Monthly Markets Memo - January 2025

Everything is Awesome vs. Is Winter Coming?

The human brain is an amazing organ that we still don’t have perfect insight and transparency into. The largest companies in the world are currently spending many billions of dollars per year to replicate the power of the brain, using vast amalgamations of silicon, copper, palladium and other elements, as opposed to neurons and gray matter. Among the multitude of mysteries the human brain contains, the ability to hold two seemingly oppositional thoughts at once is one of its unique capabilities.

The S&P 500 returned 25% in 2024, the unemployment rate is at 4.2%, consumer balance sheets haven’t been this strong in decades, and US real GDP continues growing at +3% rates, well above pre-pandemic trends. All of this macro-economic data and the exuberance of markets and business leaders regarding the prospect for tax-cut extensions and lower regulatory burdens with a new administration and congressional mix has most investors and consumers humming “Everything Is Awesome” (The Lego Movie, 2014) to themselves as we transition into 2025.

Everything is, indeed, pretty pretty good, and valuations across markets appear to fully reflect this; Fwd. P/E Ratios on the S&P 500 trade at two standard deviations above the 20-yr mean, and credit spreads are hovering above 20-yr tights. However, December’s chill came late as investors weighed a surprisingly hawkish outlook in the FOMC’s Summary of Economic Projections (SEP), showing fewer cuts in 2025 than the committee members had anticipated just three months prior in the September SEP, as well as a 2025 year-end inflation level that was also higher than the level anticipated in the September SEP. Markets reacted violently, with the 2nd largest spike in the VIX for all of 2024. Hopes for a Santa Claus rally were dashed, and coal was deposited in investors' stockings with US stocks, Int’l Stocks, and bonds all declining for the month of December.

What leaves us wondering about the winds of winter, and whether it may truly be coming for asset prices, is the lack of a general wall of worry for markets to climb. When all the current news is good, and optimism for future changes are fully priced, there’s nothing left to temper expectations. With no hurdles to clear, the only upside catalysts higher will be stronger than expected earnings. As of today, the labor market is stable, and there’s no sign of increasing layoffs... but there is a notable slowness. It is taking longer for employers to hire and for job seekers to find employment. This disconnect between employers and job seekers could be a temporary issue as the labor market settles into a new equilibrium relative to the frenzy that occurred in the pandemic recovery. Or it could be the initial signs of the pendulum completing its swing from an extremely tight labor market to one that is too soft to sustain the low unemployment and strong consumption we have benefited from for nearly half a decade now.

To be sure, everything is awesome, but the best time to prepare for winter is while the sun still shines and the harvest is plentiful.

Chart of the Month: Long Treasury Yields Rising, Correlations Falling

For much of the last several years, the shifts up and down along the yield curve can be directly and nearly fully attributable to changes in the path of rate hikes or cuts from the FOMC. But in mid-November, the longer end of the yield curve is beginning to decouple from FOMC expectations. If we view the 2Y US Treasury yield as a proxy for FOMC sensitivity, as it is the yield that’s been and remains the most sensitive to potential changes in the Federal Funds target-range, we can measure the correlation of its movements with other tenors on the yield curve. As is illustrated in the chart, the 10Y is beginning to move in much less correlated ways from the 2Y, implying that the markets are trading the 10Y Treasury bond with a focus on something beyond just the FOMC reaction function. Potential explanations for this new development range from bond investors “finally” demanding some term premium (extra yield for locking up their cash for longer terms) to markets requiring higher yields to account for increasing anxiety and risk around the fiscal situation and where it may be in a decade. As is often the case with markets, the real explanation is probably a weighted average of all the possible explanations. But one thing is for certain: something has materially changed in the bond/rates market; ignore it at your own peril.

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