pull of US capital markets. Our analysis suggests a base case 12 mth target of 6,500 for the S&P 500, underpinned by a transition into a late-cycle macro environment: slowing nominal growth, stable inflation near 2%, and a Federal Reserve that has paused quantitative tightening and stands ready to cut rates in 2026 possibly late 2025.

1.Macro Conditions: Disinflation, Growth Convergence, and the Edges of Fiscal Dominance

Real GDP is projected to slow to 1.0 to1.5% annualized in the second half of 2025, reflecting the cumulative impact of tighter financial conditions, fading global trade momentum, and cooling consumer demand as excess pandemic era savings are depleted. This deceleration marks a shift into a late-cycle macro regime, characterized by slower but still positive growth and increasing sensitivity to policy and liquidity conditions. In this phase, market leadership typically rotates toward defensive growth, margin-stable firms, and quality large caps. Nominal GDP (NGDP), while decelerating, continues to run modestly above the effective federal funds rate (EFFR). This keeps the NGDP–EFFR spread positive, suggesting that policy remains mildly accommodative in real terms, even after a historic tightening cycle. In late cycle dynamics, this spread becomes critical: it signals that the cost of capital remains below nominal income growth, preserving favorable conditions for asset valuations even as topline growth moderates.

Source : FRED

Fed funds futures now imply a high probability of a first rate cut by September 2025, with multiple cuts priced in by year end. This reflects growing conviction that the Fed will shift toward easing as growth slows and financial conditions tighten independently of further policy moves. Forward rate curves, including SOFR futures, have stabilized since May, reinforcing the narrative that the Fed is on hold and that the front end of the curve has settled into a "wait and see" equilibrium. This stabilization in rate expectations has helped compress volatility across funding markets and improved the discounting environment for long-duration assets, particularly U.S. equities and investment grade credit.

Source : CME

The result is a macro landscape where growth is slowing, but not stalling; policy is no longer tightening, but not yet stimulative. This transitional zone favors valuation support, yield curve stability, and a shift in market focus from rate sensitivity to earnings resilience and positioning.

2. Labor Market: Cooling, Not Cracking

The US labor market is showing increasing signs of late cycle softening rather than acute weakness. According to the Kansas City Fed’s Labor Market Conditions Index (LMCI) for May 2025, the level of labor market activity declined modestly, from 0.31 to 0.26, while momentum remained weak and unchanged at -0.24. This suggests the labor market is gradually losing strength, not collapsing. The expected job availability index from the Conference Board rose from 81.5 to 92.6, its highest reading since late 2024, but it remains below the neutral level of 100, indicating more people still expect job opportunities to deteriorate than improve. Meanwhile, the percentage of unemployed individuals who voluntarily left their jobs (“job leavers”) fell sharply, from 11.8% in April to 9.8% in May, continuing a downward trend that reflects declining worker confidence. Additional weaknesses emerged in temporary help employment and the share of long-term unemployed (27+ weeks), both of which deteriorated and weighed on labor momentum.

Source - Kansas FED

These trends point to a maturing labor market, where job switching slows, slack gradually builds, and wage pressures ease, creating an environment that justifies a Fed pause, rather than further tightening.

Key labor signals:

• Job leavers ↓ to 9.8%, lowest since 2023

• Job flows from unemployment to employment softening

• Temporary help employment declining

• Long-term unemployment ticking up (but still below crisis levels)
  

This view is reinforced by real-time tax withholding data. Charts tracking Withhold/FICA tax receipts (smoothed YoY % change) show a strong recovery from late 2024 lows, but also reveal that wage income growth has plateaued and is now decelerating modestly. After peaking above 7% YoY in early Q2 2025, growth in tax withholdings has steadily declined toward 5.5% to 5.6%, still positive, but clearly rolling over. This supports the interpretation that employment and wage gains are slowing, even if they remain expansionary on net.

Source - US Treasury

Together, these trends are consistent with a soft landing narrative, not a recessionary collapse.

3. Inflation Regime Update: Beneath the Surface of CPI Stability

The inflation picture in mid 2025 is increasingly defined by a disconnect between official metrics and realtime economic conditions. The May headline CPI came in at 2.3% YoY and is expected to tick up modestly to 2.4 to 2.5% in the coming months due to base effects from 2024’s soft prints and some tariff related increases. Core CPI rose just 0.13% MoM, well below JPMorgan’s “dovish trigger” threshold of 0.25%, signaling that disinflation remains intact. Beneath the surface, core goods continue to deflate, a function of easing supply chains and weak global demand, while core services appear to be plateauing, rather than reaccelerating. A key distortion lies in shelter inflation, where owners’ equivalent rent (OER) remains elevated at 4.2% YoY. However, realtime rent data from Zillow and ApartmentList indicate that actual shelter costs are flat or declining, revealing a growing divergence between measured and lived inflation. If BLS shelter were replaced with realtime rent indexes, core CPI would be closer to 1.7 to1.8%, already consistent with the Fed’s target. This suggests that the “stickiness” of inflation may be more statistical than structural.

Source: Wisdom Tree

Market reaction has been swift, Fed funds futures now price in approx two 25 bps cuts by December 2025, reflecting the dovish implications of today’s CPI print. While the Fed may stay on hold in the near term, particularly to monitor tariff driven goods inflation in H2, the overarching trend remains disinflationary, not reflationary, and markets are increasingly pricing policy accordingly.

