Insights

Strategy

As we start 2025 two things are very clear: there was no recession last year and the Fed outlook last September for several rate cuts in 2025 is out the window.  Current expectations are for 2 rate cuts this year.  GDP Now projects 4^th quarter GDP at 2.5%.  The economy is in good shape, but the risk of slightly higher inflation has pushed long-term interest rates up over 100 basis points (1.0%) since the middle of September.  The election of Donald J. Trump has resulted in the expectation of fewer regulations that stymie economic activity, and lower taxes may result in larger budget deficits which has the bond market on high alert.  Given the fact the 10-year maturity treasury note is at a 12-month high, tells us there is a real fear of higher inflation this year. December was so bad for bonds that the total return for the 30-year Treasury was -6.0% and for the entire year it was -8.0%.  The bond market is very worried about too much spending and wider deficits.   

The labor market, which is closely watched by the Fed and has a significant impact on economic growth.  The most recent low reading for unemployment was 3.4% in January of 2023. The most recent high was 4.3% in July 2024.  The current reading is 4.1%.  In 2022, the monthly average of jobs created was 136,000 and in 2023 the number increased to 290,000.  Through November, the 2024 average was 180,000.  Roughly 25% of the jobs created were government jobs.  This is not the way to have a sustained recovery. Manufacturing and transportation have been shedding workers.  Job openings have been falling and quit rates have been softening.  The hiring rate has dropped to 3.3% which is the lowest in a decade if you exclude the pandemic. 

Now that we have discussed some of the most influential aspects of economic growth, we ask ourselves: what investments look attractive in not only this environment but in the future as well?  Corporate bonds are a commonly used asset in many client portfolios.  They provide some additional yield above what a like-term US Treasury will provide.  This additional yield is called the credit spread.   While defaults are expected to remain very low, the credit spread is at a historically low level.  The correct strategy is to buy higher rated credits (A2 or higher), and shorter-term bonds can be used to add slightly lower rated credits.  Now is not the time to get aggressive with corporate bonds.

Agency backed mortgage-backed securities (MBS) is an area to get more aggressive due to the attractive pricing, attractive yields, and exceptional upside.  Here is an example: a seasoned 15-year pool with a 4.5% coupon selling for $96.  This bond has a 5.0-year average life and a 5.0% yield (the yield spread is 52 basis points).  The government guarantees timely payment of principal and interest.  Liquidity has historically been excellent.  We feel this is an interesting investment for shorter-term investors to evaluate.  A 20-year pool with a 4.5% coupon sells for $95.125 and has a 7.7-year average life.  The yield is 5.34% and the yield spread is 75 basis points.  A small increase in prepayment speeds results in a 5.70% yield and an average life shortening to 5.0 years.  The yield spread increases to 123 basis points.  This is precisely why we like this type of investment: no credit risk, great liquidity, and a higher yield if interest rates fall.

At the risk of sounding like a broken record, we have to mention non-agency MBS one more time.  The values are just too compelling.  A recent AAA rated offering was for a bond issued in 2021 and had the following characteristics: credit support was 16.6% and the only delinquencies for 701 loans was 6 loans 30 days delinquent.  This could simply be late payments.  The weighted average loan-to-value ratio was 55%.  The average FICO score is 772.  Here is where it gets interesting.  The bond is selling for $91.50.  At 6 CPR, the average life is 8 years and the yield is 6.50%.  If the prepayment speed rises to 10 CPR, the average life falls to 6.1 years and the yield rises to 6.90%.  That results in a yield spread similar to a junk bond for a AAA-rated security.  We think the yield relative to the quality for this sector may offer interesting relative value.

