With Jimmy Carter's state funeral today, markets are closed.
Politics:
But while we think the policy environment will be favorable, it is also not without risks. In fact, much of the risk is just from the opportunities failing to materialize. Keeping that in mind, here’s our survey some of the key policy risks markets may face in the year ahead.
Risk 1: The Federal Reserve Keeps Policy Too Tight
The first risk is not related to the Trump administration or Congress at all, but rather the possibility that the Federal Reserve keeps monetary policy too tight. The Fed is currently in a rate cutting regime, but expectations of the pace of rate cuts have slowed quite a bit. Shifting expectations is mostly due to improved growth expectations, which is a positive, but also a significant rise in inflation expectations, which we think is misplaced. (Sonu covered this at length in his analysis of the Federal Reserve’s recent decision, “
The Fed Pulls a Grinch.”) The Fed’s perception of both inflation uncertainty and the direction of risks changed substantially from their survey of FOMC participants in September, as shown below, and that has led to greater caution around rate cuts.
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Remember, a fed funds rate target of just 2.25 – 2.50% nearly broke the economy in 2018 – 2019, something President Trump correctly pointed out at the time, and low rates, even after some tightening, were still a major tailwind. Well, right now the target fed funds rate target is 4.25 – 4.50%, two full percentage point higher. The economy has been incredibly resilient despite high rates, but cyclical sectors, including housing, small businesses, and manufacturing, have been under pressure and the labor market, while still strong, has exhibited some underlying risk, although it remains quite stable for now. Productivity growth, which is supported by a tight labor market and has been an important contributor to recent growth, may also be damaged by policy that is too tight if it leads to a rise in layoffs.
We think the current expected slower path of rate cuts is very unlikely to push the economy into a recession on its own, but it will make the economy more sensitive to other shocks. A slower path of cuts also means the incoming Trump administration will need to be more careful about policies that would raise concerns about inflation.
Risk 2: Tariffs Push Inflation Higher
There has been a lot of speculation about tariff policy but we expect the Trump administration will have some sensitivity to the potential impact on inflation and will keep tariffs at least somewhat targeted. A strong dollar, partly in anticipation of tariffs but also due to growth rate differentials between the US and other developed economies, can also acts as an inflation buffer. For now, we think the concerns about tariffs and their impact on inflation are being overplayed. Nevertheless, even expectations of higher inflation can actually cause inflation and the Trump administration will have to be careful about how it communicates policy. As a result, credible saber rattling to strengthen the US negotiating position on tariffs could be damaging even if followed by more sensible actual policy. At this point, inflation expectations remain well anchored, but it’s a delicate balancing act. While we are suspending judgment on tariffs until we see what actually gets implemented and tilt moderately optimistic on the actual inflation impact, the potential for a policy mistake is there.
The S&P 500 fell over 6% in 2018 as the Fed tightened policy, and the trade war was raging. We’re still optimistic about markets in 2025, but the path of interest rates and uncertainty around tariffs are risks, and they are not the only ones.
Risk 3: Internal Division within the Republican Party Delays or Limits Policy Implementation
This is a policy risk that has a positive side. We noted during the election that markets tend to like mixed government. The spirit of compromise tends to get us better policy and helps avoid the ideological excesses of both parties. But we won’t have mixed government in 2025. When the new Congress is sworn in today, Republicans will hold narrow majorities in both the House and Senate. As of inauguration day on January 20, we’ll also have a Republican president in the Oval Office.
The majorities will be narrow. Republicans will hold a 53-47 majority in the Senate, as well as the tie-breaking vote by the vice president after January 20. Republicans would have held a 220-215 majority in the House, but Florida Republican Matt Gaetz resigned (he’ll have to do it again for the new Congress) and two Republican House members will take positions in the Trump administration. That will make the Republican majority 219-215 until the members assuming new roles resign and then 217-215 until special elections can be held. (Unlike the Senate, replacements in the House can’t be appointed, only elected.) There is no tie breaker in the House, so at that point Republicans will not be able to lose even a single vote in the House when a vote is along party lines.
We did not get divided government, but there are ways in which narrow majorities keep at least some of the spirit of divided government. Republicans will need their own moderates AND their most hardline conservatives to vote yes to pass policy. There could be a cushion if Freedom Caucus members hold up a bill. Some Democrats could potentially be pulled on board to support a bill if they believe it is in their interest, but would require some compromise.
