Macro Minute: Week of January 6, 2025

I Was Promised a Santa Rally, But All I Got Was a Lump of Coal 

Many market participants were positioned for a year-end rally. What we have gotten instead is a selloff that began at the start of December. As president-elect Trump rang the bell at the New York Stock Exchange, it was a signal that this leg of the bull run was pausing. The Dow Jones Industrial Average was down over 10 consecutive sessions. You must go back to the 1970’s to find the last time that has occurred. The selling intensified after Federal Reserve Chair Powell spoke on 12-19-24. While he did give a .25% cut in the Fed funds rate, he signaled that 2025 may only have two cuts instead of the four that were priced into market expectations. He expressed concern over seeing more progress on inflation. He also pointed out that some board members were forecasting expected upward inflation pressure from Trump policies. This caused the rates at the long end of the bond market to move higher. In fact, the long-end rate has moved higher ever since Powell did his first rate cut in September. The 10-year treasury, which is the most used rate in determining financing rates, has moved from around 3.75% to about 4.5%.  

So why have long rates moved up during a time when the Federal Reserve is cutting short rates, and why has it had such a negative impact on the overall stock market?  To understand this, we must first start with what market expectations were. Leading up to the first rate cut in September 2024, the market thought that the economy was going to hit a rough patch and had priced some recession risk into the bond market. This is why we had an inverted yield curve with long rates lower than short rates. Part of the reason for this concern was because market participants thought that the Federal Reserve was going to stay restrictive for too long and push the economy into a recession. As the market saw the .50% cut, and economic data continued to come in strong, that recession risk started getting priced out of the long end of the bond market. This is one of the main reasons for the long-end rate rise that has occurred since the first cut.  

Equity markets typically have a more difficult time adjusting to rising rate environments, at least initially. Eventually, businesses find a way to get on with doing business, even if they are somewhat hampered by higher financing costs due to higher rates. This is one of the reasons for the recent selloff. The main reason for the acute selloff is the same as it always is, deleveraging. There is leverage that builds up in markets as volatility has been low and certain stocks have continued to trend higher. When leverage is taken out of the market, forced selling occurs. The leverage unwinds quickly, and the market finds a bottom and resets. The best strategy in this environment is to either do nothing, or buy when this forced selling happens. Conversely, an example of a time to sell occurred a few weeks ago, when it was extremely cheap to buy puts on the S&P 500. Extremes in positioning are things that give me concerns. This is one of the reasons why I build portfolios the way I do. I want to own the market, but not be into the most crowded trades. I prefer to buy stocks that are reasonably priced for the growth of the company, and I love it when a stock has high free cash flow. This gives the company great optionality and gives them the opportunity to either pay down debt, do buybacks, or pay dividends. This also makes the company resilient to economic shocks by having that free cash flow buffer.  

As we seem to be ending the year on a bit of a whimper, let’s look at the current feel of things. U.S. large growth stocks are priced high, and are priced at a premium relative to the rest of the world, and relative to the average stock. Trump has injected a lot of speculation in crypto markets, but the bellwether bitcoin has maintained a strong bid from institutions after the ETF launch this year. The U.S. economy has proven extremely resilient to many shifts and shocks, and it also remains the strongest developed economy, followed by Japan. Speaking of the land of the rising sun, economic reforms have been very positive, and Japan looks to be on a path of continued economic expansion. China has continued to struggle domestically while thriving in international trade. They have become dominant in many industrial industries: nuclear power generation, automobiles, and heavy machinery to name just a few. This has allowed China to move up the value chain and away from being mainly the producer of trinkets and gizmos. It will remain important to watch and see if the government begins meaningful stimulus to the domestic citizens of China. Back in the U.S., the incoming government looks set to try and continue to run the economy hot. They will be looking to reduce regulation, reduce taxes, maintain high oil output to combat inflation, and overall take care of things domestically first. While this sounds good, it is yet to be seen how this will play out with Russian/Ukraine, immigration, and tariffs. Also, running the economy hot could cause long-end bond yields to rise. That could lead the stock market to struggle somewhat, and could bring an increase in inflation. Remember 2022?  I will say that if we do experience inflation, but the average person is receiving wage increases that outpace inflation, then we may not see as much uproar, provided that inflation stays below 5% or so. 

In looking at the current state of things, I will maintain a diversified portfolio that does not weight too heavily in the largest growth stocks. I still think that a significant international exposure is appropriate. I also think that the better diversifier to equity risk will be real assets and managed futures because of the potential for higher long-end bond rates. While 2024 was all about U.S. large cap growth companies, 2025 may bring a different set of winners. 

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