Interest Rate Outlook

Much has been said about whether the Fed can orchestrate a soft landing or possibly “no landing” from the double barrel growth period that followed the pandemic due to massive fiscal and monetary stimulus. Inflation has made progress toward something less painful for the population, risk asset prices are higher, corporate earnings are generally growing, people who want to work have job opportunities, and no obvious signs of a change in direction are flashing warning lights.  Somehow in all the amazement in the Fed’s recent accomplishment, the market’s short memory is failing them, that the missed call for “transitory inflation” accompanied with an overly accommodative Fed led to the level of inflation that caused pain for so many families.  The December rate cut by the Fed was questionable.  Progress toward a healthy level of inflation had already stalled, and since that cut we have seen a troubling uptick in inflationary signs in the service sector and expectations for inflation have seen a significant jump. Our observation is that perception (expectations) often becomes reality in the direction of inflation.  Purely speculation, it may be that cutting the rate offers cover for the Fed to continue Quantitative Tightening, shrinking their balance sheet, to give them the ability to face the next major market event. 

"The old investment adage of 'buy when everyone is selling and sell when everyone is buying' would seem to suggest caution given the enthusiasm in the risk markets."

Although the stock and bond markets have had a bad couple of weeks, both have seen prices decline in the last week of 2024 and the first week of 2025, general exuberance toward risk is at a level we find to be uncomfortable.  Early in Q4, stock market investor optimism (as measured by asset manager net long S&P 500 futures positions) displayed the biggest jump since recovering from the depths of the pandemic in June of 2020.  To introduce a “horse sense” perspective, when the internet bubble was popping in 2001, Warren Buffet said measuring total publicly traded stock market capitalization as a percentage of the economy (GDP) was “probably the best single measure of where valuations stand at any given moment.”  The supporting logic is probably that since publicly traded companies get their profit from “the economy” there should be a relationship between the value and output of the economy and corporate valuations. From a commonsense standpoint, especially if you are a contrarian investor, the idea that valuations will mean-revert is appealing.  To put some numbers on this metric, the peak of this number before the Great Depression was 109%.  It grew to an all-time zenith of 190% in March of 2000, and has moved lower to its current point at 133%.  Had you been out of the market from March of 2000 until now, you would have missed out on a holding period price return of almost 300% or approximately an annualized price return of under 6% over nearly 25 years – if you include dividends reinvested in the index the holding period total return increases to more than 500% and the annualized total return was better than 7.5%.  Given Mr. Buffet’s recent stock sales, it seems that he believes stock valuations are outsized and that cash equivalent securities offers a better risk-adjusted return prospect.  Since the S&P 500 index bottomed in 2022, stocks are up roughly 70%!  A couple examples of investor “enthusiasm” may be useful.  First the chipmaker Broadcom has a growth rate that is slower than Proctor & Gamble but Broadcom trades at 21 times revenue while P&G trades for five times. The price-to-earnings ratio to growth ratio (PEG ratio) for P&G is 3.3 while Broadcom is 1.7.  This is not a buy or sell recommendation of any stock, but it demonstrates how much more the market is willing to pay for a dollar of earnings or a percentage point of growth if the stock is in the “right” sector. At the extreme of market silliness is the fact that investors are willing to pay for MicroStrategy’s stock (a Bitcoin investment) 150% of the value of the underlying asset.  In December, the market cap of the stock was approaching $120 billion at the same time they had a $47 billion hoard of Bitcoin. Again, not a recommendation to buy or sell, but it seems that “investors” have become detached from the economics of their investments, or perhaps people value convenience so much they will pay 150% of the value of an asset they can easily procure themselves. According to Apollo Global in a recent survey, since the start of 2009, currently a record high percent of investors thinks there is less than a 10% chance of a market crash.  The old investment adage of “buy when everyone is selling and sell when everyone is buying” would seem to suggest caution given the enthusiasm in the risk markets.

