Market Review Q4 24

What have we learned?

Fortunately, we have a relatively recent, instructive example. As I described in Observations last week regarding bond yields during the Covid crisis:

For example, in 2021, investors assumed interest rates would remain low. That assumption was based on past policy tendencies. However, those past policy tendencies were formed in a period of extremely low inflation. In the context of the higher inflation of 2021, there was no longer the luxury of keeping interest rates exceptionally low. Even in 2024, with rates much higher than in 2021, the Biden administration was constrained by the political reality of having to appear to be fighting inflation. What happened was a disaster for bond investors — all because the narrative about what could happen with long-term rates changed when inflation arrived.

This episode reveals an important insight about interest rate narratives at the time. Even as fiscal and monetary policy unleashed massive amounts of stimulus in 2020 and 2021, the dominant narrative was that inflation was "transitory". An important part of this story line was that rates would soon "return to normal," with "normal" meaning the low single digit rates of the post-GFC years.

The lesson to be learned is in that moment, bond investors either didn’t recognize or didn’t fully account for some fundamental changes that were occurring. Changes like how huge fiscal stimulus, combined with numerous supply constraints, could unleash long-dormant inflationary pressures. Changes like the emergence of inflation evoking harsh political backlash that would constrain monetary policy.

Were there credible arguments for buying bonds in the summer of 2020? Of course! But with yields at historic lows and plausible catalysts for changes in key drivers, the risk/reward was awful. In hindsight, it seems obvious.

As we consider prospects for financial assets going forward, it is helpful to keep the lessons of this example in mind. Mainly, any expectation of a “return to normal” should be recalibrated by the degree to which underlying assumptions may have changed.

This lesson absolutely applies to stocks today. Mostly, the case for stocks relies on the assumption of a benign environment comparable to that after the GFC. However, that assumption is challenged on many fronts.

New assumptions

For starters, inflation remains a threat today in a way that just didn’t exist in the years after the financial crisis. The Covid emergency provided cover for governments to spend freely – and they did. Spending now remains quite high even without Covid. It wouldn’t take much of an economic “emergency” for spending to ratchet up to even higher levels.

Further, just as supply constraints exacerbated pricing pressures during Covid, so too can they exacerbate problems if geopolitical tensions continue to increase.

In addition, while monetary policy was the name of the game in post-GFC years, the room for maneuver has diminished considerably. The emergence of inflation, and the intense political backlash against it, forces the Fed to be considerably more cautious about cutting rates. Further, the practice of Quantitative Easing (QE) was found to increase inequality which imbued it with a stigma that is likely to significantly restrict its use in the future.

Nor is it just monetary policy that is increasingly constrained. The anti-incumbency trend I noted in Observations last year is restricting democratic governments around the world.

In the US, a large budget deficit, excessive debt, and no tolerance for inflation, suggest the Trump administration has a very narrow path to walk on public policy.

Further, while Republicans currently appear to have significant control over policy direction in the US, that appearance is deceiving. While rhetoric for change is strong, as James Politi reports in the FT ($), there are multiple threats to cohesion with the party:

While the incoming president enjoys stronger standing with the American public than at almost any time during his first term, he also has a much more diverse political coalition to satisfy.

“I’m not sure that he will actually be stronger institutionally once he’s in office,” says Lindsay Chervinsky, a political historian and executive director of the George Washington Presidential Library. “There are so many issues that people [in his camp] are going to be fundamentally and intractably in disagreement on.”

There’s already clear faultlines,” he says “To continue to expand and grow, populism has to deliver results. And that doesn’t mean tax cuts for the wealthy, it means tax cuts for the little guy.”

The combination of “clear faultlines” hindering the Republican agenda and sharp political divisions remaining across the country provide a starkly different environment than FDR had with his first 100 days of historic policymaking.

Frictions are also increasing abroad as well as at home. Several countries, including China, have developed much greater concerns about investing in the US. With the election of Trump, those concerns have expanded to America's allies as well. Martin Wolf in the FT ($) describes:

How does the world view this event [Trump’s election]? In “Alone in a Trumpian World”, the European Council on Foreign Relations has just published the results of surveys of public opinion across the world. They are fascinating. The people most disturbed by Trump’s second coming are citizens of its closest allies. Only 22 per cent of citizens of the EU, 15 per cent of the British and 11 per cent of South Koreans think his return is a good thing for their country. Meanwhile, 84 per cent of Indians, 61 per cent of the people of Saudi Arabia, 49 per cent of Russians and 46 per cent of the Chinese think it is good for their country.

