'Enter at own risk': Why raging optimism for 2025 is a risk for stocks and the economy

• Investors' exuberance for 2025 could backfire, according to BCA Research.
• The firm highlighted risks stemming from "animal spirits," like higher inflation and slower growth.
• BCA has forecast a recession and predicted stocks could fall as much as 26%.

Investors excited for another strong year for the economy and stock market could be getting in their own way — and it may be likely that growth will end up falling short of 2025 expectations, according to BCA Research.

In a note on Monday, the research firm highlighted potential risks stemming from "animal spirits" coursing through markets, referring to strong optimism for equities as investors anticipate future rate cuts and a rejuvenated economy in Donald Trump's second term.

But that bullishness could actually work against markets, BCA said, thanks to the risk that animal spirits fuel higher inflation and ensure that rates stay on the higher-for-longer track. Investors, the firm said, should "enter at own risk."

"Paradoxically, raging optimism on the US economy is making a reacceleration in growth less likely in 2025. Given the sky-high optimism embedded in asset prices, this warrants a defensive portfolio stance on a 12-month horizon," Juan Correa, global asset allocation strategist at the firm, wrote in a note, adding that investors should.

While inflation has cooled dramatically from its highs in 2022, the disinflationary trend has reversed course in recent months. Consumer prices rose 2.7% year-over-year in November, up from the prior month's 2.6% price growth, according to the Bureau of Labor Statistics.

Meanwhile, central bankers are eyeing the risk that inflation could become a problem again, with 80% of FOMC members saying they saw upside risks for core inflation, according to the Fed's latest Summary of Economic projections.

"Enthusiastic animal spirits from financial markets are currently working against the goals of both Fed Chair Powell and President Elect Trump," Correa added.

Interest rate expectations have also started to trend higher — another potential risk to markets and the economy.

Central bankers have slashed their forecasts for rate cuts this year, penciling in just two 25-basis-point reductions.

Bond yields are also climbing, with the yield on the 10-year US Treasury rising to its highest level in nearly seven months last week.

Higher bond yields could be a sign investors have "embraced the idea" of higher for-longer interest rates, and could be expecting a large amount of government stimulus in the event that the economy continues to weaken, Correa suggested.

But that optimism for future stimulus has also started to backfire on the economy, as high yields tighten financial conditions.

The average yield for seasoned AAA-rated corporate bonds rose to a seven-month high in December, according to Moody's, reflecting higher borrowing costs for companies.

The job market, meanwhile, has continued to shows signs of slowing. The hiring rate came was 3.3% in October, the lowest level in four years, Labor Department data shows.

"In our view this optimism is unwarranted. The evidence suggests that the current level of yields is weighing on economic activity," Correa added.

BCA Research holds the most bearish stock market call on Wall Street for 2025. In a previous note, the firm said it still sees a recession as the base case and predicted the S&P 500 would end the year at 4,452, reflecting 26% downside from the index's current levels.

Most forecasters are expecting a positive, but more muted year of stock returns.

Investors have been growing more cautious in recent weeks, particularly after the Santa Claus rally failed to materialize. Just 34% of investors said they were bullish on stocks over the next six months, down from 43% of investors who said they were bullish in early December, according to the AAII's latest Investors Sentiment Survey.