We saw this in action with the current House’s recent efforts to fund the government. Republicans needed some Democrats to support the bill. Trump intervened using the bully pulpit as president-elect to object to the initial bipartisan continuing resolution (CR). But 38 Republicans rejected Trump’s alternative. A somewhat stripped down version of the original CR was finally passed with more Democratic votes than Republican. Trump’s interventions did lead to some changes, but the overall effect was small. From the perspective of the current House, a narrow majority led to compromise, although things will be somewhat different once Republicans control the Senate and Trump has been inaugurated.
Narrow majorities keep more checks and balances in place, but they also increase the possibility of legislative chaos and will make it more difficult to pass any bill that doesn’t have broad consensus among Republicans. Significant delays that disappoint policy expectations could lead markets to become impatient with congressional infighting. Keep in mind that Congress will have to deal with raising the debt ceiling and government funding in Q1 2025, let alone avoid the fiscal cliff associated with expiring individual tax cuts at the end of 2025.
Risk 4: Deregulation Clashes with the Supreme Court’s Chevron Reversal
One issue receiving relatively little attention is the Supreme Court’s decision in July 2024 to overturn Chevron v. Natural Resources Defense Council. The Chevron decision gave agencies more scope to interpret the laws under which the operate. The decision to overturn Chevron was an extraordinary flip-flop in conservative jurisprudence. In 1984 the Reagan administration was an advocate of Chevron because it made
deregulation easier. The Supreme Court decision in Chevron was unanimous, representing a consensus between liberal and conservative justices on how the Constitution should be interpreted. Over time, conservatives became critics of Chevron because they believed it had the unintended consequences of giving the agencies too much leeway. Undesirable political outcomes should not change the Constitution, but even among conservatives fashions change.
Overturning Chevron was great (from a Republican perspective) when Democrats are in power, but it also makes deregulation more difficult, which is why the original Chevron case went to the Supreme Court in the first place. When it comes to deregulation efforts, Republicans may have hoisted themselves on their own Chevron petard. With the decision newly minted, some efforts to lighten regulatory requirements are likely to be met with waves of litigation that may take years to work their way through the court system. We are worse off than the Reagan administration was before the Chevron ruling, because courts will be drawn into the messy process of delineating exactly what the new ruling means. We don’t think there are major risks here, but it may make deregulation under the new Trump administration less robust than markets expect in places.
Risk 5: Immigration Policy Stunts Economic Growth
In my view, this is the most underrated risk but still secondary to tariffs and monetary policy when it comes to the absolute level of risk. Clearly there are some genuine problems with current immigration policy. But the extent to which the resilience of the US economy depends on its ability to attract and absorb global labor is often underestimated. In fact, I would say the two key factors that have led to the structural advantage the US has over other developed economies is a more business-friendly overall policy environment, including labor market flexibility, and its history of acting as a destination of choice for immigrants.
It’s hard to determine the level at which tighter immigration policy becomes a genuine risk, and before it becomes a risk there certainly may be areas where reforms would provide benefits. The aim here is not to determine what the right immigration policy should be, but just to highlight that at some point tight policy can become a significant risk.
Here are just a few of the reasons why I believe immigration policy could pose a risk from an economic perspective:
-If the current level of flow of earners falls due to immigration policy and the chilling effect on new immigration, there’s a direct impact on GDP. A dollar of income lost is a dollar of GDP lost. Policy that leads working immigrants to leave the US, or choose not to come in the first place, is the economic equivalent of exporting U.S. GDP growth to the rest of the world.
-There is a steep implicit regulatory burden on business from tight immigration policy, both by restricting their access to workers and making the cost of labor higher.
-A more restricted labor pool also has the potential to drive wages higher, posing some additional risk for inflation. This effect may be stronger with the prime age participation rate already near a record high. I think this risk is fairly small, but not non-existent.
-Demographics are destiny. Immigration has been the US’s best defense against the challenges of an aging population. According to United Nations data, the old-age to working-age dependency ration in the US in 2022 was 29.4 (29.4 people aged 65 or older for every person aged 20-64). This ratio is important because current workers pay for the Social Security and Medicare benefits of current retirees. For comparison, the dependency ratio in 2022 was 38.0 in Germany and 55.4 in Japan. For the US, that number was 14.9 in 1952. In 2052 it’s expected to be 49.1 The US fertility rate in 2022 was 1.8, a level at which immigration becomes a larger factor in changes in the dependency ratio.
-There are certain areas of the economy that are hit particularly hard by tighter immigration policy. Since the election, housing stocks have fallen considerably despite overall strength in the consumer discretionary sector. This is largely due to higher rates but expected immigration policy is likely also a factor. At the same time, prices of agricultural commodities have been rising, again with multiple factors in play.
