Market Overview
After questioning the outcome of the U.S. presidential election throughout October, the uncertainty was answered in early November. The market’s early response to the Trump victory was positive, perhaps based on the platforms of less regulation and lower taxes. Of course, questions arose around the economic impact of talks of tariffs and mass deportations. With the Republicans taking control of the Senate and the House of Representatives, the likelihood of Trump proposals being enacted was increased.
One topic most seemed to agree on was that regardless of who took office, deficit spending would continue. An estimate from the Committee for a Responsible Federal Budget estimated that the national debt would increase by $4 to $8 trillion over the next 10 years. The concern with an increasing deficit is that it necessitates more debt issuance, which can lead to higher interest rates, resulting in a risk to economic growth. Following the election, there was a turn toward fiscal austerity with the introduction of the advisory commission, the Department of Government Efficiency, which aims to improve the efficiency of the federal government and meaningfully cut government spending.
Domestic stocks performed well following the election. The S&P 500 gained 5.9% in the month, bringing its year-to-date return to 28.1%. Small-cap stocks seemed to benefit from optimism around economic growth, lower interest rates, and pro-business policies. The day following the election, small-cap stocks rose 5.8%, and for the month, gained nearly 11.0% in November. The tech-heavy Nasdaq gained 6.3%. Foreign developed stocks fell 0.57% in the month, while the emerging markets fell 3.6%. International stocks suffered from potential tariffs, a stronger dollar, and heightened Russia-Ukraine tensions. The year-to-date returns for developed foreign stocks and emerging markets stocks are 6.2% and 7.7%, respectively.
Within fixed-income, the markets remained focused on the Fed in November, and the magnitude and timing of interest-rate cuts. The Fed’s 50 basis points cut in September was intended to ensure the strength of the labor market, as the Fed felt confident inflation would reach its target. After a strong first quarter, average new job growth slowed meaningfully through most of the third quarter, and unemployment increased from 3.8% to 4.2%. However, a strong September jobs report revived some optimism and led the market to question the extent of future rate cuts. This put all eyes on the October results, but hurricanes, a Boeing strike, and a shortened data collection period all blurred the picture of whether the employment backdrop was improving.
Bond yields were volatile in November, which seemed to be driven by the incoming administration and new economic data. As anticipated, the Fed unanimously decided to cut the Fed Funds rate by 0.25% at the November meeting to a range of 4.5% to 4.75%. The Fed seems confident that its current policies will result in inflation continuing to trend towards its 2% target, while further supporting labor market conditions. As of early December, interest rate futures implied a 70% probability of another 0.25% at the Fed’s mid-December meeting. The current expectation is down from 90% in November, reflecting less certainty of the Fed’s next move. Looking to 2025, many are questioning whether the Fed will slow the pace of cuts from their latest forecast of four 25 basis point cuts, which would bring the Fed Funds rate to a range of 3.25% to 3.50%.
As for inflation, the year-over-year CPI data matched forecasts, coming in at 2.6%, which was up from the prior month’s 2.4% reading. Many quickly concluded that inflation had stalled and might fall short of the Fed’s target. We would point out that the narrative around inflation has changed a few times this year based on one month of data. We have continued to expect inflation to fluctuate but trend lower.
The U.S. Dollar
There are increasing headlines about the risk of “de-dollarization,” or the movement away from using the dollar as the main currency of exchange. The concern is that this trend will ultimately send the value of the dollar sharply lower. Supporting this concern are rising geopolitical and trade tensions, which have understandably increased some foreign countries’ anxiety about holding significant reserves in dollar-based assets. Examples include the tensions between the U.S. and China and the economic sanctions imposed on Russia—the freezing of reserve assets— following their conflict with Ukraine. We have also seen news that China has started using the yuan in commodity trades with partners such as Argentina and Brazil, and it is exploring a common non-dollar currency. Indeed, there is evidence of diversification from the dollar, but we think the factors supporting the dollar’s dominance remain entrenched, and any meaningful de-dollarization will likely take decades.
China, specifically, has been working on diversifying its reserves for over a decade. During that time, markets have worried about what would happen if China sold all their U.S. Treasury holdings. Data shows that China has indeed been selling its U.S. Treasury holdings. However, recent work by Brad Setser, a former Treasury official and fellow at the Council on Foreign Relations, shows that the percentage of China’s reserves in dollar bonds has remained stable at around 50% since 2015. Setser points out that China has been shifting Treasury holdings that show up in official U.S. data to offshore custodians and into other dollar-based assets, such as agency bonds. This is not to say that China doesn’t have ambitions to “de-dollarize” its economy. But for now, China’s selling of U.S. Treasuries seems to be more an exercise in diversification of their dollar assets, rather than full divestiture.
