From Euphoria to Caution: Markets at a Crossroad

Navigating inflationary challenges, policy dynamics, and trade strategies after US elections

Astonishing market resilience

With November 2024 behind us, the macroeconomic landscape is characterized by a remarkable convergence of pivotal factors: an unexpectedly resilient US economic performance, potential policy shifts under the incoming administration, a delicate balance between persistent inflationary pressures and increasingly cautious monetary policy expectations and, last but not least, a stubbornly euphoric market sentiment.

U.S. markets kicked off November with an upbeat reaction to the Presidential election. Despite a mid-month pullback, the S&P 500 recovered to post its biggest monthly gain of the year, up 5.96%, and the VIX closed the month below the 14 handle, its lowest level since July.

The U.S. macroeconomic backdrop reveals an exceptional performance that continues to challenge conventional economic frameworks. The labor market demonstrates remarkable strength, with jobless claims dropping to 213,000, indicating sustained economic robustness. Nominal GDP growth has effectively neutralized Federal Reserve policy, however, the long-term inflation expectations – measured by the 5-year/5-year forward rate – have remained consistently anchored around 2.25%, a metric specifically highlighted by Federal Reserve officials as critically aligned with their target inflation trajectory. This apparent stability masks a more intricate underlying dynamic of economic transformation and potential systemic risks.

In the recently released FOMC minutes, Chair Powell offered a measured and deliberate perspective. The minutes reiterated that monetary policy is not following a predetermined course and emphasized the critical importance of data-dependent decision-making. Committee members demonstrated particular attentiveness to recent data volatility, underlining the necessity of focusing on underlying economic tendencies. The minutes presented a cautiously optimistic view on inflation, with labor market data, inflation expectations, and pricing power indicators reinforcing the ongoing disinflation narrative.

Citi's rate strategists suggest the FOMC should pause its cutting cycle, barring weak payrolls data in December. However, they note that “this is a dovish Fed and the threshold to skip is high.” For the Fed to pause in December would require job growth of at least 300,000 and an increase in November core consumer prices of at least 0.35%.

A potential geopolitical development last week further complicated the market dynamics. The emergence of a potential "peace deal" between Israel and Lebanon prompted significant market movements – driving crude prices lower, impacting Bitcoin and Gold, and causing bond yields to tumble and the yield curve re-inverted.

The Trump Trade: recalibrating global economic dynamics

The macro backdrop is also evolving as markets digest both economic data and potential implications of Trump's policy agenda. The nomination of Scott Bessent as the next US Treasury Secretary has emerged as a particularly significant moment in the emerging economic narrative. Bessent is perceived as more market-friendly and pro-free trade compared to alternative candidates, viewed as a fiscal hawk who advocates for lower rates, measured tariff implementation, and tax reduction – dynamics broadly considered pro-growth. While campaign rhetoric initially proposed aggressive tariff implementations, Bessent's reputation as a fiscal pragmatist has provided nuanced reassurance to global markets.

Deutsche Bank's base case for 2025 anticipates a strategic, calculated approach to economic management. Their projection includes a measured 10% increase in tariffs on Chinese imports during the first half of the year, with potential universal baseline tariffs likely in late 2025 or early 2026. This approach represents a sophisticated economic strategy that transcends simplistic protectionist rhetoric.

President-elect Trump faces several potentially conflicting economic policy objectives, and the prioritization of these goals will significantly influence global growth and asset prices. The geopolitical implications are profound and multifaceted. The potential trade policies create a complex ecosystem where economic nationalism intersects with global interconnectedness, presenting both substantial opportunities and significant risks.

If the administration prioritizes economic growth, there's potential for positive outcomes for the US with global spillover effects elsewhere across the globe. However, this would likely require less emphasis on campaign promises like the deportation of undocumented immigrants and on tariffs. The main downside risks are more likely to emerge if greater weight is put on aggressive trade and immigration policies. This could be more negative for growth and push up inflation, potentially leading the Fed to cease the cutting cycle and possibly even contemplate restarting rate increases. This would likely put upward pressure on bond yields, with implications for the US and even more so for the rest of the world.

A maximalist Trump trade agenda and a Europe constrained to act because of fragmentation is a huge but realistic risk for the continent. Looking ahead, the German election in February will be a pivotal event. Fitch Ratings' Global Sovereigns Outlook for 2025 underscores this complexity, predicting a neutral credit environment where mild global economic slowing and anticipated interest rate cuts are offset by mounting fiscal strains and heightened geopolitical risks. The report specifically highlights how the new US administration's policies – including proposed tax cuts, increased tariffs on China, reduced immigration, and potentially unpredictable foreign relations – could generate inflationary pressures, potentially raising bond yields and creating market disruptions, particularly in emerging economies.

