by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Note: The Confluence offices will be closed tomorrow, January 9, for the Day of Mourning, and we will not publish a Daily Comment.

Good morning! Concerns about the deficit and inflation continue to weigh on investor sentiment. In sports news, New Orleans Pelicans forward Zion Williamson scored 22 points in a loss to the Timberwolves in his first game back from injury. Today’s Comment will cover our perspective on the rise in 10-year Treasury yields, tensions between the US and its allies, and several other key developments. As always, the report concludes with a summary of international and domestic data releases.

Long-Term Yields Rise: Equity prices plummeted after 10-year Treasury yields rose to their highest level since October 2023. A disappointing bond sale and broader concerns about a return of inflation drove the rise in interest rates. As a result, the S&P 500 fell 1.1% on the day, while the tech-heavy NASDAQ composite closed down 1.9%.

• On Tuesday, $39 billion of Treasury securities were auctioned at a concerningly high yield of 4.68%. This yield, marginally above the initial indicated level, signaled weak investor demand. While the 10-year Treasury rates reached 5% in 2023, the auction marked the highest yield for newly issued securities in over 16 years, raising concerns about the state of the Treasury market.
• Fears of a resurgence in inflationary pressures and tightening labor market conditions may have influenced the auction’s relatively weak performance. The December ISM PMI Services Index registered at 54.1, surpassing expectations of 53.3, with its sub-component prices index exceeding 60 for the first time since January 2024. Concurrently, the BLS Job Openings and Labor Turnover Survey (JOLTS) revealed a significant increase in job listings in November, rising from 7.839 million to 8.098 million.

• The weak auction and stronger-than-expected economic data will likely heighten market focus on the upcoming jobs report. The unemployment rate will be particularly scrutinized, as last year’s rise from 3.7% to 4.2% significantly influenced the Fed’s decision to cut rates by 100 basis points in 2024. A decline in the unemployment rate could jeopardize projected cuts unless inflation demonstrates a substantial decrease.
• The CME FedWatch Tool currently suggests only a 25-basis-point rate cut by the central bank for 2025. While this scenario seems plausible, we believe the possibility of rates remaining unchanged throughout the year remains significant, especially if inflation fails to demonstrate substantial progress, and the labor market remains tight in the coming months.

Rifts Emerge Within the Western Alliance: President-elect Donald Trump has proposed annexing Canada and Greenland, as well as renaming the Gulf of Mexico to the Gulf of America, signaling a dramatic shift in US policy. In a news conference, Trump declined to rule out the use of military or economic measures to achieve these ambitions, further raising tensions.

• Western allies have unsurprisingly dismissed Trump’s attempts to acquire additional territory, warning of potential retaliation if aggression occurs. French Minister Jean-Noël Barrot stated that the EU is ready to defend the sovereignty of its members against any use of force. Similarly, Canadian PM Justin Trudeau firmly rejected the idea of being annexed by the US and implied that force would not be beneficial to either side.
• The move coincides with the incoming administration’s shift away from the US’s traditional role as a benevolent hegemon. This administration appears poised to adopt a more assertive, potentially even adversarial, foreign policy. Consequently, they are likely to prioritize transactional agreements that maximize national self-interest.

• Currently, financial markets seem to be discounting the risk of a significant rift between the US and its allies. Investor attention remains largely fixated on domestic concerns like inflation and the growing national debt. However, escalating tensions between the US and its allies could inject renewed uncertainty into global markets. This increased volatility could bolster demand for traditional safe-haven assets like gold and silver.
• As US global influence wanes, we anticipate a rise in demand for alternatives to the dollar. Gold and silver are likely to emerge as contenders. The current gold-to-silver ratio exceeds 80, significantly higher than the 30-year average of 67, suggesting gold’s relative expensiveness compared to silver. However, this elevated ratio may now be the norm, given its consistent range between 80 and 90 over the past four years.

Virginia Election Races: The first political test following Donald Trump’s victory brought no surprises in Virginia. Democrats retained two State House seats in left-leaning Loudoun County, while Republicans held onto their State Senate seat. The closely watched contest was seen as an early indicator of the state’s political direction for when Republican Governor Glenn Youngkin’s term ends next year.

Immigration Bill: The new Congress has passed its first bill of the year, the Laken Riley Act, which mandates the detention of undocumented immigrants for non-violent offenses such as theft. This legislation is likely the first in a series of measures aimed at restricting immigration. Financial markets will closely monitor the potential impact of this crackdown on the labor market, as it could exacerbate labor shortages and push up wages for businesses.

China’s Woes Continue: The country’s currency fell to a 16-year low due to fears that the Trump tariffs are likely to complicate the country’s growth efforts. Prior to this escalation, the country had been grappling with sluggish growth and deflation, exacerbated by waning investor and consumer confidence.