The U.S. dollar remains the world’s primary reserve currency and is by far the most used currency for transactions around the world. The majority of global trade is done in U.S. dollars—even when the U.S. is not part of the transaction. Analysis from the Brookings Institute shows that 54% of global trade invoices are done in dollars, and 88% of foreign exchange transactions happen in dollars. The lack of a viable alternative has helped the U.S. dollar remain dominant. The euro and Chinese renminbi are the first two currencies that are often held up as alternatives to the dollar. However, for now, Europe’s less liquid markets, decreasing economic strength, and political dysfunction make it hard to see it dethroning the dollar. The renminbi is also illiquid compared to the dollar, and it is still effectively pegged to the dollar, China’s strict capital controls make it difficult to move money in and out of the country. Other currencies could, at the margin, challenge the U.S. dollar should the U.S. continue to weaponize the dollar. As mentioned above, taking the top spot from the dollar seems unlikely in the near term, and any meaningful transition would take decades.
From a valuation perspective, the dollar has appreciated significantly since the Great Financial Crisis in 2008. This has been a headwind to returns for unhedged foreign assets. Since the start of 2010, the U.S. dollar index has gone from roughly 78 to over 106 today—more than a two-thirds increase (see chart below). The past couple of years have seen the dollar trade sideways in a range from 100 to 105. Whether it definitively breaks out of that range post-U.S. elections remains to be seen. However, should the dollar find a new trend, the shorter-term momentum would appear to be on the upside for several reasons.
First, economic growth in the U.S. remains persistent whereas it continues to prove challenging in China and Europe. For example, Europe’s largest economy, Germany, has seen its economic growth stagnate for the better part of two years. Relative weakness in Europe could mean they cut interest rates meaningfully in 2025, whereas the U.S. might be forced to keep rates higher amid persistent growth. Relatively higher U.S. rates due to widening growth expectations could mean more demand for the dollar.
Other factors that could benefit the dollar next year include some of President-elect Trump’s policies, which include tax cuts and deregulation. Both of these would be tailwinds for the dollar, but of course, what gets implemented remains to be seen. Trump’s Treasury Secretary pick, Scott Bessent, has promoted a “3-3-3” policy (3% federal deficit, 3% GDP growth, produce 3 million more barrels of oil daily), which would be dollar positive as well. Additionally, tariffs on trading partners would depreciate their currencies and strengthen the dollar further. Any ratcheting up of trade tensions would likely bring more upside to the dollar.
One scenario that could hurt the dollar next year would be a sharp acceleration of economic growth outside the U.S. But for now, growth differentials are increasing and not providing any support for the euro. Longer term, there are reasons to expect a lower dollar—namely, the U.S.’s twin deficits (combined trade and budget deficits). Policies that would further widen the twin deficits would deteriorate the dollar’s standing. Despite what could be a longer-term issue for the dollar, we see more reasons why the dollar could be supported at these levels in the short term. If a recession in the U.S. does occur, then the dollar will benefit from its counter-cyclical, safe-haven properties. If a U.S. recession doesn’t come to pass, bond yields will likely remain elevated, also supporting the dollar. For now, we see dollar strength persisting due to continued U.S. exceptionalism.
Portfolio Positioning
We remain at our strategic allocations for equities, remaining globally diversified. We continue to closely monitor valuations in large-cap U.S. equities as they are expensive relative to historical averages. It comes as no surprise that investor sentiment is elevated, reflecting lots of optimism. According to the Conference Board, consumers are as optimistic about stock prices as they have ever been. Mega-caps and high-growth tech stocks are largely responsible for today’s high valuations. But valuations for small- and mid-cap companies remain more reasonable.
Within fixed-income, we continue to focus on less interest-rate sensitive bonds in favor of shorter-term, higher-yielding securities. We believe this shorter duration credit strategy can better navigate today’s complex market conditions while capturing attractive yields with a more resilient risk-return profile. In other words, we think this positioning will give us a smoother ride with better returns.
For now, we remain cautiously optimistic about the current investment landscape. While there are promising signs of growth and resilience in the economy, we are also acutely aware of the potential risks that could impact market stability and will remain vigilant in monitoring developments. Our focus will continue to be on identifying opportunities to improve long-term returns in line with the risk targets for the portfolios. By being disciplined and opportunistic, we aim to navigate the complexities of the market and position our investments for long-term success. As always, we appreciate your trust.
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