Investment Commentary – January 13, 2025

Executive Summary

Last week, US stocks and bonds were down. The MSCI EAFE (non US developed) and MSCI emerging markets indices outperformed the S&P 500. The best performing sectors in the S&P 500 were energy, health care, and materials. Across U.S. style & market cap indices, large-cap value did the best, and the value factor led more broadly.

As for fixed income, the 10 yr. treasury yield rose 17 bps on the week to 4.77%, and the 2year – 10year treasury yield spread steepened to +38 bps.  The push higher in yields put some pressure on big tech. In addition, the dollar has appreciated (higher relative interest rates and growth vs. the rest of the world) which weighs on sectors such as tech which generate 30%+ of their revenues from overseas. It was only a few weeks ago that market expectations of 100+ basis points (bps) of Fed cuts in 2025 were likely.  The futures curve is now suggesting 30bps.  Bond yields have been rising despite the recent Fed cuts due to several factors including anticipated US growth in the 2%+ range, sticky inflation (closer to 3% annually than the Fed 2% target), the Trump pro-growth agenda (tax extensions/cuts, deregulation) and the anticipated continued Federal government spending deficits.

We believe investors should emphasize the macro trends rather than the most recent data points. While the recent payroll report was higher than consensus the trend over the last few months suggests more muted economic activity where the JOLTS and quits reports indicate the labor market is cooling suggesting less wage inflation pressure.

Is the UK scenario predicting the US future? In the UK, the Treasury last week tried to calm markets and reaffirmed its commitment to fiscal rules after a sell-off in the pound sterling and UK government bonds, which propelled the 10-year gilt government yield to 4.8%, the highest level since August 2008. The move reflected a broader increase in bond yields stoked, in part, by concerns over President-elect Donald Trump’s policies and a more hawkish outlook for U.S. interest rates. Mounting investor concerns about the UK’s debt levels and the Labor government’s ability to shore up the public finances while implementing budget plans added to the upward pressure on gilt yields as inflation remains sticky. In short, the stagflation regime (sticky inflation and slowing growth) seems to be an increasing threat to the market.  The Times of London reported that Chancellor of the Exchequer Rachel Reeves, the UK finance minister, asked colleagues at a Cabinet meeting to come up with ideas to boost economic growth.

What’s next. The big data releases this week are inflation reports regarding Consumer (CPI) and Producer (PPI), with the market searching for information about the pace of inflation after progress stalled in Q4. The question investors should be asking is there a risk of inflation expectations reaccelerating.  The current 5 year and 10 year market expectations drifting in the 2.5% range.  The two reports will play a key role in setting the direction of the stock and bond markets for Q1 2025 combined with the timing, scale and scope of Trump 2.0 policy initiatives. 

We expect positive but lower equity S&P 500 returns than 2024 as a result of elevated valuations across many sectors and the prospect for higher yields (price down).  Inflation will prove higher than the Fed target but manageable based on history.  We believe positive earnings growth will provide a tailwind of support for many companies but price action will be more volatile than last year due to bond yield volatility.  All of these forecasts are subject to the mixing in of various wildcards related to geopolitics and policy uncertainty (US & China).

California Municipals

The Investment Office has been in contact with several municipal asset managers.  They have shared there has not been any significant repricing across California municipal bonds, although some bonds closest to the disaster have begun to trade at a wider spread – which is a natural function of the market repricing the risk of investment.

According to our conversations, there are three factors which give investors confidence in California’s ability to face this current disaster.

1) The underlying strength of the state economy - California has the fifth largest economy in the world, and comprises 14% of US GDP.

2) The substantial cash reserves at the state and local level - California has $21 billion in its rainy-day fund with borrowable resources of around $90 billion. Los Angeles county reported a general fund reserve of $5.4 billion.

3) Access to Federal assistance – This includes FEMA, which can reimburse up to 75% of damages for local governments, businesses and households.

We would like to emphasize this is still a dynamic situation and our thoughts go out to everyone in the California community impacted by this disaster.

Equities

The S&P 500 returned -1.9% for the week. Yields rose as traders reversed their outlook on how quickly the Fed will continue to cut interest rates after a strong jobs report. Separate data fueled concerns of stubborn inflation as oil prices rose and a gauge of consumer inflation expectations rose to its highest level since 2008. The technology-heavy NASDAQ returned -2.3% while small caps dropped -3.5%. Energy (+0.9%) and healthcare (+0.5%) were the best performing sectors in S&P 500; real estate (-4.1%) and technology (-3.1%) were the laggards. EAFE markets returned -0.4% with gains in Europe (+0.4%) and the U.K. (+0.3%) offset by losses in Japan (-2.6%). EM markets returned -1.5% with China (-4.4%) and India (-3.8%) leading the index lower.

From a valuation perspective, U.S. markets (other than midcaps) trade above +1 standard deviation based on historical forward P/E ratios as the S&P 500 is at +1.9, the NASDAQ is at +1.2 and U.S. small caps are at +1.7. For the next 12 months, EPS growth for S&P 500 is expected to be 10.1% (vs. 6.9% annualized over the last 20 years). For the next 12 months, EPS growth for NASDAQ is expected to be 19.1% (vs. 10.4% annualized over the last 20 years). For the next 12 months, EPS growth for the Russell 2000 is expected to be 8.4% (vs. 6.3% annualized over the last 20 years). All U.S. indices, including the S&P 500 (US Large Cap), NASDAQ, Russell Midcap (US Midcap) and the Russell 2000 (US Small Cap) trade at or above their 20-year averages based on forward P/E ratios while the MSCI EAFE (Non-US Developed Market Equities) and MSCI EM (EM Equities) are inline.

Fixed Income

Investment grade fixed income sectors posted negative returns as rates jumped higher across the curve. Municipals returned -0.6%, US AGG returned -0.9% and US IG returned -1.0%. HY bonds returned -0.3% while bank loans returned 0.2%. EM debt returned -0.4% as the US dollar rose 0.6%.

Rates

Rates jumped higher across the curve as markets as markets slashed expectations on rate cuts amid concerns about sticky inflation. The recession-watch 3M-10Y spread widened 14bps to +43bps. The 2year-10year spread widened 6bps to +38. Rates rose in other developed markets other than the U.K. The BTP-Bund spread is at 1.18%. 5-year breakeven inflation expectations rose 12bps to 2.53% - their highest level since April 2024 (vs. low of 1.88% on Sept 10); 10-year breakeven inflation expectations rose 10bps to 2.44% - their highest level since Oct 2023 (vs. recent low of 2.03% on Sept 10); the 10year real yield rose 6bps to 2.31%. The market now expects one cut in 2025 vs the Fed’s guidance of two cuts. At year-end 2025, the market expects the Fed Funds rate to be 4.0% vs. the Fed’s guidance of 3.75%-4.00%.

Currencies/Commodities

The dollar rose 0.6%. The commodities complex rose 3.6% as energy prices jumped 4.7% for the week. Brent prices rose 4.2% to $80/bbl. US natural gas prices rose 18.8% amid colder weather while European gas fell 9.7% amid warmer weather.

Market monitors

Volatility rose for equities and for bonds (VIX = 20, MOVE = 97); the 10-year average for each is VIX=18, MOVE = 78. Market sentiment (at midweek) fell from 1 to -3 as market jitters have made investors more cautious.