Credit overview: the duration risk come back

The credit market enters a fascinating phase of uncertainty and potential transformation that challenges traditional analytical frameworks. Goldman Sachs analysts describe the current environment as a “valuation conundrum”, characterized by investment-grade and high-yield bond spreads expected to remain within extraordinarily tight ranges. Average U.S. high-grade bond spreads are unchanged at 77 bps, approaching their lowest levels in over 25 years, while U.S. junk-bond spreads closed at 266 bps – a testament to the market's sophisticated risk assessment mechanisms.

Attractive yields continue to make the fixed income asset class compelling and we see that dispersion remains elevated in the high yield market, creating attractive opportunities in specific names. The Trump election and strong economic indicators have fueled risk appetite, pushing the High Yield indices to near its tightest level in over 15 years. However, potential policy measures like tariffs on U.S. imports and immigration restrictions could introduce fresh inflationary pressures just as the economy shows signs of reaccelerating, affecting spreads, rates and market sentiment.

Barring a selloff between now and year-end, investors will likely enter 2025 with the most severe valuation constraints in more than two decades. The High Yield market has delivered an impressive +8.18% YTD return (in USD terms) with spreads approaching historical tights, yet forecasts suggest primary market activity could actually accelerate in 2025. High Yield bond issuance could exceed $300 billion next year driven by increased M&A activity and a softer regulatory environment.

The rates market presents an environment of remarkable complexity. U.S. 10-year Treasury yields have experienced significant volatility, predominantly driven by real rates rather than inflation expectations. DataTrek Research notes that 68% of the 78 bps rise from September lows originated from real rate adjustments, reflecting the underlying economic strength.

Pimco's perspective of Treasuries as a “very low volatility asset with high return” captures the nuanced opportunity landscape. While according to Bank of America, bond yields remain in a Goldilocks range as bear catalysts of rising 3% inflation, $36 trillion debt, and a 7% of GDP deficit are offset by bull catalysts of central bank rate cuts in 2025, peak geopolitical risk, and optimism that Trump (and especially his new Treasury Secretary Bessent) knows it would be political malpractice to allow a second wave of higher inflation in 2025 (although that's precisely what may happen). BofA Strategists Hartnett says the expectation that Trump 2.0 equals a US inflationary boom means the bid for Crypto and Gold is likely to continue.

The Federal Reserve's approach to monetary policy has become increasingly nuanced and cautious. The CME's FedWatch tool indicates a 55-56% probability of a December rate cut, with market expectations now recalibrating to approximately three cuts in 2025 – a significant moderation from earlier, more optimistic projections. Federal Reserve officials like Austan Goolsbee have signaled a measured approach, suggesting that while rates will likely end up lower than current levels over the next year, the path will be carefully calibrated. Neel Kashkari has further complicated the narrative by highlighting geopolitical risks and the potential inflationary implications of retaliatory tariffs.

Institutional investors must recognize we are witnessing a moment of profound financial transition. Unprecedented capital flows into US equities – nearly $448 billion year-to-date, almost double the combined total of 2022 and 2023 – underscore market bullish sentiment and confidence. Yet, this is tempered by increasing awareness of potential risks: elevated valuations, optimistic earnings expectations, and a market potentially pricing in an overly rosy scenario.

As spreads hover near post-Global Financial Crisis tights and Treasury volatility moderates, the market's resilience will be tested by this changing macro backdrop. The upcoming weeks of economic data and policy signals will be crucial in determining whether current valuations can be sustained into year-end and beyond.

We are skeptical that spreads will remain within their recent range. In 2014, for example, high-grade only remained below 100 bps for five months before sharply retracing to nearly 200 bps by first-quarter of 2016. But there are many counterexamples where high-grade and junk spreads broke below 100 bps and 350 bps respectively for a sustained period.

From a purely tactical point of view, we believe it is time to add some duration risk after a significant move up in rates.

Source: Ashenden Fixed Income Monthly Report

Every month, we publish the Fixed Income Monthly report. The report is a synthesis of the Ashenden’s team view on Fixed Income, pursuing a global approach through the full spectrum of the asset class and providing bond picks. We range from Investment Grade bonds to High Yields & Emerging Markets.

In the report we disclose our bond model portfolio (6 years track record) with more than 60 individual names. We include new single bond ideas, switches, new entries and exits.

All this is corroborated by a bottom-up analysis for each single position (new and old) and merged with a top-down consideration so to include the key market drivers.

This is one of the research piece our team produces internally. The intent of the report is to support wealth managers/asset managers in their decision and allocation process.

Feel free to ask us more information: write to us at research@ashendenfinance.ch