• The negative sentiment has also spread into the country’s bond market with the yield on 30-year government debt falling below the psychological level of 2%, placing it below the current level in Japan.

• A weakening Chinese economy poses a significant risk to global growth, as subdued consumption in the world’s second-largest economy will inevitably impact global demand. While the US remains an attractive destination for equity investments, we believe that compelling opportunities exist in international markets, particularly when analyzed on a sector-specific or individual stock basis.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with new US moves to constrain the Chinese economy and military buildup. We next review several other international and US developments with the potential to affect the financial markets today, including some notes on yesterday’s resignation of Canadian Prime Minister Trudeau and a positive new outlook for artificial-intelligence darling Nvidia.

United States-China: The Department of Defense yesterday put a slew of additional high-profile Chinese companies on its list of firms that support the People’s Liberation Army. Firms added to the list include social media giant Tencent, electric-vehicle battery maker CATL, and shipping firm COSCO. Companies on the list aren’t automatically sanctioned, but Western firms and investors typically become skittish about doing business with them or investing in them.

• The action appears to mark yet another of the Biden administration’s parting shots at Beijing and its military.
• Biden’s outgoing China hawks may fear that President-elect Trump will be convinced by the Chinese and/or the internationalist business interests in his administration to go soft on Beijing. Indeed, Trump’s recent moves on immigration and tariffs suggest he will favor his corporate supporters over the populist nationalists in his coalition.
• As we outlined in our recent Outlook 2025 report, “Technology Sector Supporters” are a key part of Trump’s coalition. This constituency includes many tech leaders who hadn’t been close to Trump in the past but are investing heavily to curry favor with him to protect their business interests both domestically and internationally.
• In the latest example of this today, Meta CEO Mark Zuckerberg said Facebook and Instagram will stop fact-checking and end speech restrictions, aligning the platforms with Trump and his incoming administration.

North Atlantic Treaty Organization: In an interview with the Financial Times today, the chief of the NATO’s military committee said Western rating agencies, banks, and investors are being “stupid” for not investing more in defense companies. Consistent with our own analysis here at Confluence, Adm. Rob Bauer pointed to the huge amounts of new money European governments are pouring into defense rebuilding. We continue to believe that European and Asian defense stocks are especially well positioned to benefit from this new spending.

Eurozone: The December consumer price index was up 2.4% from the same month one year earlier, accelerating from a rise of 2.2% in the year to November and 2.0% in the year to October. Eurozone price inflation has now accelerated for three straight months and remains above the European Central Bank’s target of 2.0%. Because of the eurozone’s sluggish economic growth, the ECB is still expected to cut interest rates at its January 30 policy meeting, but sticky inflation will complicate the outlook for further rate cuts.

Canada: Prime Minister Trudeau announced his resignation yesterday, finally bowing to his many critics both within his Liberal Party and outside of it. The deeply unpopular Trudeau said he will stay on as prime minister until the party picks his successor, which could take several months. To forestall a no-confidence vote in the meantime, he also suspended parliament.

• Trudeau is the latest of the world’s progressive national leaders to lose power over issues such as weak economic growth, high price inflation, burgeoning debt, burdensome new climate regulations, and rising immigration.
• Going forward, Trudeau’s resignation leaves Pierre Poilievre and his right-wing Conservative Party in pole position to win Canada’s next parliamentary election. If Poilievre were to become prime minister, he would likely push pro-growth policies such as tax cuts and deregulation.

US Monetary Policy: Fed Vice Chair for Supervision Michael Barr yesterday said he will resign his regulatory role in February but will remain on the central bank’s board of governors. Barr has pushed for tough bank regulations, raising the prospect of conflicts with the incoming Trump administration and its plan to push for deregulation. Now, that prospect of conflict is much reduced, as Trump will be able to nominate his own vice chair from the other remaining Fed governors.

US International Trade Policy: Yesterday, President-elect Trump denied the Washington Post’s early morning report that his proposed big import tariffs would be limited to critical goods. True to character, he described the report as “fake news.” In response, the US dollar regained much of the value it had lost early in the day, with the US Dollar Index closing down only slightly.

US Economy: According to S&P Global, at least 686 companies in the US filed for bankruptcy in 2024, up about 8% from 2023 and the most since 2010, when filings associated with the Great Financial Crisis peaked at 828 filings. The report is a reminder that despite the US economy’s continued strong growth and moderating price inflation, it still has pockets of weakness. High interest rates have probably been one key reason for the rise in business failures.

US Technology Sector: Nvidia CEO Jensen Huang yesterday laid out a future vision for the firm that encompasses not only more growth in its current business of producing chips for developing artificial-intelligence systems, but also “trillions of dollars” of opportunities in areas such as robotics and self-driving vehicles. Given that Nvidia has been such a key driver of the US stock market over the last couple of years, a credible outlook for continued strong growth that can keep the stock’s price moving upward is important to the overall US market.

