Written January 17, 2025

In November, Republicans secured a decisive victory, with President Trump at the helm, leading a slim majority in the House and a narrow edge in the Senate. This political shift prompted an immediate rally in the equity markets, particularly for large-cap growth stocks, adding to an already strong year. The S&P 500 delivered a robust 25% return, showing remarkable resilience despite ongoing geopolitical tensions and fluctuations in commodity prices.

However, Santa forgot the bow when he wrapped the fourth quarter, and he may not have used enough tape. The rally has come almost fully undone since the election as reality and expectations are finally starting to align and the mood is souring—for now. Pro-growth initiatives initially fueled equity investor optimism, but political infighting and mounting worries over the deficit are casting a shadow of uncertainty over the outlook, reflected in the Treasury market. The unpredictability surrounding the new administration is palpable, with the possibility of up to 100 executive orders in this first week. Key issues such as immigration, energy policy, financial services, and trade remain in flux, making it difficult to forecast the precise trajectory of the economy and markets.

Given this environment of heightened uncertainty and rapidly shifting dynamics, we have decided to take a different approach this quarter. Rather than providing our typical economic and market outlook in this letter, we will send timely commentary to our clients as noteworthy developments unfold that could influence the markets and economic outlook. This approach will allow us to provide more meaningful insights as clarity emerges.

This is not the same market or economic environment President Trump inherited in 2017. The low-hanging fruit of economic growth has already been plucked and properly addressing the fiscal situation today will require difficult, unpopular decisions—and likely a recession. Government spending has been propping up growth and the baton needs to be passed to the private sector for the economy to remain stable. It is unclear whether the recent improvement in manufacturing and new orders data reflects companies trying to get ahead of trade issues or signals genuine consumption and investment demand, something we will monitor closely.

Our view changed last year, stating that a recession was unlikely until after the election given the level of government spending. Now that the election has passed, cutting government spending seems politically untenable. While the economy is stable, risks linger. The labor market appears healthy, but much of the strength comes from the public sector, an area on Elon Musk and DOGE’s (Department of Government Efficiency) chopping block. Federal workers may need to return to the office, making it easier to reduce government employment.

Under the surface, inflationary pressures appear to be bubbling again. The inflation bear hibernated for so long, many forgot how quickly it can reappear. The pandemic revived inflationary forces, but long-term factors such as globalization and demographics—tailwinds that kept inflation in check—have changed. The bear is going to keep reemerging every time food is left out at the campsite, making it harder to rely on monetary stimulus or rate cuts to solve issues. Instead, real, sustainable solutions may be necessary.

We believe immigration will be included in Trump’s initial executive actions, likely stopping the flow of illegal immigration into the US, but widespread deportations are less likely until later this year. Tariffs, particularly toward China, may also be included in initial executive actions. Both policies are potentially inflationary and negative for economic growth.

While President Trump may be unwilling to cut spending independently, the bond market could force his hand. In calendar year 2024, despite decent economic growth and the Federal Reserve’s efforts to combat inflation, the United States borrowed TWO TRILLION DOLLARS. Due to increased spending and slightly lower revenues, the October-December deficit was 39% higher than 2023. Numerous decisions in the coming years could potentially add trillions to the deficit. We are set to spend more on debt servicing this year than national defense or Medicare.

A widening deficit could increase inflation, bond issuance, the neutral fed funds rate, yields, and credit spreads. Unless interest rates are held near zero forever, which worked until inflation returned, eventually the ratio of government debt to income needs to stabilize. If left unchecked, debt service could consume the entire budget.

The ten-year yield has increased by over 100 basis points since the Fed kicked off its current easing cycle in September, steepening the yield curve out of inversion. While it is normal for investors to demand higher yields for the risk of holding longer-term bonds, this shift suggests concerns about the long-term fiscal trajectory of the US. Is this merely another tantrum or is there more to it? Inflation break-evens have risen, indicating part of the increase may be inflation concerns. Part of the increase may reflect a stronger growth outlook, but the remaining increase appears to be attributable to the US fiscal position.

This could be a reset to a “new-old” normal of higher rates, where ultra-low yields post-Global Financial Crisis become a historical anomaly. Near-zero rates, contained inflation, persistent quantitative easing, and fiscal stimulus fueled an impressive rally, but what happens as these tailwinds disappear? What if the risk-free rate permanently rises above 4%, or the ten-year reaches 5%? A significant market adjustment would be expected, and investors and markets are unprepared. We continue to expect a “higher for longer” environment with a potential for no rate cuts in 2025, particularly if Investment picks up and the economy remains stable.

Because the US Treasury market serves as the worldwide lending benchmark, this rise in bond yields has led borrowing costs higher globally. Investors are growing wary of debt in Japan, France, and the United Kingdom. These bond markets are also sending a signal to tread cautiously and showing a willingness to be the governor of fiscal discipline if no one else is. If ignored, the bond market could force a reckoning.

Higher bond yields have significant implications for the economy and markets. Treasury yields, particularly the ten-year, influence borrowing costs. As yields rise, borrowing becomes more expensive for households and businesses, potentially weakening corporate credit quality if persistent. Despite three rate cuts in 2024, borrowers have seen limited relief, with mortgage rates and credit card rates largely unchanged. Companies looking to issue debt face higher return hurdles. Many borrowers have been insulated by fixed, low-rate bonds, but may be forced to refinance or roll over debt at higher rates. What would warrant more concern would be the widening of credit spreads, something we are monitoring closely but have yet to observe.

Both equity and credit markets are pricing in significant optimism about corporate profitability. Relative to the past two decades, earnings yields are less attractive than bond yields, and credit spreads to Treasuries are very tight. Treasury yields are an input for many investors’ equity valuation models. Low yields persuade investors to pay more for stocks. When yields rise, theoretically, stock valuations fall. A ten-year yield above 4.5% has historically become a pain point for equities. Lofty expectations set a higher bar for a continuation of the market rally. Companies need to meet and then exceed analyst expectations to sustain the rally, leaving ample room for disappointment. All else equal, higher bond yields should demand greater returns from equities to compensate investors for the additional risk. This could ultimately lead to a downward recalibration in equity valuations.

Today, our US equity weighting is neutral versus our benchmark, with an underweight to large-cap growth and an overweight to quality, defensives, mid-caps, and value. We remain significantly underweight international markets, except Japan. We have taken advantage of some compelling opportunities over the past month, increasing our equity exposure and allowing us to begin building some international exposure. In Fixed Income, we remain very underweight credit and duration risk, with most of our portfolio in short-term Treasuries.

Part of building wealth over the long-term is protecting capital when risks are elevated. In today’s environment we believe it is prudent to remain defensively positioned while capitalizing on opportunities that offer a margin of safety. We are selectively taking risks where appropriate and remain disciplined with clients’ long-term goals in mind, customizing portfolios to suit individual needs and risk tolerances. Today, it is critical to take only the amount of risk necessary to achieve client objectives, stay diversified, and avoid being overweight the most overvalued areas of the market. Our substantial short-term Treasury buffer, earning over 4.3%, remains ready to take advantage of opportunities arising from market volatility.

We hope you had a wonderful holiday season and wish you all a prosperous and healthy New Year!

As always, please reach out with any questions.

Kasey

One Seven (“One Seven”) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. Services are provided under the name Stone Creek Advisors, LLC, a DBA of One Seven. Investment products are not FDIC insured, offer no bank guarantee, and may lose value.