The exuberance isn’t limited to the stock market.  The bond market is getting in on all the positivity too.  Risk spreads (the incremental yield investors earn for accepting credit risk for a bond, relative to a like-maturity Treasury) for investment grade bond hit the lowest level since 1998 during the 4^th quarter.  The high yield (also known as “junk bond”) sector has seen similar spread tightening. It is a concern if the economy slows and the risk of corporate defaults increases, but there is a nuanced change in the bond market that makes the stingy spread environment less alarming. Since the pandemic we have just seen the second largest wave of credit upgrades in the past 10 years.  So, although spreads are historically “tight” the perceived quality of the index (the universe of corporate bonds) is of a higher quality.  Also, factoring into an analysis of bond spreads is the fact that since we have been in a higher yield environment for the past couple of years, market coupons for many outstanding bonds are higher than they have been for much of the past 15 years.  Higher coupons tend to reduce the interest rate risk of a bond and at a large scale, the composition of the indexes now reflects most bonds having larger coupons and less interest rate environment sensitivity, meaning the index has less interest rate risk (duration) relative to where it has been for a long time. Bond spreads are at a point where the likelihood of further material tightening is less likely and widening is more likely, especially if the economy slows.  The chances that this dynamic works against bond valuations is something we have incorporated into our strategy.  As a result, we favor high quality issuers with stable earnings relative to their debt burden and Treasuries, because that posture allows us to capture much of the benefits of the higher yield environment without as much risk of the spread widening environment that should accompany the next economic slowdown.  Whether it is stocks or bonds, there is a lot of “perfection” priced into the markets. If reality doesn’t match up with perfection, price adjustments or stagnation are a likely outcome.  The U.S. economy, markets, corporate structures, demographics and culture are all different than Japan’s but as an example of an extended recovery period when the market normalizes after exuberance, it took investors in the Nikkei 225 Index in late 1989 approximately 34 years for their investment values to recover.  Exuberance can feel “fun,” but it can also be the cause of a lot of hardship.           

As indicated earlier our forecast for 2024 was that in the back half of the year, consumers would finally succumb to the stresses that surround the bulk of the population.  We also suggested that the risk of single party rule, and resulting profligate spending, was limited.  Perhaps we should stick to economic and market forecasts and leave the political guesswork to the “experts.”  The lack of any major blowups and a consumer who is somehow treading water allowed for many markets to be near record highs as the year ended.  Fed officials have generally indicated that additional cuts would need to be preceded by softening in the job market or months of stagnant inflation or some further improvement in inflation.  Chicago Fed President Austan Goolsbee recently pointed out that over the past 6 months, the PCE has been running at an annualized rate of 1.9%, so although year-over-year numbers indicate the Fed has more work to do, he seems to believe that more recent segments of the metric suggest the inflation fight has largely been won.

Last quarter we detailed the elevated levels of credit outstanding as well as the dangerous trends in credit delinquency metrics. Although recent wage growth statistics suggest that people’s incomes are currently keeping pace with broad measures of inflation, near record levels of debt being carried at interest rates in excess of 20% should overwhelm many family budgets.  Given the election outcome, the holiday that many student loan borrowers have enjoyed is about to be over.  That will introduce an additional drag on many borrowers’ ability to spend. Another area that isn’t postured to offer any relief is home affordability.  According to Nerdwallet.com, 30-year mortgage rates are nearly 7% and there doesn’t seem to be a significant impetus for home prices to plummet (although marginally there seems to be a possibility of some domestic population growth shrinkage in the short term).  The point is that in our bifurcated economy, there will be a large number of consumers who have been thrown so many credit “lifelines,” which are eventually anchors around their necks, that a day of reckoning as it relates to their ability to consume will come.  Debt forbearance, buy now pay later, store credit cards at 25% interest rates, personal responsibility, and freedoms are good, but the sad truth is a drowning man will grab on to anything, even if you throw him a stone. We think the consumer may experience some shocks while the federal government is (hopefully) getting its fiscal house in order.  It may not happen in 2025 but a recalibration for the consumer seems long overdue.

"... we are always looking for early signs of economic weakening and market jitters."