US Financial Services Industry: According to the Financial Times, the US private-equity industry is preparing to lobby the incoming Trump administration to broaden the types of investors that can invest in its funds. For example, one deregulation goal would be to allow defined contribution retirement plans, such as 401(k)s, to invest in private-equity funds.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our first Comment of the New Year opens with the same old geopolitical tensions in Asia, this time with reports touching China, Taiwan, and Japan. We next review several other international and US developments with the potential to affect the financial markets today, including the new French government’s decision to ease its deficit-cutting target and news that President-elect Trump will try to pass all of his major policy initiatives in a single bill once the new Congress is in place.

China-Taiwan: Beijing has reportedly launched a new program under which Taiwanese visiting the mainland are being urged to sign up for local resident cards, bank accounts, and mobile-phone numbers, which in total allow them to apply for the identity cards used by Chinese citizens. The program appears to be another effort by Beijing to undermine Taipei’s jurisdiction over Taiwan. In a worst-case scenario, it could also be used as an excuse for Beijing to intervene in the island’s domestic affairs or even to invade.

Japan: New reports say Tokyo will release its first-ever arms export plan sometime this year. Developed with Japanese industrial firms, the plan will lay out medium- and long-term targets for defense equipment exports. Its goal will be to strengthen Japan’s arms makers so they can better support the country’s defense buildup ahead of a potential conflict with China. Development of the plan illustrates how defense is becoming a growth industry worldwide, but especially in Asia and Europe.

• According to the authoritative Stockholm International Peace Research Institute, the world’s 100 largest defense firms boosted their total domestic and foreign arms revenues to $632 billion in 2023, for an inflation-adjusted increase of 4.2% from 2022.
• The five Japan-based companies in that total — Mitsubishi Heavy Industries, Kawasaki Heavy Industries, Fujitsu, NEC, and Mitsubishi Electric — increased their total defense revenues to $10 billion, up 35% on the year.
• As in many other countries, the Japanese budget for reconnaissance and strike drones is rising especially fast, reflecting both their critical role in the Ukraine war and troop recruiting challenges related to Japan’s low birthrate.

France: The new minority government of Prime Minister Bayrou today said it would only try to cut the budget deficit from an estimated 6.1% of gross domestic product in 2024 to a range of 5.0% to 5.5% in 2025. Ostensibly to help protect economic growth, the target would be a bit easier to achieve than the 5.0% planned by the previous prime minister before he lost power in a no-confidence vote. Since it would also require smaller tax hikes and spending cuts, the new target also has a better chance of being passed by parliament and averting a fiscal crisis.

US International Trade Policy: We noticed a headline on Bloomberg television today saying the enormous tariffs that President-elect Trump has threatened to impose on foreign imports will only apply to “critical” inputs. However, we still have not seen the details behind the report. In any case, the news appears to have pushed the US dollar sharply lower against most major foreign currencies so far today. As of this writing, the US Dollar Index is down 0.9% to 107.95.

US Fiscal and Regulatory Policy: President-elect Trump and House Speaker Johnson have reportedly decided to pursue a single mega-bill encompassing all the Republicans’ major policy priorities once the new Congress is in session later this month, rather than the two-bill strategy considered previously. The single bill would include everything from extending and expanding the 2017 tax cuts and cutting spending to cracking down on immigration and deregulating the energy industry.

• Because of the Republican party’s very narrow majorities in Congress, both the strategies have political risks. A single bill covering such a large number of issues may also take much longer to be passed. Observers currently think such a bill couldn’t be signed into law until at least late April or May.
• In any case, the policies covered by the bill would be in sync with a recent research paper by Steve Miran, the incoming chair of Trump’s Council of Economic Advisors. In his paper, Miran argues that boosting growth would best be achieved by slashing regulation to incentivize more investment related to artificial intelligence and other technologies required for military modernization.

US Monetary Policy: In a speech Friday, Richmond FRB President Barkin said the continued strength in the labor market and waning price pressures mean there are more upside risks than downside risks to economic growth in 2025. However, he warned that such a scenario means there are also more upside than downside risks to inflation. Barkin’s statement is consistent with our view that the Federal Reserve may cut interest rates less than expected this year.

US Critical Minerals Mining Industry: The US Forest Service late Friday granted a permit for Perpetua Resources’ “Stibnite” gold and antimony mine in Idaho. When it starts producing in 2028, the mine is expected to supply some 35% of the nation’s demand for antimony, a rare mineral used in armor-piercing ammunition, solar panels, and other high-technology goods. In response to the news, Perpetua’s stock price surged 9.1% in after-market trading.