Immigration reform is a positive goal, but also comes with some risks. How high those risks are depends on actual policy. It would take a fairly large mistake to have enough of an impact on the economy to weigh on markets, but the potential for a large mistake is non-trivial.
Risk 6: Unpredictability Restrains Animal Spirits
Unpredictability is part of Trump’s MO and he is capable of deploying it very effectively. But while unpredictability can be powerful when negotiating, it can create a difficult environment for businesses. Companies put a lot of capital at risk based on expectations of future profits, and generally want policy clarity. (Of course, if the risk is a better policy environment, the risk associated with uncertainty is lower.) Businesses do not want a president who interferes with capital markets in a fit of pique. An uncertain policy environment can make it harder to do business, although sometimes it does also present opportunities. I would only view this is a small risk. Every policy environment has its element of unpredictability. But with the last Trump administration, for example, we did see tariff policy uncertainty weighed heavily on business investment in 2018-2019 and put a dent in the expected supply-side impact of the Tax Cuts and Jobs Act.
Risk 7: Fed Independence
I would consider this a very small risk, but with the consequences of a misstep potentially large. Trump will try to put pressure on the Federal Reserve to lower rates as soon as he takes office. That in and of itself isn’t a problem. There are mechanisms that help maintain Fed independence. But if there is an effort to overstep or to appoint a loyal and partisan Fed chair when Jerome Powell (himself a Trump appointee) steps down in May 2026, markets will respond. This one is unlikely to be a slow burn. If Trump oversteps, I would expect the market response to be unmistakable. If Trump floats test balloons that cause market jitters but can easily be stepped back, it’s not an issue. But a genuine threat to Fed independence that cannot be walked back could be a problem.
There you have it, seven policy risks that we’ll be watching for in 2025, with tariff unpredictability and the Fed’s rate decisions the most meaningful, but a few others to keep an eye on as well. Our view remains squarely in the camp that policy remains a tailwind, but Donald Trump was elected to be a disruptor, and while disruption can be valuable, it also can often come with unintended consequences.
The UK
Gilts Near Fearful Truss Moments |
The global bond selloff is unnerving for many reasons, but perhaps most because of the burden rising yields place on governments’ fiscal operations. The pain inflicted by rapidly rising borrowing costs is hardest to mask for countries like the UK with razor-thin spending buffers. And so it really hurts that long-dated gilt yields spiked to the highest levels since the late 2000s — or, in the case of the 30-year gilt, since 1998.
Capital Economics estimates that the recent move has added almost £9 billion ($11 billion) to the UKs borrowing costs — and that will virtually wipe out Chancellor Rachel Reeves’ spending buffer of £9.9 billion. Plugging that gap will require tax hikes, spending cuts, or both. The scale of fiscal consolidation required will depend on how far the bond market's rout goes. The combination of rising gilt yields relative to Treasuries with a weakening pound is concerning. Still, the comparison with Liz Truss’ self-inflicted 2022 gilt crisis is overblown:
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Truss’ ill-fated tax-cutting budget pushed the 10-year gilt spread over Treasuries to its highest in over a decade. To date, this mess is far less extreme, but needs urgent sorting. The UK’s current and capital account deficit leave it vulnerable to foreign investors who might demand higher yields and a cheaper pound before they’re prepared to buy gilts. The country is “dependent on foreigners,” as one investment banker put it. The surge in the 30-year gilt back at levels not seen since before the financial crisis caused by the little-remembered Russian default of 1998 shows that the situation is serious:
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While Truss-style deficit spending may not be revisited, Reeves has an uncomfortable decision. Ahead of the UK’s Office of Budget Responsibility forecast in March, Nico FitzRoy and David Pagliaro of Signum Global Advisors argue that the government could declare a breach of its own fiscal rules if the buffer evaporates further:
None of this is at all welcome for a new government that has had a rocky start. On the other side of the Atlantic, the rise in Treasury yields is as painful, but far from tragic. The 10-year benchmark yield is on a four-day rising streak — gliding past 4.7%, its most since April. Inescapable reasons for this surge include a change in fundamentals and the strong dollar. Joseph Lavorgna of SMBC Nikko Securities (and an adviser to Donald Trump in his first presidential term) attributes the currency’s strength to the strong inflows to US financial markets generated by equity performance and expectations that Trump’s pro-growth agenda can raise productivity.
