December 2024 Market Update

A new year and new leadership. 2025 is projected to be a year of common sense.

The Fed began cutting interest rates to help the economy in September. Since then, the Fed has cut 1% percent or 100 basis points. However, the cuts so far have not had the desired effect. Mortgage rates have since climbed approximately 1% percent, pushing home affordability down even further.

We believe treasury yields are rising because the Fed is cutting interest rates while nGDP (nominal GDP) growth is slowing, net national savings is almost negative, and the market is pricing in more interest rate cuts and stimulus. The economic lesson approaching is one where average borrowing costs rise as the Fed cuts interest rates. This may surprise many investors. If the new Trump Administration attempts to stimulate nGDP growth using debt, deficits or interest rate cuts, then borrowing costs may very well rise in response and those policy efforts could become self-defeating.

Under the Biden Administration the market has been focused on “fiscal dominance” whereas, government spending and borrowing make it difficult for the Fed to manage inflation and economic growth through monetary policy. This term has made Wall Street confident in the sustainability of nGDP growth even while it has slowed significantly over the past two years. We believe confidence in nGDP growth from fiscal dominance is a myth and should not be relied on for investment decisions. The chart below demonstrates how higher debt, and deficits have always resulted in lower nGDP growth. The U.S. economy can’t even sustainably grow greater than 3% real and 5% nominal. The federal funds rate is at 4.25% with real GDP growth at 2.8%. Monetary policy is tight.

Liquidity, on the other hand, has been abundant or ample, but is soon to run dry as leadership change occurs on January 20th.

Earlier this month, President -elect Donald J. Trump announced Stephen Miran as his Chairman to the Council of Economic Advisers. Over the past few years Stephen has been very critical of Janet Yellen and her attempt to offset Fed tightening through adding liquidity to the Treasury. In our view, this is why stocks look the way they do. Highly concentrated, volatile, lack of earnings growth, expensive and dependent on Government.

The Trump Administration is taking over the economy as U.S. markets appear to be headed for a liquidity event. The new Secretary of Treasury, Scott Bessent will immediately be tested. If liquidity is not added, then markets will likely struggle, and unemployment will begin its ascent higher. If liquidity is added, then markets may remain stuck in a bubble, but the cost of living and owning a home will rise, likely hurting Americans ability to consume and slowing the overall economic growth rate. We believe Bessent will remove liquidity, allowing prices to decline and then interest rates, so that interest expense declines, by issuing long dated government bonds to fund the Treasury, instead of t-bills.

The Trump administration should lean into a recession, allow liquidity to be drained from the system, prices to decline and interest rates to follow. If the Treasury constrains liquidity, contrary to what it did under Janet Yellen, then the federal funds rate could decline to be in line or slightly below real GDP, which currently sits at 2.8%. If the federal funds rate can drop below 2.75%, which is the approximate rate where the U.S. government is no longer forced to print money to pay interest expense, then the U.S. can sell debt with confidence and without interest expenses contributing to a rising deficit.

We believe the bond market has lost faith in both the Treasury and Federal Reserve’s ability, together, to cut interest rates and print money to create sustainable economic growth to support current asset valuations. Mortgage rates rising while the Fed cuts interest rates as longer-term inflation expectations decline, in our view, means the market no longer believes the Feds narrative. We believe it is likely that next year, the market begins hearing "the fed has lost control" as a new theme.

If there were one chart which we could encourage investors to appreciate and understand, it is the one below. We believe interest rates are rising because the U.S. is about to enter a recession and the market is forecasting interest rate cuts, liquidity and stimulus as the policy response, and because the U.S. is basically out of savings, those policies may result in higher average borrowing costs/interest rates even with a lower federal funds rate, and as a result, a lower real economic growth rate. For interest rates to decline America must be encouraged to save.

Our recommendation since January of 2023 has been to position portfolios to endure a recession, in a defensive manor, risk off and in cash, T-bills, money market funds, fixed income duration extended in September 2023 from 0-5 year to 0-30-year U.S. Treasury bills and notes, 10-year minus 2-year yield curve re-steepening, 10-year minus 3-month yield curve re-steepening added September 2024, Short USDJPY from 153, and select low duration U.S. equities.

Getting paid to wait for growth assets to be priced at discounts, while being positioned to benefit from bond price appreciation as interest rates decline from downward economic pressure, continues to be a profitable and rewarding strategy. We remain patient and focused on managing risk through 2025.

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