• Antimony is not currently produced in the US, and Beijing has recently restricted its exports to retaliate for Washington restricting the sale of advanced semiconductor technology to China. Approval of the mine illustrates how US-China tensions and global fracturing have spurred re-industrialization in the US, especially regarding goods critical to national security and advanced technologies.
• Although US industrial firms are often constrained by stringent environmental and other regulations, we think the US’s new prioritization of defense and economic growth could lead to those rules being watered down. If so, we could see many more examples of new mining and other industrial investments related to defense and technology.
• Indeed, the US defense budget and industrial-development programs could provide much of the funding for these investments. In fact, the $1.3-billion Stibnite project has been partly funded by the US Export-Import Bank and the Defense Department.

US Commercial Real Estate Industry: The Wall Street Journal today has an interesting article on the shortage of space at open-air shopping centers and the resulting strong performance of real estate investment trusts (REITs) focused on retail properties. The article notes that the sector has benefitted from reduced construction after the Great Financial Crisis and work-from-home rules that allow people to shop throughout the week. The article illustrates why investors may not want to avoid REITs entirely, despite the current challenges facing the office sector.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Note to readers: the Daily Comment will go on hiatus after today’s Comment and will return on January 6, 2025. From all of us at Confluence Investment Management, have a Happy Holiday and a Happy New Year!

Our Comment today opens with new US trade action against China, this time setting the stage for President-elect Trump to eventually impose trade barriers and punitive tariffs against China’s relatively less-expensive “legacy” computer chips. We next review several other international and US developments with the potential to affect the financial markets today, including Trump’s message to European leaders that he will maintain US military aid for Ukraine in return for them hiking their defense spending to at least 5% of GDP, and some observations on the new stopgap spending bill that Congress passed over the weekend to keep the federal government funded until mid-March.

United States-China: The Biden administration today opened an investigation into China’s use of “anti-competitive, non-market” measures to promote its legacy semiconductors. The probe targets China’s relatively cheap, less advanced, commoditized chips of the types used heavily in the automotive, healthcare, infrastructure, aerospace, and defense industries. When the probe is completed under the new administration, President-elect Trump could be empowered to impose trade restrictions or tariffs on the Chinese chips to protect US producers.

• The new probe follows more than two years of US efforts to restrict the sale of advanced semiconductors and semiconductor technology to China. The aim of those efforts is to constrain China’s military development so it would be less of a threat.
• If new restrictions are placed on importing China’s legacy chips, it would be yet another example of how global supply chains are fracturing amid the US-China rivalry.
• As we’ve argued many times before, this global fracturing is likely to boost price inflation and interest rates over time.

United States-Europe: President-elect Trump has reportedly told European leaders that he will continue providing US military aid to Ukraine while it negotiates for a peaceful end to Russia’s invasion. However, in return for that aid, he will demand that the non-US members of the North Atlantic Treaty Organization hike their defense spending to at least 5% of gross domestic product, up from the currently agreed standard of 2%. He will also demand that they provide better trade terms to the US.

• Trump’s demands will be discussed during a NATO summit at the Hague in June.
• Trump’s demand for enormous defense spending hikes by the non-US members of NATO is further evidence that he will seek outright cuts to the US defense budget, probably to help pay for extending the 2017 tax cuts. Any such cuts to US defense spending would likely fall heavily on the big, traditional US defense industry “primes,” but they would probably favor smaller firms providing cheaper, technology-enabled defense products, such as those in the new consortium further discussed below in the Syria comments.

Iran-Jordan-Israel: Jordanian and Israeli intelligence officers reportedly held a secret meeting on Friday to coordinate efforts to stop Iran from smuggling weapons and explosives into Jordan, from which some have been smuggled to Palestinian militants in the West Bank. The meeting illustrates how Iran is still trying to leverage proxies to destabilize Israel and nearby enemies, despite the body blows it’s recently suffered from Israel’s military action in the region and the fall of Syrian dictator Bashar al-Assad.

• Although Iran hasn’t entirely given up supporting its Middle Eastern proxies, it’s failure to protect Assad, Hezbollah, and Hamas has greatly undermined its political position both internationally and domestically. The survival of the theocratic regime in Tehran is probably more in question now than it has been in decades. Whether it survives and how it might falter would have huge implications for global energy supplies and prices.
• Adding to the government’s vulnerabilities, Iran is now facing an energy crisis. After years of foreign sanctions and domestic mismanagement, the energy system can’t produce enough natural gas to heat homes and generate needed electricity. The government has therefore curtailed power supplies to industry, closing down factories, retail shops, and offices.

Syria: In a weekend report dissecting the Syrian government’s fall, the New York Times said the rebels’ ability to wield hundreds of strike drones against Syrian army command posts was a key military advantage. Of course, Assad’s fall stemmed mostly from Russia and Iran refusing to give additional military support and Assad’s army being in an advanced state of rot, while Turkey and other outside powers upped their materiel and intelligence aid to the rebels. Still, the report is more evidence of the critical role that drones have taken in modern war.

