FED CUTS, BRACES FOR TRUMP POLICIES & INFLATION
Macroeconomic developments in Q4’24 relieved earlier concerns about the labor market and growth, but the progress on inflation was disappointing. Although the Fed completed its initial phase of reducing its policy interest rate, Donald Trump’s re-election added uncertainty in markets and at the Fed to the path for inflation and rates.
Inflation rose 2.9% YOY in December, up from 2.4% in September, as measured by CPI. Much of the step up was attributable to energy prices, but the core CPI, which excludes the more volatile food and energy prices, was nearly flat at 3.2%. This reignited concerns that inflation was stuck above the Fed’s inflation target so interest rates could remain elevated. However, details in the inflation data were somewhat more encouraging. For example, the increase in shelter prices, a key driver of
excess inflation, moved down close to the pre-pandemic pace in Q4 and core services excluding shelter slowed (see chart).
The offsetting pick-up in core goods inflation, such as motor vehicles, was likely part of normalization from post-pandemic swings. Even so, Q4 was another reminder that disinflation could remain uneven and gradual.
The labor market surprised with its resilience in Q4. After unemployment rose to a cycle peak of 4.2% in Q3 and fueled worries about further weakening (and possibly a recession), the rate decreased to 4.1% in Q4. Payroll employment rose an average of 170,000, close to a solid, pre-pandemic pace, despite the disruptions from a hurricane and port strike in October. Q4 showed signs that the labor market is stabilizing after years of gradual cooling. However, the decline in rates for firms
hiring and workers quitting for new jobs makes the labor market less dynamic so some further cooling remains a risk.
In December the Fed completed its “recalibration” phase that began in September, totaling one percentage point in reductions in the federal funds rate. The cuts reflected substantial disinflation since 2022 and better balance in the labor market with reduced inflationary pressures from wages. In addition, Fed officials viewed the high funds rate as a risk to its employment mandate. With recalibration complete, the solid labor market conditions and firmer inflation in Q4 helped shift
the Fed toward a ‘wait and see’ approach to further easing.
Donald Trump’s re-election in November, along with Republican majorities in Congress, set off a shift in policy expectations and heightened uncertainty. Several policies that Trump proposed (e.g. tariffs, mass deportation, and tax cuts) could boost inflation, even if only temporarily. The details will matter, and implementation will take time. The fiscal policy uncertainty reinforced the Fed’s switch to a rate pause.
QUARTER IN REVIEW
During the fourth quarter, investor sentiment exhibited significant volatility, beginning with fear and escalating to extreme greed before retreating back to fear. The quarter concluded with an increased number of bearish investors, while bullish sentiment reached its lowest point of the year.
The Aggregate Bond Index returned -3.06%. The Barclays Treasury Index returned -3.14% and TIPS returned -2.96%, outperforming their nominal comparators by 26 bps.
Within the Aggregate, corporate excess return was 82 bps, supported by tightening spreads across the board. IG spreads contracted by 9 bps overall, with similar narrowing across sectors including utilities (10 bps), industrials (9 bps) and financials (9 bps). In structured products, ABS posted an excess return of 61 bps, and CMBS excess return was 66 bps. MBS lagged with an excess return of -13 bps. Sovereign excess return was -61 bps.
The US yield curve bear steepened, with longer dated rates rising more than shorter dated yields. Two year, 10-year, and 30-year yields jumped 60 bps, 79 bps and 66 bps respectively, to end the quarter at 4.24%, 4.57%, and 4.78%. Fed Fund futures ended the quarter pricing ~2 cuts by the end of 2025
OUTLOOK
The global economy continues to grow, but we anticipate a modest slowdown in growth due to increasing uncertainty, particularly related to U.S. fiscal policies and tariffs. We expect global growth to remain around 2.5-3% in 2025 and anticipate that post-COVID disinflation will persist. However, the uncertainty surrounding our inflation forecasts has increased. The divergence in growth among global economies is likely to lead to uneven policy normalization. Potential deregulation and
changes in trade, fiscal, and energy policies in the U.S. may have significant implications for global growth and inflation. Nevertheless, disruptive new trade and immigration policies, along with a deteriorating fiscal outlook, could pose a challenge to global growth.