Below the surface of the seemingly calm water are a lot of jagged rocks that could portend our next economic event.  The money supply continues to shrink, economic activity tends to correlate with population growth, and the degree of political uncertainty through one party rule as well because of the complete division and demonization the two parties project on each other, all threaten the scenario of a smooth path toward economic growth.  In past quarters we highlighted looming areas of potential challenge.  Commercial real estate (CRE) investors may have hoped for a lower cost financing environment to help them push off the day of office space reckoning to another day. The higher yield environment is providing them with no such relief.  From Manhattan to Minneapolis and Los Angeles, stories of CRE losses in the range of 60% or more are not hard to uncover.  Private credit, a recent darling of the industry, is seeing assets piling into this sector, but the private credit market currently offers little in the way of an illiquidity yield premium over publicly traded debt securities.  The problem with illiquid securities is that when markets misbehave, the cost of finding liquidity (getting out of the investment) can be ugly.  As a result, we are always looking for early signs of economic weakening and market jitters.  One such example is the 13% to 24% chance the online betting forums are placing on the WHO declaring the H5N1 Avian Flu (the “Bird Flu”) as a pandemic by the end of 2025.  Over 60 human cases in the U.S. have been confirmed since April and if it mutates to the point of human-to-human transmission health officials fear the outcome would be catastrophic.  Hopefully you held on to your personal protective equipment. 

A metric we are watching is the number of people with temporary positions.  Recently the number of temporary workers has been declining and that tends to occur ahead of softening of the employment environment and recessions.  What feels material about the change is that following the November election, small business optimism made a large jump, and yet the use of temporary workers continues to decline.  Partner that with large employers announcing that they are moving back to five day in office work weeks, which will push some less committed employees to quit or retire, and it feels like companies are positioning themselves to be operating in a leaner and meaner fashion.  It is natural for the pendulum to swing back in the other direction for the balance of power between employers and employees.  Absent a traditional business cycle “cleaning of house” for underperforming employees, it may be a trend that catches hold in the coming months.  Recently Alphabet (Google’s parent company) announced staffing redundancy reductions of 12,000 employees, totaling about 6% of their workforce.  JP Morgan announced in office workweeks.  Employer interest in operating more efficiently may weigh on future wage gains and economic activity.       

Earlier we mentioned that in the face of fiscal policy uncertainty, a market response that involved taking the cost of “risk-free” U.S. Treasury financing higher seemed prudent.  There seem to be several supply/demand influences that are worth examining.  The obvious one is the supply side.  Not knowing the path of fiscal spending related to what Trump’s policies will be put forward, which ones were campaign promises, and what the end result will be of the political sausage-making exercise, anticipating ongoing federal deficits feels like the projection of least resistance.  On the demand side of the analysis, you have the largest buyer/owner of U.S. Treasuries letting their investments roll off through the QT program. A reduction in foreign buying of U.S. Treasuries will not help the situation.  As recently as 2018, the largest foreign holder of U.S. debt, China has been a net seller of Treasuries for most of the past five years.  The result of uncertain supply with negative demand influences has increased the amount of yield investors want for holding longer term U.S. Treasury debt.  A measure of this bond market anxiety, called the Term Premium, recently hit the highest level since 2015.  It means the consequences of past federal deficits have increasing consequences and the penalty for continuing down the same path will likely be greater than we have been operating under over the past decade.  2025 will be the third straight year with deficits in excess of 6% of GDP growth.  President-Elect Trump’s pick for Treasury Secretary, Scott Bessent, has discussed what he calls his “3-3-3 plan” which involves boosting economic growth to 3% a year through deregulation and lower taxes, while reducing the federal deficit to 3% of GDP and aiding the economy with cheap energy, by increasing U.S. energy production by 3 million barrels per day.  Since there are a multitude of scenarios where some aspects of the 3-3-3 plan can work at cross purposes with each other, we expect the term premium will remain elevated until policy unfolds into reality and a directional hunch is presented to the markets about the direction of the federal deficits and related debt issuance.   