• According to other reports we’ve seen, even Ukraine sent a significant number of drones and more than a dozen operators to help the rebels, probably in part hoping to create a distraction for the Russian military.
• In any case, there is mounting evidence that large numbers of small, cheap, expendable drones have become a key determinant of military power. The large, expensive, “exquisite” systems that the US military specializes in (aircraft carriers, fighter jets, tanks, and the like) are still important, but countries around the world will now need to shift more resources to drones of various types, creating new winners and losers among defense industry firms.
• Indeed, the Financial Times yesterday scooped that more than a dozen younger, smaller US defense technology firms specializing in areas like artificial intelligence and aerospace are forming a consortium to jointly bid on Pentagon contracts and get more of the US defense budget. Top companies in the consortium include SpaceX, Palantir, and Anduril.

North Korea-Russia: While observers continue to focus on Pyongyang’s provision of troops to Russia for its war against Ukraine, new satellite imagery shows North Korea has also recently ramped up its arms shipments to the country. According to the Ukrainian military, North Korea is now providing 60% of the artillery and mortar shells that Russia fires at Ukrainian forces each day, along with about 30% of the ballistic missiles it is firing. In return, North Korea has reportedly received cash, oil, food, and perhaps even fighter jets and air defense systems.

• The discovery is consistent with our view that the major countries in the China-led geopolitical bloc are increasingly cooperating, coordinating, and collaborating.
• If China, Russia, Iran, and North Korea continue to draw closer and pool their resources, they would likely become an even more formidable rival to the US-led bloc, as we outlined in our Geopolitical Outlook for 2025, published last week.

Japan: Major automakers Honda and Nissan today announced that they have entered formal negotiations to merge. Including Nissan’s partner Mitsubishi, the resulting company would be the third-largest carmaker in the world, with more than eight million vehicles sold annually. The goal of the merger is to find cost efficiencies and help the firms compete in the face of rapidly changing technologies and increasing competition from Chinese automakers.

Germany: Auto giant Volkswagen and its union on Friday reached a deal in which the firm will keep all its German plants open and avoid any forced job cuts until at least 2030 in return for the union foregoing any further work stoppages. Under the deal, Volkswagen will only be able to cut headcount by early retirements and other “socially responsible” ways, while the union will forego wage hikes and give up certain bonuses. The deal highlights the pressures European auto firms are under from the region’s slowing economic growth and rising competition from China.

United States-Panama: Signaling a possible new foreign policy issue under the incoming administration, President-elect Trump on Saturday complained that US vessels are being charged “exorbitant” fees to transit the Panama Canal and demanded that the Panamanian government either reduce the charges or return the facility to the US.

US Monetary Policy: President-elect Trump yesterday named Stephen Miran to chair his Council of Economic Advisors. Miran was a senior economic policy advisor at the Treasury Department during Trump’s first term, and he is now a senior strategist at hedge fund Hudson Bay Capital Management. Importantly, Miran has also been critical of current Federal Reserve Chair Powell, potentially signaling future tensions between the White House and the Fed.

US Fiscal Policy: On Saturday, Congress passed and President Biden signed into law a new stopgap spending bill that will fund the federal government, largely at current levels, through the middle of March. Additional funding added included about $100 billion for hurricane relief and some $10 billion in aid for farmers. However, the law did not include any boost to or elimination of the federal debt ceiling that President-elect Trump demanded.

• Approval of the stopgap bill pushes off the possibility of a partial shutdown of the government for three months. Investors are likely to welcome the prospect of stable fiscal policy for the time being.
• However, Congress and the Trump administration will now face the likelihood of renewed disputes in March. This fiscal bargaining will give us a sense of how Trump intends to balance the disparate and conflicting demands from the various constituencies in his coalition, as we describe in our 2025 Outlook.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! The market is processing the latest PCE price index data. In sports news, Tottenham Hotspur defeated Manchester United to make it to the semifinals of the Carabao Cup. In today’s Comment, we will discuss why the government may be headed for a shutdown, explain the reasons we remain confident that dollar strength will continue, and provide an update on Germany as it prepares for new elections. As usual, the report will conclude with a roundup of international and domestic data releases.

Government Shutdown: A government shutdown looms after President-elect Donald Trump and Elon Musk rejected a stopgap spending bill and called for the elimination of the debt ceiling.

• There is growing uncertainty about whether a shutdown can be avoided before the Friday deadline. Republican lawmakers met on Thursday to discuss an alternative spending package aimed at reaching broader consensus. The proposal would extend funding until mid-March, similar to the previous plan, but would exclude unpopular provisions such as a pay increase. It would also allow Congress to raise the debt ceiling twice through budget reconciliation. These adjustments are designed to give lawmakers greater flexibility next year to advance their agenda without negotiating with Democrats.
• This week’s dispute over government funding is likely a way to prevent a bigger fight  over the debt ceiling, which expires January, from derailing Trump’s agenda. Typically, there are three budget reconciliation processes used for revenue, spending, and the debt ceiling. The purpose of these bills is to allow for government funding without the threat of a filibuster. While this measure has facilitated the passage of legislation to keep the government funded, it has also been used to push through major legislation like the Affordable Care Act, the Tax Cuts and Jobs Act, and the Inflation Reduction Act.