Duration (Overweight): Moderating inflation and a Fed committed to gradually normalizing interest rates is supportive of duration in the short-term. While we agree the risk of structurally higher inflation could lead to a slightly higher long-term nominal rate vs. the Fed’s 2.875% Summary of Economic Projections (SEP) target, the market implied long-term Fed Funds rate, at 4.0%, is too high and implies restrictive monetary policy for years to come. Yields should fall from current levels to reflect a more neutral policy rate.
Yield Curve (Favor intermediate bonds): Favor intermediate maturity bonds based on our view the terminal Fed Funds rate is too high. It should decline to reflect the risk of a recession in coming years, which is bullish for intermediate maturity bonds. In addition, overweighting intermediate bonds gains exposure to a steepening yield curve (which we favor), while maintaining a duration overweight.
Credit (Underweight): Underweight IG credit given tight spread valuations, flat credit curves and attractive relative value opportunities in securitized assets like agency MBS and certain ABS sectors. Overweight 5-10 year maturities. Underweight long credit, primarily in high quality 30-year Industrials. Still like the relative value of well-capitalized banks, aircraft lessors and insurance brokers. Prefer higher rated, liquid issuers in cyclically resistant sectors. Additionally, we like issuers exhibiting credit-friendly capital allocation plan and continue to avoid sectors and issuers that have M&A and releveraging risk or a history of shareholder-friendly actions.
ABS (Overweight): ABS offers attractive carry and better downside protection vs. investment-grade credit. Favor digital infrastructure (data center and fiber securities).
Agency MBS (Overweight): Mortgages remain cheap relative to investment-grade credit. Favor lower coupon, credit impaired bonds which have higher repayments, and will do well if the yield curve steepens. Also favor 5.0-5.5% coupon bonds which offer attractive carry, enough discount to perform well even if rates rally, and limited extension risk.
Non-Agency RMBS (Overweight): Favor AAA-rated, deep discount, positively convex mortgages that will benefit from a rally in short and intermediate yields. Also favor new issue, high coupon securities with limited extension risk.
CMBS (Overweight): Favor an overweight short and intermediate maturity, AAA-rated CMBS relative to investment-grade credit. Select front-pay bonds trade at maximum extension and will benefit from unscheduled cash flows (defaults). Also favor single-asset CMBS.
Inflation (Overweight): At 2.0-2.5%, real yields are too high. TIPS remain an attractive hedge for structurally higher inflation
STRATEGY HIGHLIGHT
NCA’s robust opportunity set for Short Duration Plus accounts provided yields between 4.97% and 5.18%, depending on client guidelines, as of year-end 2024. We increased our duration overweight over the quarter, primarily through an increase in our allocation to agency mortgages and CMOs. We trimmed our position slightly in commercial mortgages and asset-backed securities. We decreased our allocation to investment-grade corporate bonds and added to government-related. We decreased our allocation to TIPS, taking profits as TIPS responded to increased inflation expectations, and added to nominal Treasuries. We favor a more bulleted portfolio in the most attractive part of the yield curve.
Important Disclosures:
Past performance is no indication of future results. there is no guarantee that the investment objective of the strategy will be achieved. index returns reflect the reinvestment of income dividends and capital gains, if any, but do no reflect fees, brokerage commissions or other expenses of investing. Clients must be prepared to bear the risk of a total loss of their investment. The themes and strategies and asset allocations herein are not to be construed as recommendations. They are for illustration purposes only and subject to change without notice.
