The Age of Reason

Neither Fish nor Fowl: The market finds itself in a conundrum. The incoming administration’s policies seem to be focused on the two ends of the economic spectrum, alleviating the financial burden for the lower middle class while gifting tax breaks and deregulation to the ultra-wealthy. There will be policy conflict ahead because it is likely that both goals cannot be achieved. Many people who voted for this administration count on financial support from government organizations, yet those programs will be on the cutting board to help pay for the tax breaks. These same voters will suffer when rising labor costs from restrictions on immigration plus tariffs push prices higher. Because the Cabinet is comprised of many very wealthy individuals who funded this campaign, they may tend to push for programs helping the rich. However, a Republican Congress must also please their constituents, many of whom are lower middle class. The market is struggling with these diverging paths, and the Fed may face stagflation that will force them to choose between fighting inflation or keeping the economy afloat. There is a potential of no real middle ground, leaving investors in a bit of a quandary trying to forecast two binary outcomes.

Murphy’s Law

When there are conflicting economic and policy paths, the market can first price in one forecast and then reverse, pricing in the other. The key to investment success in 2025 is to be open to…anything. Since the election, stocks, bond yields, and the dollar have moved higher, pricing in a consensus of American Exceptionalism: AI-driven productivity, fueled by lower taxes and deregulation boosting economic activity. Foreign capital flowing into America is expected to propel the dollar even higher, extending equity outperformance versus emerging markets in particular.  

Additionally, the two-year-old theme of supercharged AI spending has been extended, pushing mega-cap tech stock outperformance to new highs.

OK, that explains how we got here. Now what? 

When investors become this entrenched in their investment outlook, it is time to question the consensus. There is a staggering combination of potential policy surprises that could potentially result in quick price breaks across equity sectors and asset classes. The current one-sided positioning has set a backdrop for trend reversals, so we are considering unpopular concepts such as:

·       What if inflation starts to drop?

·       What if the administration cannot push their directives through a fiscally conservative Congress?

·       What if Trump has changed his mind on maximum tariffs?

·       What if Treasury Secretary Bessent starts to issue significantly longer maturity Treasuries?

The list goes on, but just considering the first question, if rental inflation has peaked and inflation falls, then those who are betting on a higher dollar and higher bond yields are exposed to losses. The current extreme positions held by investors long the dollar and short bonds are exposed to significant losses. Overweighting bonds and going long commodities/commodity-related stocks, plus rotating into emerging market equities, could be the big winners of 2025 if that scenario unfolds.

Your mantra for 2025: do not forget the original version of Murphy’s Law from Augustus De Morgan—whatever can happen, will. Our models incorporate 88 risk factors and 59 return factors in our optimization process as we rebalance client portfolios monthly. The objective is to be positioned for the changes that can arise in 2025. Under this investment environment, it is especially important to pay attention to portfolio shifts signaled by our models.

Stop the Presses

The thoughts we laid out in Murphy’s Law just got some instant gratification. We received news this morning of a potential policy change on how tariffs may unfold. The Washington Post revealed that the incoming administration is leaning toward targeted tariffs on strategic goods, not universally across the board, sparing items such as food and other staples. The news unsurprisingly was met with a positive reaction in the stock market; emerging market equities were flying, and there was a sharp reaction lower in the dollar because if this were to be enacted, it would have a significantly smaller impact on inflation. The question is whether this holds, knowing that there are China hawks in the Cabinet, such as Commerce Secretary Howard Lutnick and U.S. Trade Representative Jamieson Greer. 

As of this morning, investors believe there will be one less outside influence on their decision-making process whether stocks and their earnings and growth are worth the current prices. Caveat: Because we are confident in our “be open to anything” theme for 2025, do not be surprised if this new directive changes at some point.

Update: As we were writing this before the market open, Trump then denied the Washington Post story, and the dollar and fixed income markets had to backtrack. However, would we be surprised if this retraction gets retracted? Of course not.

Small is Getting Smaller

The Russell 2000 is behind the eight ball, but that could end up being a good thing. The small cap index has underperformed for a record eight straight years, and this year was the index’s fourth worst relative performance on record. Jeffries calculated rolling cumulative returns over a 10-year window, and between 2015-2024 the Russell sits in the bottom 99^th percentile relative to the last century. Calling this a washout does not even do it justice.

Normally, lower interest rates and good business conditions (tight credit spreads) support the Russell because smaller companies benefit greatly from cheap borrowing costs. Yet, the Russell still stumbled when those two beneficial factors were present. The main problem is that small caps as a group have not seen positive earnings for over a year. The good news is that smaller firms are expected to post solid profits in 2025. The bad news is that capital needs to flow out of the mega cap sector to see a sustainable Russell outperformance. The magnificent seven is now five times the size of the entire Russell 2000 and over 20% of the market capitalization of the world. Overdone, for sure; the setup is favorable, but the profit trigger is not in sight.

It pays to know that reversals can be swift: between July and August of 2024, Microsoft dropped from 465 to 385, and NVIDIA fell from 135 to 90 while the Russell held firm. However, small caps only benefited because there was panic selling of tech stocks as the yen carry trade unwound and Russell shorts were bought back. The question is whether a favorable rotation into small caps can occur during normal market conditions. As we said earlier, stay open to surprises in 2025, and this is one that can pay off handsomely, so it is on our radar.

What to Look for This Week

1. Friday, January 10 at 8:30 a.m. E.S.T. the December Employment Situation is released. We are focusing on construction employment given the strong underperformance of the housing sector. With 10-year Treasury yields near a fair-value level of 4.60%-4.70%, we could see bond buying coming in after the data is broadcast.

2. Wednesday, January 8 at 8:30 a.m. E.S.T. Fed Governor Christopher Waller speaks about the Economic Outlook. He is quite influential among the FOMC, so his comments will have weight. Later in the day at 2:00 p.m. E.S.T. We will see the December 17-18 GOMC meeting minutes. Depending on what they choose to reveal, we may find out how worried the participants are regarding inflation. Uber-hawk Michelle Bowman speaks at 1:35 p.m. E.S.T. on Thursday January 9. She could comment that the Fed has already hit the neutral rate, and we will be monitoring the market tone if that happens. If there is little reaction, that is bullish.

3. Tuesday, January 7 at 10:00 a.m. E.S.T. is scheduled for the December ISM Non-Manufacturing Report. We will look at the Prices and Employment subcategories. Prices have stayed below 60 so any move above could cause concern, but Services Employment has been solid, so a move below 50 would be negative considering ISM Manufacturing Employment has been stuck below 50. November’s Job Openings and Labor Turnover Survey (JOLTS) is released at the same time; focus on the Hirings Rate.