• The market’s best chance of replicating its 2024 performance hinges on confidence in the incoming administration’s ability to implement its agenda with minimal obstacles. While high expectations for growth (which have been driven by anticipated tax cuts and deregulation) create optimism, they also heighten the risk of a market pullback if complications arise. A comprehensive budget resolution that facilitates legislative progress and avoids another divisive debt ceiling debate could strengthen investor confidence and drive higher asset prices as 2024 concludes.

Greenback’s Rise: The US dollar is on track to have its biggest annual rally since 2015, and we think there is evidence that this could continue in the coming year.

• The US dollar spot index has surged 7% year-to-date, primarily driven by market expectations of increased US GDP growth and relatively restrictive monetary policy. Despite concerns about a potential economic slowdown in 2024, the US economy managed to outperform other G-7 nations. This robust economic performance has enabled the Federal Reserve to exercise greater restraint in easing monetary policy compared to its peers, ensuring that inflation continues to progress toward its target.
• Tariffs are likely to have a positive impact on the US dollar. The possibility of a universal tariff regime has led investors to flock to the dollar as a safe-haven asset. This is because if the US were to implement such tariffs, it could have significant negative consequences for the global economy, particularly for major exporters to the US. In response to these potential economic risks, central banks such as the Bank of Japan, European Central Bank, and People’s Bank of China have recently shown reluctance in maintaining tight monetary policies.

• The continued strength of the US dollar will likely persist as long as investors maintain confidence in the stability of the US economy and the Federal Reserve’s cautious approach to reducing its policy rate. However, the dollar may become vulnerable to changes in market expectations, particularly if global economic growth begins to accelerate or if there are doubts about the severity of potential tariffs. For the time being, we believe that the US dollar will continue to strengthen throughout the coming year.

German Elections: Europe’s largest economy is heading for early elections in February as voters seek a party capable of reversing the country’s economic slump.

• Current polls indicate that voters are likely to shift to the right in the next election, with the center-right Union parties (CDU/CSU) and the far-right Alternative for Germany (AfD) projected to secure 32% and 18% of the vote, respectively. While this would theoretically give them enough support to form a government, ideological differences make a coalition between the two unlikely. This could create opportunities for left-leaning parties to play a role in the next government. Despite declining popularity, the center left Social Democratic Party’s expected 16% share could prove pivotal in forming a centrist coalition.
• A stronger-than-expected victory for the AfD party could significantly impact European markets. The party advocates for Germany’s withdrawal from both the European Union and the shared currency system. In its place, it proposes a “Europe of Fatherlands,” emphasizing cooperation among sovereign states without forming a unified superstate. If victorious, AfD plans to push for a Brexit-style referendum, allowing voters to decide whether Germany should remain in the EU. A poll earlier this year revealed that only 29% of Germans saw more advantages than disadvantages in EU membership.

• Although the chances of AfD gaining power remain slim, its new platform is likely to pressure other parties into resisting some of the EU’s stricter regulations. This could lead to a softening of the country’s unpopular climate goals as it seeks to bolster its weakening manufacturing sector. Additionally, there may be efforts to limit the number of asylum seekers accepted. A strong performance by AfD, however, could weigh on the euro and potentially drive-up bond yields across Europe.

In Other News: Amazon workers have gone on strike at several locations, indicating that labor still has leverage to demand higher wages. Senators are urging President Biden to extend the deadline by 90 days for ByteDance to sell the US assets of TikTok, in a sign that law is facing renewed pushback.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning. The market is digesting the latest GDP data. In sports, Real Madrid secured its fifth trophy of the year by winning the FIFA Intercontinental Cup. In today’s Comment, we’ll analyze the Federal Reserve’s latest rate decision, explore why long-term bond yields continue to rise, and review the Bank of Japan’s choice to maintain its monetary policy stance. As always, the report includes a roundup of key international and domestic data releases.

Fed’s Hawkish Cut: The Federal Open Market Committee voted to cut rates but also scaled back the number of projected rate cuts for 2025.

