Looking Back and Looking Forward
With central banks around the world initiating rate-cutting cycles in 2024, it’s difficult to find a stock market that didn’t produce double-digit returns on the year. Despite this rate-cutting, North American bond markets were flat to slightly down on a price basis, but of course bonds now pay substantially more interest than during the post-GFC TINA (There Is No Alternative) period.
What’s most notable, in our opinion, is that the U.S. Federal Reserve has cut its overnight rate by 100bp since September, and yet the yield on the U.S. 10-year Treasury has actually RISEN by about 100 basis points. Yes – RISEN. Going back to 1963, the only other time when 10-year Treasury yields rose more during Fed rate cuts was back in 1981. Back then, Fed Chair Paul Volcker took the Fed funds rate down from its high of ~20%, and bond market investors responded with a tantrum, sending yields higher because they were worried about inflation.
Even in Canada, with the BoC having slashed interest rates 175 basis points since June 2024, the yield on the GoC 10-year bond has increased from 3.08% at the start of 2024 to 3.23% by the end.
What is the message of rising yields as central banks cut? Let’s take the U.S., for example. Is the message that the the U.S. economy is seemingly fine for now and so rate cuts are not necessary, in fact doing so will only stoke inflation (which has remained stubbornly above the 2% target)? Is it concern about Trump pro-growth policies (low tax rates, deregulation, tariffs, and deportations) which are inherently inflationary and could drive up nominal bond yields? Is it that bond market participants now simply require a higher rate of return to reflect the higher risk of ballooning U.S. government debt?
It’s probably a combination of all these factors, but what matters most is the impact of these rising yields on the broader economy and equity markets. We noted in last quarter’s newsletter that the equity market seems to have difficulty when 10-year Treasury yields push toward 4.5%. The 10-year Treasury yield sits at around 4.7% today, and equity markets have not been behaving particularly well lately.
The November-December period just past may provide a glimpse of what’s to come in 2025. The Republican sweep in early November ignited a “Trump trade” rally, followed by a fizzle in December as the average S&P 500 stock was down almost 7% on the month. In November, market participants very quickly priced in the perceived benefits of forthcoming Republican policy. This quickly dissipated in December as markets began to consider potential costs and consequences; concurrently, rising bond yields started to really apply pressure.
Whatever 2025 brings, one thing we would fully expect is market volatility, especially given the high market valuation in place to start the year. At a mid-twenties earnings multiple on the S&P 500, the U.S. equity market looks to be pricing in an awful lot of good news, which of course may be re-assessed as new events unfold. While the market multiple on the S&P/TSX Composite is less demanding than its U.S. peer, there are plenty of political and economic issues in Canada that could take down that multiple further.
Our Core Model Portfolios
We remained steadfast in Q4 as far as the asset allocation in our model portfolios. The quarter promised a lot of uncertainty, particularly around the U.S. general election, and this has certainly not lifted entirely, as we all wait patiently to see what policies roll out in coming weeks south of the border.
The most significant change we made to our core model porfolios during Q4 was a material shortening of duration in our fixed income allocations. As discussed earlier, central banks were cutting rates and yet bond yields were moving higher (pushing bond prices lower). We identified this message of the market early on and took down duration to lower the sensitivity of client bond holdings to rising yields.
As we start 2025, our core models remain exposed to global equities and short-duration investment-grade bonds, with small exposures geared to precious metals and commodities more broadly. We expect the news cycle to pick up swiftly, particularly after the hand-over of power in the U.S., and we will stand ready to respond on behalf of our clients.
We close by taking this opportunity to wish all of you a very happy and healthy 2025!