If you needed reminding the market remains closely tethered to monetary policy – we received it this week. Stocks surged on the back of two things: (i) CPI coming in slightly better than expectations; and (ii) the prospect of the Fed having more room to ease rates. Bond yields dropped and stocks jumped. There’s nothing quite like the sniff of cheaper money to get the animal spirits moving. However, it’s still far too premature to jump to conclusions.
"Interest Rates / Bonds"
A Bad Day for the Fed
A few months ago Jay Powell claimed victory. Last Sept he said words to the effect of “the time has come to start easing rates”. He initially cut rates by 50 points – followed by two more cuts of 25 basis points. Markets were thrilled at the thought of more cheap money – pricing in as many as 6 or 7 rate cuts over the next 12 months. However, at the time I asked why the need to cut? The data simply didn’t support it. Jobs were fine. The economy was growing. Inflation was not yet at its desired level. Why cut? However, whilst the Fed was busy running a victory lap – the bond market was less convinced. The US 10-year yield went the other direction — and appears likely to retest 5.0% in the next few months. What does this do to valuations?
What Could Possibly Go Wrong?
It would not surprise me to see 2025 repeat the drawdowns we saw in 2022. And we could see 10-15% lower in the first half. For example, during Q4 2021 – I warned of excessive valuations (specifically in tech). That was timely. However, it’s different this time. 10-year yields are now above 4.70%. And should they continue their march towards 5.0% – valuations (and earnings) will be challenged. That said, Wall St. “experts” are assuming significant earnings growth for next year (evidenced by the average 6,600 2025 target at an expected 25x forward multiple). They’re adopting a “lottery ticket” mentality – where the majority of investors naively expect extraordinary returns with little regard for downside risks.
Fed’s Balancing Act for 2025
2025 will not be without its challenges for both investors and central baks. For example, if we consider: monetary and fiscal policy risks; likely introduction of tariffs and price increases; geopolitical risks as global central banks navigate U.S. policy; a stronger US dollar with a rising 10-year treasury yield; ongoing debt and deficits concerns; the risk of stubborn inflation (notably services); and a weakening employment picture – this presents a complex web of related variables or risks. How are markets pricing this in? For now they remain complacent – trading at record highs – at near 22x forward earnings.
For a full list of posts from 2017…