• In a widely anticipated decision, the Federal Reserve lowered its target range for the federal funds rate to 4.25%–4.50%. While most policymakers endorsed the move, Cleveland Fed President Beth Hammack dissented, advocating for no change. Alongside the rate cut, the Fed revised its economic projections, raising its 2025 inflation forecast from 2.1% to 2.5% and reducing its expected rate cuts from 100 to 50 basis points. During the press conference, Fed Chair Jerome Powell cautioned that the outlook for rate cuts could shift if inflation moderates further next year.
• The Federal Reserve’s ability to lower interest rates in 2025 will depend on inflation trends during the first quarter. In the first three months of 2024, monthly inflation peaked, driven by sharp increases in financial services, insurance, and housing costs. While the preceding months have moderated, the spike complicated the Fed’s efforts to meet its target inflation rate. The latest Personal Consumption Expenditure (PCE) price index indicates that while headline inflation was 2.3% year-over-year, underlying price pressures, excluding the surge from the first quarter, have moderated to an annualized rate of 1.9%.

• The Federal Reserve’s future policy rate decisions will hinge on inflation trends in the first quarter. If inflation moderates during this period, the Fed may adopt a more accommodative stance. Conversely, if inflation accelerates, a more restrictive policy may be necessary. This is because reducing inflation becomes more challenging after the first quarter, as spring and summer inflation trends have aligned with historical norms over the last two years. Consequently, we advise investors to remain cautious, as interest rates could move in either direction depending on how inflation unfolds.

Bond Market Roars: The 10-year Treasury yield has surged amid growing deficit worries and the Fed’s less accommodative policy stance.

• On Wednesday, the 10-year Treasury yield climbed to 4.5%, a level not seen since May. This rise was primarily driven by growing uncertainty about the Federal Reserve’s potential to cut interest rates in 2025. Since the Fed’s rate cut in September, Treasury yields have increased by nearly 90 basis points as investors became increasingly concerned that a widening budget deficit could exacerbate inflationary pressures. The Congressional Budget Office’s recent upward revisions to its forecasts for inflation, unemployment, and long-term interest rates have further fueled these concerns.
• Uncertainty surrounding next year’s policy direction, particularly the potential inflationary impact of tariffs and tax cuts, may be driving up bond yields. A recent study underscores the inflationary risks associated with these policies, estimating that a 10% tariff increase could raise the PCE price index by 0.6%, a 60% tariff on Chinese goods could add 0.4%, and a combination of both could increase it by 1%. Additionally, the proposed tax cuts, which are expected to boost aggregate demand, could further exacerbate inflationary pressures.

• Long-term Treasury yields are likely to be highly sensitive to fiscal policy changes in the year ahead. If the Trump administration proposes sufficient spending cuts or scales back some campaign promises, the bond market is likely to respond favorably. Moreover, tariffs, which are likely to face legal challenges, could prove less inflationary than currently anticipated. While we recognize the potential for upside risk in Treasury yields, we remain cautiously optimistic that market fears may not fully materialize.

The BOJ Holds: Japanese central bankers opted to maintain the current monetary policy stance, indicating a strategic pause before potentially implementing a third interest rate hike.

• The Bank of Japan (BoJ) held its benchmark interest rate steady at 0.25%, aligning with market expectations. However, one policymaker dissented, advocating for a rate hike to 0.5%. While policymakers expressed concerns about potential wage pressures, the decision to maintain the current rate likely reflects worries about the potential economic impact of US tariffs. During the press conference, BoJ Governor Kazuo Ueda hinted at the possibility of a future rate hike, possibly in January or March, when the central bank has a clearer understanding of wage pressures.
• Japanese policymakers’ persistent adherence to accommodative monetary policy has exacerbated concerns about their ability to effectively control inflation. This sentiment was reflected in the yen’s (JPY) depreciation following the central bank’s decision, surpassing the key 155 JPY level against the dollar. While overall inflation appears to be moderating, core inflation, excluding volatile energy prices, remains above the 2% target, signaling persistent price pressures. Notably, service sector inflation has accelerated, indicating that businesses are increasingly capable of passing on rising labor costs to consumers.

• The Bank of Japan’s decision to maintain low interest rates underscores the potential for countries to employ accommodative monetary policy to mitigate the potential negative impact of tariffs. By keeping their currencies relatively weak, these countries aim to maintain export competitiveness. However, this approach may lead to higher inflation within their own economies. As tariff tensions escalate, the dollar is likely to strengthen due to increased demand for a safe-haven currency. Furthermore, a lack of progress in global inflation could boost the appeal of commodities as investments.

In Other News: Russian President Vladimir Putin has expressed an openness to meeting with Donald Trump, a discussion that could potentially pave the way for resolving the conflict in Ukraine. Meanwhile, the US government is facing an increased risk of a shutdown as Elon Musk and Trump oppose a continuing resolution to prevent it.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! The market is closely watching for the Federal Reserve’s latest rate decision. In sports, Real Madrid’s Vinícius Júnior has been awarded FIFA’s The Best player, a moment many see as restoring balance to the football world. In today’s Comment, we’ll preview the Fed’s decision, analyze the Dow Jones’ recent slump, and provide an update on Brazil. As always, we’ll conclude with a roundup of key domestic and international data releases.

Fed Decision: While the Fed is expected to cut rates today, markets will focus on the accompanying economic projections.