In trade-weighted terms, the greenback benefited from the US election and the recent repricing of the Fed’s likely trajectory to gain 6.4% in the last quarter, according to Bank of America. With such dominance, there is speculation about whether a version of the 1985
Plaza Accord that devalued the dollar against its peers would be needed. Using the Fed’s own measure, the dollar looks far less overextended now:
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Bannockburn Global FX's Marc Chandler argues that all else equal, the Fed’s relative hawkishness in their
December meeting will keep the world’s reserve currency strong. While Trump’s tariff agenda poses an inflation risk, Chandler argues that it will ultimately hurt far more in other countries, such as Canada and Mexico, which export 80% or more of their products to the US. That would mean a stronger dollar.
The currency’s strength could wane as and when we have clarity on Trump’s trade policy, according to Bank of America’s analysts. They expect the dollar to stay strong in the short term thanks to worries about inflation and particularly tariffs, but to weaken later in the year as these policies take a toll on the US economy the rest of the world responds. That would relieve pressure on the rest of the world, but is unlikely to come in time to relieve Rachel Reeves from some difficult decisions.
Animal Spirits
Of Irrational Exuberance and Animal Spirits |
When all else fails, and you cannot explain why markets are so high, John Maynard Keynes and Alan Greenspan have some concepts to help. You can blame “animal spirits” (Keynes) or “irrational exuberance (Greenspan). The question is whether they really explain anything.
Greenspan gave us the concept of irrational exuberance in December 1996. Bill Clinton had just been reelected and stocks were motoring along. In a speech,
Greenspan asked this question:
Markets took him to mean that he thought asset prices too high and was intending to do something about it. Stocks fell. Three months later, he followed up with a 25 basis-point hike, driving a correction in the S&P 500 of nearly 10%. But rates didn’t move again for 18 months.
Greenspan tells Congress what he means in 1999.
Photographer: Linda Spillers/Bloomberg
To explain why he was worried, we can use another Greenspan concept, the
Fed Model. Testifying to Congress, he often compared the earnings yield (inverse of price/earnings) for stocks with bond yields. The higher equity yields reached compared to bonds, the cheaper stocks were. And vice versa. High bond yields made stretched equity valuations harder to justify.
We can illustrate this with the spread of the S&P earnings yield over the 10-year Treasury. When it drops, or falls below zero, stocks are expensive. This simple model (there are more sophisticated versions, but this captures Greenspan’s concept) showed that stocks were way too expensive:
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For current purposes, this measure now says that stocks are their most expensive since 2002 — and coincidentally at exactly the level on Dec. 5, 1996, that prompted Greenspan to sound his warning. So concerns about irrational exuberance seem justified. There is also something of a morality tale in what happened in the autumn of 1998. Following the Russian default and the meltdown of the Long-Term Capital Management hedge fund, the spread went positive again — stocks yielded slightly more than bonds. But the corporate credit market was becalmed, and Greenspan decided to cut the fed funds rate between meetings, launching the most extreme phase of the dot-com boom. We cannot know what would have happened if the Fed had held its nerve after LTCM, but with hindsight it looks like a mistake.
Some six decades before Greenspan,
Keynes offered the concept of animal spirits in his
General Theory. This is how he introduced it:
Most of the time, Keynes’ cost-benefit analysis will satisfactorily explain asset price moves, but sometimes it won’t. When we can’t understand what’s going on, we tend to cite “animal spirits” as a get-out clause. Use of the term might therefore offer a guide to when valuations have become inexplicable (or, as Greenspan would have it, irrationally exuberant). Ian Harnett of Absolute Strategy Research tried using it this way, and produced the following search of English language articles on the
Factiva database. It goes back to 2001, and shows that invocations of animal spirits ended last year at an extreme:
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If there are animal spirits at work, Harnett warns, “then investors might want to be wary of what kind of ‘spirits’ they really are!” In his experience, “they tend to be capricious little things with a nasty bite.”
I delved further into this with a Bloomberg News Trends search, which counted all references to animal spirits in stories published on the Bloomberg terminal from all sources. This goes back to only 2015, but might have the advantage of being drawn more exclusively from stories aimed at people in finance. Using this version confirms a surge in excitement about animal spirits, but suggests they were causing even more excitement in early 2017, when Trump was taking office the first time:
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There was a second surge in the term in January 2018 when the Trump tax cuts went into effect, much against widespread expectation. Their passage had looked unlikely until late in 2017, so this was a positive surprise. Harnett’s Factiva chart also shows a rise in animal spirits after Trump’s first election.
Where does this leave us? It’s hard to explain current asset prices without invoking a woolly concept like animal spirits. Trump is the best explanation for their resurgence. Stocks are riding on potent optimism that Trump 2.0 will be good for the market. Should he disappoint in the months ahead, the exuberance will fade, and we would be left with a stock market that looks way too expensive.
