Time To Brush Up On Your Bond Math
Equities are coming off their best week of gains since the November election, with the S&P 500 popping +2.9% (all eleven sectors in the green) and the Nasdaq Composite jumping +2.5%. In a reminder that it's all one trade (everything moving together), small caps bested their larger cap brethren with a +4% gain, aided and abetted by lower interest rates following last week's lower-than-feared inflation prints. Digging deeper into the scorecard, we had oil (although slipping on Friday and carrying over into today) up for the fourth straight week as the outgoing Biden administration ramped up sanctions against Russia and expectations that the new Trump administration will likely set the sanctions sights on Iran. Oil wasn’t the only commodity registering gains as the S&P GSCI commodity index rose a little over +1%, which also marked a fourth consecutive week of gains.
With sentiment, positioning, and relative strength indices registering oversold readings coming into last week, it wasn’t going to take much positive news to ignite a rally in equities. Adding fuel to the fire was a sweep of top and bottom-line earnings beats from the big money-center banks (JPMorgan, Goldman, Wells Fargo, Bank of America, and Citi). The banking sector is an area of the market that can and should continue to be viewed as a source of growth in 2025, driven by a slew of constructive tailwinds: a favorable regulatory environment, increased M&A, and higher asset management fees. Ceteris paribus, we’ll be looking for spots to increase our exposure to this sector when the opportunity presents itself.
The week ahead is quiet on the economic data front, but do not worry, as earnings reports and policy announcements from the new Trump administration will be sure to keep markets on their toes. So far, markets are trading higher on the relief that a barrage of tariff announcements didn’t follow Trump's inauguration. However, it's still early days, and as we learned during his last term – a random tweet is all it takes to change the market sentiment on a dime.
From a markets perspective there is a high level of optimism and uncertainty that comes with the ambitious agenda of the incoming administration. Not to mention an elevated level of embedded fragility structurally built into the financial system at the moment: the equity market is trading at one of its richest valuation levels in history, households' exposure to equities is at its highest levels in history, and the broad market has never been more concentrated. As for the bond market, U.S. debt on both an absolute and relative to GDP basis is at all-time highs, deficits of 6-7% while supportive for economic growth are not sustainable, and government borrowing requirements (both new issuance and refinancings) are crowding out other investments. I point this out because the Trump administration has a tall task of striking a balance between implementing the agenda he got elected on and navigating the fragility of the financial system that doesn’t provide a lot of latitude for slip-ups.
While it is never just ‘one’ thing when it comes to markets, the uncertainty of tariffs and fiscal policy has caused financial conditions to tighten significantly since the Fed first cut rates back in mid-September. It’s not just the rise in Treasury yields either; mortgage rates are up nearly +100 basis points, the average interest rate in investment-grade corporate debt is up +70 basis points, and by nearly +40 basis points in the high yield market. Add to this the +9% rise in the DXY dollar index since September, and it's no wonder that Bloomberg pointed out that financial conditions are reacting like the Fed actually instituted two hikes rather than four cuts. This all happened before the Trump administration even took office.
Keep in mind that the sequence of how and when Trump’s agenda gets enacted will matter. In Trump’s first term, he led with the fiscal goodies of sweeping tax cuts (passed at the end of 2017) before getting to tariffs (late 2018 / 2019). Expectations are that the sequence will be reversed this go-round, and the bar is high for additional tax cuts beyond extending the 2018 cuts, which will sunset at the end of 2025 if nothing is done. Then, there is the debate over the inflationary impact of tariffs and what this means for the Fed. In Trump 1.0, there was no lasting impact on inflation from the tariffs he implemented – don’t forget that the Biden administration kept most of them in place and added some tariffs in other areas.
From an economic perspective, tariffs are a shock to the price level (a one-time change in the level) and, therefore, mechanically become inflationary only if tariffs are raised yearly (like OPEC did with oil prices during the 1970s). Inflation is a process measured on a rate-of-change basis, not a price level. Moreover, the manner in which the parties affected by the tariffs share the burden matters to the inflationary impact. Does the domestic importer pass on the cost increase at the risk of losing market share, or does it eat it through reduced margins? Does the foreign exporter get bailed out via currency depreciation, which balances out the cost of the tariff? Is the product caught up in this complex dynamic elastic or inelastic to the final consumer? As you can see, it's not as simple as the media sometimes makes it out to be. The bottom line is that we shouldn’t be too quick to rush to a final verdict on how tariff policy will work its way through the global financial system; it is not a static process.