• The latest CME Group FedWatch Tool indicates a near-certainty of a 25 basis point rate cut today, with a 95% probability priced in. This confidence stems from reassurances from Fed officials and signs that the economic risks have become more balanced between inflation and unemployment. Earlier this month, Fed Governor Christopher Waller and Atlanta Fed President Raphael Bostic both signaled openness to a rate cut. Additionally, the November CPI inflation report, while up year-over-year, largely aligned with market expectations. At the same time, the unemployment rate has risen back to its 2024 peak level.
• While the rate cut at this meeting is widely anticipated, the market will be closely watching the number of rate cuts projected for 2025 in the updated dot plot. The September dot plot indicated that Fed officials expected to cut the federal funds rate target by a total of 100 basis points in 2025 to a range of 3.25%-3.50%. However, stronger-than-expected economic growth and inflation’s failure to reach new lows have prompted officials to call for a slower pace of rate cuts heading into the new year. As a result, the market now projects that the Fed could cut rates by 75 bps next year.

• In our view, the Fed’s ability to cut rates will be determined by inflation’s progress in the first three months of the year. As the chart above illustrates, the start of this year saw the widest gap between monthly PCE price inflation increases and its three-year pre-pandemic average. This divergence led several officials to question the need for rate cuts in 2025. Consequently, if inflation remains stubbornly high at the beginning of next year, the central bank may be less inclined to implement the projected rate cuts. This could mean that the Fed may end up cutting less than what the market currently expects.

Dow Jones Trouble: Recent S&P 500 and NASDAQ gains contrast the declining Dow Jones, highlighting the increasing influence of tech giants.

• The Dow Jones Industrial Average Index extended its losing streak to nine consecutive days on Tuesday, marking its longest downturn since the Jimmy Carter administration. The Dow Jones Index has not benefited from the rally in tech stocks, as only four of the Magnificent 7 companies (Amazon, Microsoft, Apple, and Nvidia) are included. Additionally, the index has been significantly impacted by the struggles of healthcare services following the tragic killing of the UnitedHealth CEO and the incoming administration’s plans to regulate pharmacy benefit managers.

• The poor performance of the Dow Jones is another example of how concentrated equity markets have become in recent years. Tech stocks have been the primary drivers of the S&P 500’s performance this year, with the Magnificent 7 accounting for nearly 60% of the gains, which allowed them to increased their combined share of the S&P 500 to nearly 35% in the first six months of the year. This increased concentration means the overall index performance is highly sensitive to changes in sentiment toward the tech sector.

• Going into next year, we expect momentum to continue playing a major role in equity performance. As a result, we anticipate that mega cap tech companies will thrive as long as market expectations remain relatively unchanged. We believe that in 2025 many investors will flock to familiar names in search of safety amid concerns about elevated inflation and uncertainty regarding fiscal and monetary policy. However, the increased concentration of the S&P 500 suggests that the index is highly susceptible to exogenous shocks, which we will be monitoring closely in the coming months.

Brazil’s Problems Deepen: Brazilian markets have plummeted as investors have sought to reduce their exposure to Latin America’s largest economy due to concerns over its widening deficit.

• On Tuesday, the Brazilian real (BRL) plummeted to a record low, prompting investors to reduce their exposure to the country’s debt and equities. The market turmoil was triggered by the lower house’s approval of a spending package that included weakened measures to curb spending if revenue falls short of expectations. While the central bank intervened to stabilize the currency, serious concerns persist about Brazil’s fiscal situation, which is likely to continue weighing on investor sentiment, especially as lawmakers prepare to pass three additional proposals.
• The country’s budget deficit has reached 10% of GDP, exceeding the levels recorded during President Luiz Inácio Lula da Silva’s first term. In response, Lula proposed a plan to cut annual spending by 70 billion BRL ($11.5 billion). However, the inclusion of income tax breaks in the bill have raised concerns over the budgets’ ability to rein in the deficit. Compounding the issue is the speculation that lawmakers may weaken provisions affecting social spending. Additionally, a key measure to rein in military pension expenses has been delayed until next year, further casting doubt on the plan’s timely implementation.

• Brazil’s reluctance to make tough decisions to curb spending suggests that the central bank will likely bear the brunt of the burden. To prevent the country’s widening deficit from exacerbating inflationary pressures, the Central Bank of Brazil may need to tighten financial conditions. This policy could eventually weigh on the country’s GDP growth potential and negatively impact equities. However, if lawmakers adopt a stricter stance on the budget or if government revenues exceed expectations, investors may reconsider their outlook on Brazil.

In Other News: Nissan and Honda are reportedly discussing a potential merger as a strategy to increase their size and competitiveness in the automotive industry. Meanwhile, congressional lawmakers have reached an agreement to avert a government shutdown, which is expected to alleviate market uncertainty.

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