Last quarter we suggested 10-year Treasuries would retest the 4.50% area and drift below 3% during the weakest part of 2025.  Higher for longer seems like it will hold for much of this year.  If 10-year Treasuries break out above 5% it would seem we will test a level between closer to 5.5% and the floor we are now forecasting is 3%.  If we can get our fiscal house in order or if any number of events that could cause a “flight to quality” and trigger a run to the safety of U.S. Treasuries, interest rates should fall.  Fed policy could change on a dime, and it seems like bonds are postured to see decent returns in 2025.  Historically, purchased yield on a bond has a high correlation to forward-looking total return.  Stated another way, the better the yield at which you buy a bond, the better your total return in the future tends to be realized.

Summary  

Sometimes it is very liberating to embrace the reality that we don’t know what the future holds.  The next two years offer the possibility of an environment where acknowledging the folly of forecasting, while having the experience to discern the key emerging developments from the market noise may be helpful in navigating the rough waters.  Nobody knows what policies will see the light of day, to what degree they will be enacted, and how they will impact the economy.  It appears that President-Elect Trump has made some serious picks for his cabinet.  We see it as a positive that in the mix it appears that he picked some people who don’t come off as sycophants (understanding full well that the cabinet serves at the president’s pleasure).  We are in serious times, where the consequences of failure feel elevated.  Can meaningful deficit reduction occur at the same time as we pursue an agenda of economic growth?  We better hope so.

A couple of paths we can envision for the economy involve growth policies, and potentially tariff policy, that could stoke inflation. That would likely drive bond yields, or the term premium, higher.  Another path is if Trump’s policies don’t work and a fiscal spending “Hail Mary” is needed for political purposes.  Our expectation is that the likely path is a push and pull economy where waves of positivity are met with some shocks to the system.  At a minimum it will be “interesting” to have a non-legacy system thinker like Elon Musk attempting to bring the level of efficiency and operational change to government that has generally been reserved for corporations and shoe-string budget not-for-profits.  In the seesaw environment it seems like after some period of hope, the consumer will succumb to the consequences of too many obligations and either too few assets or not enough cashflow.  We just don’t see the productivity gains or wage improvement to make that outcome a likely scenario over the next couple of years. 

What we can observe from history is that for a bond portfolio, higher purchased yield tends to mean favorable total returns.  We expect that historically high borrowing costs, along with record levels of debt for both the consumer as well as for the U.S. government demands a change in trajectory.  The “weight” of the consequences of excessive borrowing may be its own governor as it relates to a continuation of bad habits.  From a strategy standpoint, the Fed seems to be on hold until the last half of 2025.  It makes short-term bonds a stable part of the continuation of our barbell strategy. Cash equivalents and short-term bonds offer an attractive yield without much interest rate risk and the shorter maturities offer the ability to have a dynamic ability to respond to future credit concerns.  On the other side of the barbell, we like high quality issues spread through the 5-year area of the yield curve through the 10-year part of the curve.  It offers investors approximately 90% to 96% of the yield of the 30-year segment of the yield curve without the interest rate risk. We anticipate that when the forgotten consumer displays their exhaustion, the economy will slow, and the longer segment of our barbell strategy will see solid returns. 

Our thoughts are with all the people impacted by the California wildfires.       

This Newsletter is impersonal and does not provide individual advice or recommendations for any specific subscriber, reader or portfolio.  This Newsletter is not and should not be construed by any user and/or prospective user as, 1) a solicitation or 2) provision of investment related advice or services tailored to any particular individual’s or entity’s financial situation or investment objective(s).   Investment involves substantial risk.  Neither the Author, nor Advanced Capital Group, Inc. makes any guarantee or other promise as to any results that may be obtained from using the Newsletter.  No reader should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence.  To the maximum extent permitted by law, the Author and Advanced Capital Group, Inc., disclaim any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in the Newsletter prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses.  The Newsletter’s commentary, analysis, options, advice and recommendations present the personal and subjective views of the Author and are subject to change at any time without notice.  The information provided in this Newsletter is obtained from sources which the Author and Advanced Capital Group, Inc. believe to be reliable.  However, neither the Author nor Advanced Capital Group, Inc.  has independently verified or otherwise investigated all such information.  Neither the Author nor Advanced Capital Group, Inc. guarantee the accuracy or completeness of any such information.