One thing I am sure of is that if Trump 2.0's policies turn out to be inflationary, there will be a price to pay come the next election cycle. One of the most obvious takeaways from the last election is that the median voter has zero appetite for inflation. Inflation is a social disease that impairs the most vulnerable parts of society (the poor and elderly), and they do vote. And what we know about Trump, given his real estate background, is that he is a big debt guy and, therefore, a low interest rates guy. He and is cabinet appointments who pay attention to such things are acutely aware of the societal disdain for inflation which I expect will act as a form of governor to there aggressiveness on the policy front. I know, I know, to assume I have any read on how Trump or his cabinet will think or act is lunacy, but give me a little latitude as we all have to have a base line to work from.
But this is where the bond market comes in as the white night or evil villain to keep this administration in check. The way the bond market has been trading the last eighteen months suggests it is paying more and more attention to the ugly fiscal outlook. The CBO’s new budget forecasts predict that the United States will record a $1.9 trillion budget deficit this fiscal year and that deficits over the next decade will total $21.1 trillion. That will be piled on to a national debt that currently exceeds $36 trillion. By 2035, the debt as a share of the U.S. economy will rise to 118% (the largest in history), from close to 100% of GDP currently. There may end up being limits to financial market stability from numbers like these, even for the reserve currency.
And keep in mind that the CBO’s forecasts now assume that much of the 2017 tax cuts will expire this year. Extending these tax cuts is a top priority for this administration – reminiscent of Ronald Reagan's famous line, “Nothing lasts longer than a temporary government program.” So, on top of the abovementioned numbers, we can add another $4 trillion over the next decade to the public purse. This is what is stirring some of the anxiety in the bond market and begs the question, at what yield level will Treasury yields have to increase to for Uncle Sam to clear all the bonds it has to issue?
Let’s focus on bonds for the duration of this missive, which will likely turn most of you off from reading further, but investors can invest in other markets besides equities. A good place to start would be by acknowledging how dreadful a performance period it has been for U.S. Treasuries over the past decade. On Friday, BofA Investment Strategist Michael Hartnett published a couple of charts and historical data detailing how painful it has been. For the first time in the past 90 years, long-duration Treasuries (+15-years) have registered a negative 10-year rolling annualized return (-0.5%).
These results pale in comparison to U.S. stocks at 13.1% (see chart below), commodities at +4.5%, investment grade bonds at +2.4%, and T-bills at +1.8%.
But here is the rub. None of this is new, and it is important to understand where interest rates came from (zero) to properly contextualize why long-term Treasuries (or bonds in general) have performed so poorly. However, we are not at zero today. Interest rates across the spectrum are at or near their highest levels in a decade and a half. It’s a completely different starting point where the interest rate sensitivity to a further push higher in yields is much better insulated. Consider the following table included in Hartnett’s report, where he details the 12 and 24-month returns of a bond portfolio (20% T-bills, 20% 30-year T-bonds, 20% IG, 20% HY, and 20% EM debt) if bond yields drop by 100bps or rise by 100bps.
The asymmetry of the return payoff is eye-catching in that a 100bps fall in yields generates a 1-year return of +12% versus a -1.0% return if bond yields rose by 100bps. The 2-year return profile is even more compelling, with both generating a positive return if rates rose or fell 100bps. As you can see from the current level of interest rates, the sensitivity of fixed income to a rise in yields is less than it is to a corresponding fall in yields. That should at least catch some investors' attention, especially when you contrast it with the expected return profile of equities based on metrics like the Equity Risk Premium, which signals that bonds offer a more favorable risk/reward opportunity given the current setup (see chart below).
I’m neither a raging bond bull nor a ravenous equity bear. But, admittedly, I like bonds at current yield levels, and I will like them even more if long-end Treasury yields push up to or above 5%. Given the current setup, the risk to bond prices at higher yield levels diminishes while the risk to equities increases as yields press higher from here. Don’t get me wrong, on a longer-term structural timeline, investors should favor tangible assets and equities over bonds. However, this looks like one of those windows where the security and potential return profile of bonds match up favorably relative to equities.
I look at 2025 as a year where uncertainty on economic growth, inflation, and policy is much higher than in the previous two years, and the setup for the equity market is much less constructive. Therefore, I’m inclined to lean towards a more tactical approach to equity markets this year. I expect we will get a drawdown in equities of -10%, maybe even get as deep as -20%, and that will be an opportunity to size up in equities where the setup shifts back to being favorable from unfavorable. In the interim, I’m content to sit on a portion of a portfolio that offers a secure mid-single-digit return with moderate risk and pays investors for their patience. Diversification is no longer a dirty fourteen-letter word, and I suspect bonds will act as a very nice ballast in a portfolio that includes gold, stocks, and other risk assets.
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