This week in the markets: interest rate fears and high valuations cloud the equity outlook.
In the weeks following the US Presidential election, the equity market glass was very much half full. Investors embraced with open arms the prospect of lower taxes and deregulation. Potential tariffs were seen as a positive for US companies.
Stock markets remain close to the high points they reached during that autumnal Trump Bump, but enthusiasm has started to wane as inauguration day approaches. Sometimes it is better to travel than to arrive and the glass is starting to look more half empty as the new President prepares to return to the White House.
After the last two years’ stellar gains for stock market investors, it was always likely that investors would face a tougher time in 2025. With valuations in the US now at historically high levels, it was always going to be a tough ask to repeat the 20%+ returns of 2023 and 2024.
Even with the US economy still firing on all cylinders, as demonstrated by last week’s better than expected jobs data, it is hard to avoid the conclusion that much of the good news is well and truly baked into share prices.
Related to that economic strength, the realisation that the Fed may only have one more interest rate cut or even be finished for the current cycle is pushing bond yields higher. Not just that, worries about fiscal sustainability mean bond investors are demanding more compensation to lend for longer periods.
This is pushing long bond yields yet higher, back towards the 5% level at which bonds start to look much more competitive compared to shares. This essentially is what caused the equity market correction in 2022 and investors who have ridden the wave over the past two years are starting to wonder whether the best is now over for the 27 month old cyclical bull market.
This is starting to show up in a few different places in the stock market. Although the Magnificent Seven tech stocks continue to perform, the broadening out of the market rally is showing worrying signs of running out of steam. Only 24% of shares are now above their 50-day moving average and 29% of shares are outperforming the index.
Meanwhile smaller companies have dipped below the upward trend line they have followed for the past 15 months or so since they belatedly joined in the market resurgence.
As we have been saying for some time now, the baton is being handed from valuations to earnings, so this week’s start of the Q4 earnings season will attract plenty of investor attention. The expected growth rate is 7% currently, and this usually rises as results actually start to emerge so another double digit quarter is in prospect. That could help the bull market keep going, albeit with less vigour.
If investors are turning more cautious, this will bring them more into line with economists who never quite bought into the Trump Bump in the way that stock market participants did. The positive forecasts of equity strategists in the year end outlook round, was at odds with warnings from economy watchers that Trump’s protectionist policies could hit economic growth, raise inflation and limit the ability of the Fed to ease monetary policy.
In part, that divergence was simply a difference of views about how seriously we should take Trump’s campaign rhetoric. Economists basically took him at his word on tariffs especially while investors were betting that his bark would be worse than his bite. The reality, of course, is that both could be right but over different time scales. Tax cuts could give the market a continuing sugar rush through the early part of this year with a worsening federal budget deficit and damage to growth from tariffs and immigration curbs kicking in later.
Looking at prospects for markets elsewhere in the world, the big issue is the strength of the dollar. The US currency has hit a two year high against other major currencies after last week’s strong jobs data led investors to slash expectations for rate cuts. The pound has fallen from around $1.34 to $1.22 since last autumn and other currency pairs have suffered a similar if less extreme fate.
That’s feeding into the outlook for equity markets too. High US bond yields and a strong dollar are typically bad news for emerging market equities as investors have less reason to take the perceived risk of investing outside the US. China has been the most obvious victim of this, with the outlook for Chinese equities also clouded by fading hopes for a big bazooka economic stimulus from Beijing.
Some key asset managers are now starting to caution their clients to take a more defensive position and to weight their portfolios more towards bonds and away from equities. Vanguard, in its 2025 outlook suggested advisers allocate only 38% of their clients’ portfolios to shares, effectively turning the traditional 60/40 portfolio balance on its head.
That’s also in line with a recent warning from Goldman Sachs which suggested that today’s elevated share valuations could result in disappointing long term returns from equities. It forecast 3% a year over ten years, which would be well below recent history. That prediction chimes with analysis that shows the inverse link between the price investors pay when they buy an asset and its expected long-term performance.
Here in the UK, Britain’s bond market is being buffeted by global factors, but yields are being pushed higher by domestic concerns as well. Chancellor Rachel Reeves has been forced to promise that she will stick to the UK government’s fiscal rules in a bid to soothe concerns in the UK bond market where borrowing costs have hit their highest level since the financial crisis.
The 10-year gilt yield rose as high as 4.93% last week and the pound dropped to its lowest level in a year as investors started to fret about the UK’s fiscal position. They are worried that the government’s heavy borrowing needs and the growing threat of stagflation - persistent inflation and sluggish growth - could force the government into raising taxes or cutting spending or both.
When the Chancellor announced a £40bn tax raising package in October’s Budget she left herself only a small £9.9bn of headroom against her revised fiscal rules which promise to fund all day to day public spending with tax receipts by 2030. The increasing cost of financing public debts makes it progressively harder to meet those rules.
Looking into this final week of the Joe Biden presidency, there’s plenty for investors to keep an eye on. Inflation will be in focus on both sides of the Atlantic with US and UK CPI readings for December due on Wednesday. Here, we will also have retail sales numbers on Friday and an estimate of the November GDP figure.
On the results front, the US banks kick things off as usual with Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan Chase and Wells Fargo all reporting on Wednesday, followed by Bank of America and Morgan Stanley on Thursday. The UK trading updates will also be in full flow with the likes of Ocado, Currys and Whitbread providing an insight into how Christmas looked ahead of the official retail data at the end of the week.