In short, geopolitical friends and adversaries alike have a waning interest in supporting US policy and, by extension, capital markets. Worse yet, as many of those countries confront economic challenges of their own, they will have significant incentives to act in their own interest, even if that comes at the expense of the US. Meanwhile, adversaries will be on the lookout for opportunities to cause disruption.

Summing up, when all of the major constraints are taken into consideration, two things become clear. One is that many of the key assumptions investors have used to build up narratives for stocks are no longer valid, at least not nearly to the same degree. Another is there are only a limited number of ways forward for policy measures; there are too many constraints for a wide open playbook.

The good news is the path ahead is far less unpredictable, at least in broad strokes, than we might imagine. This establishes some useful clarity: While new policies could possibly lead to significant improvement in the investment landscape, and we should all be hopeful for that, the odds are strongly against it.

This isn’t normal

Another assumption that should be scrutinized is what constitutes “normal”. Whether it be in regard to inflation, American exceptionalism, or other phenomena, the default forecast is often a return to “normal”.

As the graph below from The Daily Shot indicates, however, US bond yields have definitely NOT been normal for most of the last thirty years. Not only did 10-year yields fall persistently over most of the period shown, but they hit an all-time low in 2020. Further, those yields were also well below the modeled rate which is a good proxy for a “fair value” rate.

The graph also suggests why this was the case: Prices, and therefore yields, were set by buyers who didn’t care about price; they had other objectives. First China in the late 1990s through the GFC, then the Federal Reserve from the GFC through the pandemic, with a brief respite just before the pandemic.

One may argue, so what? As long as large government authorities want something to happen, such as long-term interest rates to be below “fair value” rates, who is to stop them? Fair question, but as discussed previously, monetary, economic, political, and geopolitical conditions are all imposing new constraints on policy actions. The government simply does not have the same capacity to coddle owners of financial assets as it has had in the past.

So, a return to the old sense of “normal” is extremely unlikely. That means investors will need to figure out what the new notion of “normal” looks like.

Implications

There are a lot of reasons why bond investors have suffered so much over the last four years. Partly there was greed and partly there was a lack of historic perspective. Mainly, however, the slowness to appreciate that underlying assumptions had changed materially and the misguided baseline for normalcy were the key mistakes.

These same keys apply today to investors in stocks and other risk assets. The benign conditions of the past are under threat on many fronts. As a result, it is no longer a safe assumption that inflation will remain low, that central bankers will protect the downside, or that the political environment will favor the stock market. Indeed, we may have gotten a good preview this week of how narratives can break down and send stocks reeling with the disruption to the entire artificial intelligence space by DeepSeek.

While the longer-term prognosis is negative for stocks, that doesn’t necessarily imply there will be a crash. For one, there are strong policy incentives to maintain stability and prevent disruption. For another, the positive narratives around stocks are so strong, they will take a long time to completely break down. This may very well provide tradeable opportunities along the way. Make no mistake, however, the longer-term risk/reward for stocks is awful and there is very long way to fall for current narratives.

Finally, none of this suggests a doomsday scenario. The US has more resources and more policy levers than most countries, even if they are much more limited than in the past. That should allow the economy to remain in decent shape, even if financial assets get hit.

Conclusion

As investors scramble to make sense of the investment environment under a new president and new policies, it’s easy to get overwhelmed by the sheer volume of news and ideas. One way to overcome the challenge is to reframe the effort by considering the constraints on policy, i.e., by considering what is unlikely to happen. This helps filter out a lot of noise.

Doing so highlights the fact that there are some intractable problems in an environment of unforgiving politics. Stocks are near all-time high valuations and many of the benign conditions of the past are fading away. This makes the risk/reward proposition for stocks truly terrible over a longer horizon like ten years.

Of course, there is nothing wrong with optimism and there are certainly situations where optimism can create its own opportunities. But there is something wrong with overly optimistic sentiments that overwhelm objectively bad risks. Bond investors have learned this lesson over the last three and a half three years. Stock investors are up next. Plan accordingly.

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