Trump and the Fed:
President-elect Trump says interest rates are far too high, but his own economic agenda might play a key role in keeping them elevated for longer.
Why it matters: Fed chair Jerome Powell has been hesitant to directly comment on the incoming administration's policies, but it's clear some of his colleagues on the Fed's policy-setting committee see huge tariffs and restrictive immigration policy as inflationary.
- With Trump's election came the potential for huge shifts in policy that risk making price pressures more persistent, pushing off plans to cut rates further.
Driving the news: Fed officials plan to tread carefully in considering when (or whether) to continue its rate-cutting cycle, minutes from its Dec. 17-18 closed-door policy meeting show.
- It was less certain, until now, the extent to which Trump shocks factored into expectations for stickier inflation and fewer rate cuts in 2025.
- "[P]articipants expected that inflation would continue to move toward 2 percent, although they noted that recent higher-than-expected readings on inflation, and the effects of potential changes in trade and immigration policy, suggested that the process could take longer than previously anticipated," according to the minutes.
The intrigue: Powell has called out the difficulty in projecting how Trump's policies will impact the economy, with little clarity about what such policies will ultimately look like.
- Fed economists, however, took a shot and modeled out how Trump policies might shake out with a "preliminary placeholder assumption."
- Stalled progress in cooling price pressures would keep inflation higher in 2024, the staff said — and inflation would not decline much further this year.
- "Inflation in 2025 was expected to remain at about the same rate as in 2024, as the effects of the staff's placeholder trade policy assumptions held inflation up," according to the minutes.
- "The risks around the inflation forecast were seen as tilted to the upside, as core inflation had not come down as much as expected in 2024 and the effects of trade policy changes could be larger than the staff had assumed."
The big picture: The Fed has slashed interest rates by 1 percentage point since September, including the quarter-point cut last month — a decision that was "finely balanced," with some agreeing there was merit in keeping rates on hold, the minutes said.
- In making a case to take a more gradual approach to cutting rates — that is, moving away from rate cuts at consecutive meetings — many officials cited "the current high degree of uncertainty," a possible nod to Trump policies.
The bottom line: The Fed minutes don't mention Trump by name, but the possible fallout from his policies has already shifted assumptions about the economy in 2025.
JC and the first five days:
The S&P500 is less than 3% away from making new all-time highs, but investors are losing their minds.
You notice how everyone is now a "breadth expert"? One by one, they're all out there mansplaining breadth deterioration to anyone who will listen.
The odd thing about these johnny-come-lately breadth "experts", is that none of them include sector rotation into their weak attempts at describing the current market breadth.
Sector Rotation is the lifeblood of a bull market. You see Airlines? You see Medical Devices? How about the new all-time lows for Consumer Staples relative to S&Ps?
Sector rotation IS market breadth. To ignore this rotation in favor of some arbitrary calculation of the weighting of the top 10 stocks in one index is foolish.
Trust me, I know. I used to do stupid **** like that too when I was a lot younger.
Anyway, the market is closed today, but not before it completed the first 5 days of the new year.
This is the 2nd big indicator of the now-famous January Trifecta, which includes the Santa Claus Rally, First 5 days, and the January Barometer.
The S&P500 and other large-cap indexes did NOT rally during this year's Santa Claus Rally period. Small-caps and Micro-cap Indexes did.
So mixed results there.
The First 5 Days Indicator, however, was in fact positive. According to the Stock Trader's Almanac, the last 48 up First Five Days were followed by full-year gains 40 times, for an 83.3% accuracy ratio and a 14.2% average gain in all 48 years. |
The market has a great track record of performance after the first 5 days of the year are positive. But in my experience, and also according to Jeff Hirsch, editor of the Stock Trader's Almanac, it's the January Barometer that is the most powerful of the Trifecta.
"As January goes, so goes the rest of the Year", is how I learned it.
But more importantly than all of these seasonal studies, it's the sector rotation and the actual breadth of the market.
And when I say breadth, I'm not talking about these silly superlatives they share on the internet to try and boost their page views. We don't write glorified gossip columns here, nor are we whoring ourselves out on twitter looking for attention.
Facts only around here.
It's the sector rotation and the broad participation that I'm most interested in. And at this point, it's really the lack of stocks going down that really stands out the most. If there is going to be a correction, expect to see an expansion in the number of stocks that are actually going down in price. So far, this has yet to happen.
Also, look for the defensive Consumer Staples to show some signs of life, if markets are going to correct. We haven't seen that at all. Just new relative lows week after week.
This week, we all got together, took a step back and zoomed out on markets to really understand where we are in the current cycle. |
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A couple of interesting ETFs
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jog on
duc