4. Monetary Plumbing and the Edges of Dominance

The Federal Reserve’s current policy stance occupies a transitional space, not QE, but no longer true tightening either. In early 2025, the Fed reduced its monthly Treasury runoff under quantitative tightening (QT) from $25B to $5B, a strategic move designed to ease stress in the Treasury market without formally returning to asset purchases. This slower balance sheet reduction enables ongoing SOMA reinvestment, which recycles proceeds from maturing Treasuries into new auctions, softening front end issuance pressure without creating new bank reserves.

Meanwhile, the reverse repo facility (RRP) has nearly drained, falling below $200B in early 2025 after peaking above $2.3T in 2022. This depletion marks a critical shift in system liquidity dynamics, new Treasury issuance must now compete for reserves or private sector capital directly, rather than tapping sidelined Fed liquidity. It also reflects a broader exhaustion of “buffer liquidity” in the system, making market plumbing more fragile and amplifying volatility risk as the Treasury rebuilds the TGA (Treasury General Account).

Source : FRED

However, in contrast to this visible tightening, broad money indicators are quietly reaccelerating. Divisia M4, a sophisticated monetary aggregate that weights components by their liquidity, shows year-over-year growth of +4.09% as of April 2025. Even Divisia M4 excluding Treasuries is growing at +3.41%, reversing its 2023 contraction. This rebound suggests that functional liquidity in the economy is expanding, largely due to:

• Renewed private credit creation,

• Increased dealer intermediation of Treasury collateral, and

• The market’s growing treatment of short-duration Treasuries as cash equivalents.

  
  

  

  Source: CFFS

  
  

While the Fed is technically still shrinking its balance sheet, liquidity conditions are no longer tightening meaningfully. The sharp drop in RRP balances means that the system's buffer of excess liquidity is nearly exhausted. Yet Divisia M4, a weighted, broad money measure, has started to grow again. This suggests that non-reserve forms of liquidity (like Treasury repo, MMF flows, and private credit creation) are picking up the slack. It’s not “easing,” but it’s also not pure tightening. The market is operating in a gray zone where liquidity is being reshuffled, not drained and despite ongoing structural deficits (~$2T per yr), Treasury market absorption remains smooth, helped by SOMA reinvestment, persistent foreign demand, and pensions/insurers seeking duration. Moreover, with over 60% of marketable debt maturing within three years, any eventual Fed rate cuts could mechanically lower interest costs, further reducing rollover risk in the short term.

Source : US Treasury

5. Earnings, Positioning, and Sentiment: Resilient Fundamentals, Compressing Risk Premiums

The S&P 500's earnings outlook remains supportive, with EPS growth forecasted at +8 to 9% in 2025. This strength is being driven by continued AI-led capital investment, margin normalization across cyclical sectors, and services-sector resilience. The forward P/E multiple sits around 21.5x, a level that historically aligns with disinflation, policy pivot expectations, and a stable global backdrop. Even as valuations expand, they remain defensible relative to real earnings yields, especially when compared to international peers.

However, a critical dynamic in recent months has been the continued decline in the Equity Risk Premium (ERP). After spiking above 5% during the early year policy volatility and tariff fears, the implied ERP has fallen sharply to just under 3.8%, with no clear bottom yet in sight. This compression is not being driven by improved earnings forecasts, but rather by a fading risk premium, markets are increasingly pricing in a benign macro path, softer inflation, and a Federal Reserve likely to ease in 2026. While this reflects a rising risk appetite and declining volatility, it also means the margin of safety is shrinking. Any reacceleration in yields or an EPS miss could reverse this move quickly.

Source: FRED

On the positioning front, speculative investors have reversed course and are steadily increasing their net long exposure to U.S. equities, particularly in S&P 500 futures. The latest CFTC data shows that net speculative positioning has rebounded sharply from deeply negative levels, climbing from nearly -400,000 contracts to around -100,000, a clear sign that bearish sentiment is fading. Yet, positioning is still not overly extended, which means there’s room for further upside support if macro conditions remain stable. Meanwhile, volatility targeting funds and dealer gamma hedging continue to reinforce market stability, often acting as automatic buyers on pullbacks. On the institutional side, investors are rotating into investment grade credit and USD hedged international equities, expressing cautious optimism without excessive crowding. A projected 8 to 9% decline in the USD over the next year could further enhance foreign earnings translation, especially for multinationals in the S&P 500, providing an additional tailwind for equity performance.

Source : CFTC

The US equity market is transitioning into a mature, slower growth phase, but it is far from nearing collapse. A confluence of supportive dynamics continues to underpin risk assets: a disinflationary trend that is more advanced than headline CPI suggests (due to shelter lag effects), a dovish shift in policy expectations with rate cuts priced in for late 2025 or early 2026, resilient corporate earnings driven by AI investment and stable margins, and structural inflows from foreign capital seeking safety and yield in US markets. Together, these forces are creating a soft landing backdrop even as macro and geopolitical risks remain elevated. For now, the S&P 500 sits at the center of global financial gravity: calm, but surrounded by risk.