The Uneven Path to Disinflation
The S&P 500 was up ~2.8% in January, while its equal-weighted counterpart returned ~3.5%, and the Barclays U.S. Bond Aggregate Index was up ~0.5%. The 10-year Treasury yield retreated from its mid-January peak of 4.79% but remains elevated at 4.45%. Performance has broadened across sectors as investors grapple with economic, monetary, and trade uncertainty. Volatility briefly reentered the fray with the emergence of DeepSeek, a Chinese artificial intelligence startup that introduced a competitive AI language model that caused a short-lived market downturn, particularly affecting technology stocks.
The Federal Reserve released its policy decision last Wednesday, opting to hold interest rates in a range of 4.25%-4.50% for the foreseeable future. Markets took particular exception to the Fed’s removal of language referring to inflation having “made progress” toward getting down toward the official 2% target. In its place, the Fed reiterated that “inflation remains somewhat elevated.” The FOMC is in wait-and-see mode as the uncertainty over how President Trump’s policies on immigration, tariffs, fiscal policy, and regulation could modify their expectations for the economy. “We need to let those policies be articulated before we can even begin to make a plausible assessment of what their implications for the economy will be,” Fed Chair Powell said. He stressed the U.S. economy is in a “good place” overall and said policymakers want to see further easing in inflation before cutting rates again, adding unexpected weakness in the labor market could also trigger a move. Fed officials want to keep some downward pressure on the economy to enable inflation to cool to their 2% target, but a critical question for policymakers at this point is just how restrictive current interest rates are on activity. Powell said rates are still “meaningfully” above the so-called neutral rate, the level at which the Fed is neither enhancing nor slowing the economy. CPI bottomed at 2.4% in September, but has increased every month since to the most recent reading of 2.9%. This reacceleration of inflation toward 3% is likely the motive for the FOMC statement striking any specific reference of progress toward the Fed’s 2% target. Investors are fully pricing in a first cut by July, with an 80% chance of a second by December, a substantial change in expectations from just a few months ago.
Interest rates will likely find their new equilibrium at higher absolute levels than in the 2010s. This backdrop provides a more compelling scenario for fixed income investments in the coming years. While near-term risks including historically tight credit spreads remain, higher going-in yields have improved the calculus for fixed income allocations. Higher yields provide a coupon cushion, meaning that future bond returns are less vulnerable to modest increases in rates. Fixed income will continue to play a role as ballast in long-term portfolios, and the “death of the 60/40” portfolio has been greatly exaggerated.
At 22x, the S&P 500 forward price to earnings ratio looks stretched. According to Bloomberg, mom-and-pop investor sentiment has reached the highest level on record, surpassing what was seen during the 2021 meme-stock frenzy. And according to JP Morgan, households’ equity weight as a share of total assets is at a record high. We expect heightened volatility amidst a market that has little margin for error. That being said, we are still constructive on a continuation of the broadening market rotation. Small cap stocks would benefit from the continued strength in the U.S. dollar and would be key beneficiaries of deregulation, any improvement in business optimism, and increased merger activity. They are also trading at relatively cheaper valuations. Financials would also outperform on the heels of deregulation, robust loan growth, and improving corporate activity. We also remain positive on energy; constraints on energy imports are supportive of oil prices and will improve profitability of oil producers. Bond yields remain one of the most important components for equities and rising yields will hamper the stock rally. Newly appointed Treasury Secretary Scott Bessent yesterday told Fox Business that he and President Trump are focused on lowering 10-year yields rather than the Fed’s short-term interest rate. They will have their work cut out for them as blowout budget deficits and continued debt/GDP expansion put upward pressure on rates. Market participants will be paying close attention to tomorrow’s employment report for January as it holds the next set of data points for shaping policy going forward.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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