Returns are presented gross & net of management fees. Gross returns will be reduced by investment advisors fees. Different methods can be applied to the calculation of performance data. Periods over one year is annualized. The deduction of advisory fees and the compounding effect thereof over time will reduce the total return on any account. For example, an account of $10 million with a 1% fee which experienced a 10% compounding annualized total return over a period of five years would result in an ending dollar value of $16,105,100 without the deduction of advisory fees. If an annual advisory fee of 1% were deducted from the account for the same five year period, the annualized return would be 9%, with an ending dollar value of $15,386,240. Additional information regarding policies for calculating and reporting returns is available upon request. A fee schedule is an integral part of a complete presentation and is described in part ii of the firm’s ADV, which is available upon request. Returns include the reinvestment of dividends and other earnings, where applicable.
Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. New century advisors believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.
The discussion of any investments in this presentation is for illustrative purposes only and there is no assurance that the adviser will make any investments with the same or similar characteristics as any investments presented. The investments identified and described do not represent all of the investments purchased or sold for client accounts. The representative investments discussed were selected based on a number of factors including
investment process and subject matter applicability. The reader should not assume that an investment identified was or will be profitable. There is no assurance that any investments identified will remain in client accounts at the time you receive this document.
CERTAIN PERFORMANCE CALCULATIONS ARE PREPARED INTERNALLY AND HAVE NOT BEEN AUDITED OR VERIFIED BY A THIRD PARTY. THE USE OF A DIFFERENT METHODOLOGY FOR PREPARING, CALCULATING OR PRESENTING PERFORMANCE RETURNS MAY LEAD TO DIFFERENT RESULTS AND SUCH DIFFERENCES MAY BE MATERIAL. YOU MAY NOT RELY ON THIS PRESENTATION AS THE BASIS UPON WHICH TO MAKE AN INVESTMENT DECISION. OPINIONS EXPRESSED ARE NEW CENTURY ADVISOR’S PRESENT OPINIONS ONLY AND ARE SUBJECT TO CHANGES BASED ON MARKET, ECONOMIC AND OTHER CONDITIONS AND MAY NOT ACTUALLY COME TO PASS. ANY HISTORICAL PRICE(S) OR VALUES(S) ARE ALSO ONLY AS OF THE DATE INDICATED.
ONE CANNOT INVEST DIRECTLY IN AN INDEX. The index/benchmark comparisons herein are provided for informational purposes only and should not be used as the basis for making an investment decision. There are significant differences between client accounts and the indices/benchmarks referenced including, but not limited to, risk profile, liquidity, volatility and asset composition. BENCHMARK AND MARKET DATA IS PROVIDED BY A THIRD PARTY.
NEW CENTURY ADVISORS DOES NOT GUARANTEE OR WARRANT THE ACCURACY, TIMELINESS, OR COMPLETENESS OF THIRD PARTY INFORMATION PROVIDED AND IS NOT RESPONSIBLE FOR ANY ERRORS OR OMISSIONS. Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or proposed by NCA will be profitable.
Bloomberg Bank of America 1-3 Year Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S.
Government having a maturity of at least one year and less than three years. The index is produced by Bloomberg to match the Bank of America Merrill Lynch 1-3 Year Treasury Index.
Bloomberg Bank of America 1 Year Treasury-Bill Index – Is an unmanaged index tracking U.S. government securities. The index is produced by Bloomberg to match the Bank of America Merrill Lynch 1 Year Treasury-Bill Index.
Bloomberg U.S. Aggregate Index is an unmanaged market index which represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
Bloomberg U.S. Intermediate Aggregate Index is an unmanaged market index which represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with less than 10 years to maturity. The index components are government and corporate securities, mortgage pass-through securities, and asset-backed securities.
Bloomberg U.S. Treasury Inflation-Linked Bond Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade or better, having at least one year to final maturity, and at least $500m par amount outstanding.
Bloomberg Global Aggregate Credit Index is broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities.
Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods
and services. It is calculated and maintained by the US Bureau of Labor and Statistics.