January 2025 Market Strategy
Everyone is bullish and fears nothing but a rate scare. I am bearish and I fear a growth scare.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This article is entirely free to read.
In my December 2024 Market Strategy, I noted that the inflation problem showed some sign of life with the first problematic CPI print in 7 months. I expected however that this would not turn into a larger reflation theme. I also highlighted that the strong deficit reacceleration had continued in November which was fueling the stock market rally. And I pointed to extraordinary risk appetite among investors as evidenced in institutional investor positioning and sentiment data. Investors loved US stocks and the US Dollar while avoiding international exposure, bonds and cash.
The most likely pain trade would be weakening growth in the US, more rate cuts than currently priced in, a weaker Dollar and potentially an economic resurrection in the rest of the world. The catalyst for this could be declining deficits or lower productivity of existing deficits, something that the labor market may already be foreshadowing.
Let’s check how the picture has evolved since then.
TLDR Summary
Headline CPI accelerated again in December to 0.4% month-over-month, driven however by volatility in energy prices which doesn’t seem representative for inflation overall. The 0.2% core CPI was in line with the Fed’s target. Alternative inflation measures that correct for the noise in the shelter calculation point to even lower inflation. I don’t see reflation as a theme for 2025.
Fiscal deficits have continued their reacceleration, now $237bn ahead of prior year on a fiscal year to date basis. With Trump’s inauguration, the time has come to prove or disprove my suspicion that this has been Biden’s farewell present. If not, it will be powerful bull market fuel. If yes, we have a catalyst for my bearish macro case to unfold.
Risk appetite has come down a bit over the last month. But it still remains elevated. Investors expect continued economic strength and elevated inflation. What they most fear is that the latter will cause a disorderly rise in bond yields with subsequent economic havoc. They are afraid of a rate scare.
I could not be more opposed to this consensus. What we must fear is a growth scare, not a rate scare. As long as rates are high, economic growth is strong which points to productivity in fiscal liquidity.
Over the last three years, the Fed has fueled this bull market. Their tight policy has accelerated deficit spending which boosted GDP growth and attracted capital from abroad. And the enormous supply of securities from both the Treasury and the Fed has forced investors into a rebalancing bid into risk assets. Falling rates and a falling US Dollar will turn this virtuous cycle into a vicious cycle. Timing is uncertain. But it’s the most obvious and in fact the only imaginable mechanism to end this bull market eventually. And given current sentiment, I don’t think a reasonable risk premium can be earned to bet that it will happen later than sooner.
Inflation
December headline was 0.4% month-over-month, which was however distorted by highly volatile energy costs. Core was just 0.2%, which was inline with the Fed’s target.
Per the Penn State/ACY Alternative Inflation Index, headline CPI stands at 1.3% year-over-year and core is at 1.5%.
As a reminder, this index replaces shelter in the CPI by a so called marginal rent index which is derived from implied rents in recent property transaction prices. As such, it measures housing costs more objectively and more currently than the official metric.
Monetary Policy
Policy rate expectations have remained completely unchanged since last month. Only one rate cut is expected for the entire year.
Fiscal Policy
Based on its daily cash accounting, the Treasury’s fiscal year to date deficits stands at $655bn as of January 16, 2025. This exceeds prior year by $237bn, implying that the excessive spending we have seen since October has continued in December and in the first half of January.
It can’t be overstated what a stunning reversal this is vs. the trend we had for most of 2024. For example, check out the deficit comparison from my July 2024 Market Strategy:
Just six months ago, with 75% of the fiscal year completed, the primary deficit was tracking $313bn below prior fiscal year. The total deficit was tracking $173bn lower. As a reminder, this was because tax receipts outpaced outlays because private sector incomes recovered from the inflation and interest rate shock. It’s actually quite normal for the deficit to trend down over time because receipts tend to rise with nominal GDP growth while outlays tend to grow with inflation, leaving real growth as the residual. It’s the distinct fiscal impulses we see every few years that sends the deficit higher again and launches the next cycle.
Now we are $237bn ahead of prior year after just 16 weeks of FY25. If there is any merit to my suspicion that this is Biden’s farewell present then this new trend cannot continue. There would be some sort of fiscal cliff incoming. The moment for this to reveal itself would be now.
Bank of America Global Fund Manager Survey
Somewhat surprisingly, institutional investors poured heavily in the Eurozone during the last month, which was funded by selling US exposure. They have also sold equities and raised some cash. From a sector perspective, rotation flow was mixed.
This has reduced some of the geographic and asset class imbalances from a month ago when US exposure was more than two standard deviations above the historical mean. US exposure is still very high, but it doesn’t look as extreme anymore against history. Same goes for equities in general.
The affection of institutional investors for equities and US exposure is also visible when positioning is compared to their benchmarks (as opposed to their historical allocation):
And it’s visible in sentiment data. Bond investors are capitulating.
38% of respondents expect no landing, i.e. continued economic strength alongside high rates and stubborn inflation. It’s the highest reading ever since Bank of America included this question in their survey.
As a result of the macro consensus, investors continue to love US equities, global equities and Bitcoin. The top 3 spots are all risk-on assets. The improvement of government bonds in fourth place is a bit surprising. February will show whether this is signal or noise.
From a currency perspective, investors expect most from the US Dollar…
…which feels a bit dissonant given they consider it overvalued already.
Nobody wants cash…
…and most investors don’t like bonds either. Granted, their bond exposure is still higher than during most of the 2010s. However, we must not forget that this was the ZIRP age when bonds simply weren’t an investment alternative for many investors. I generally prefer comparing positioning against history as opposed to comparing it against benchmarks. But it’s a bit more nuanced for bonds for this reason.
Why is a growth scare more likely than a rate scare?
The three articles below provide the most important context to understand my current macro perspective.
I have come to the conclusion that the primary driver for the bull market since 2022 has been the Federal Reserve themselves. With their rate hikes and the reduction in their securities portfolio, they have
increased the Treasury's deficits which has boosted GDP,
forced a rebalancing bid by investors into risk assets, and
sucked capital into the US from abroad.
High interest rates along the entire Treasury yield curve and a strong US Dollar are both manifestations of this virtuous cycle created by the Federal Reserve.
Rate cuts will turn it into a vicious cycle. It doesn't matter how gradual they will be happening. The momentum is pointing the other way. In my opinion, we will see a bear market that rhymes with 2001 to 2003. It probably won’t be as deep because overall asset prices have not decoupled from liquidity measures as much as back then. But it will appear similar in principle with lower stocks, lower rates, lower Dollar and a continued strength in home prices.
The reason I qualify home prices here is that residential real estate has not attracted as much capital as the stock market lately. Both transaction activity and sentiment have been extremely weak. Also, falling rates help home prices more than stocks
For most of 2024, my anticipation of a credit impulse from rate cuts has been a pillar to my bullish point of view. I still believe it to be likely that rate sensitive industries will get an uplift when bond yields start falling again. But these industries have become quite small in terms of their market caps. I doubt that they can move the needle from a total US stock market perspective.
In addition to this fundamental perspective, I am most alarmed by the risk appetite and the macro misperceptions evident in institutional asset allocation as discussed above and by the high correlation between crypto and stocks. I view crypto as a release valve for the risk rebalancing bid. Investors have a ton of government bonds to digest due to the deficits. Since IPO activity has been weak, investors have turned to crypto issuance. Needless to say, it’s not a sustainable release valve because it doesn’t create economic value.
Sincerely,
Rene
So, if I understand you correctly, you see a world where yields, the dollar, and stocks are down, while cyclicals and housing-related equities go up?