Our December Investment Quarterly (IQ) was held in New York the day after the Federal Reserve (Fed) cut rates by 25 basis points (bps) and then proceeded to derail markets with an incoherent Summary of Economic Projections (the dot plot) and a clumsy press conference. While the 25bps rate cut was in line with market expectations, the reduction in expected rate cuts for 2025, and an increase in the policymaking committee’s inflation projections, set a very hawkish tone. 

Fed Chair Jerome Powell made matters worse during the press conference when he admitted that some Federal Open Market Committee (FOMC) members had factored into their forecasts estimates of the impact of perceived policies from the incoming Trump administration (Trump 2.0). That directly contradicted what Powell had told the markets during the last FOMC meeting in November: that the Committee does not guess, speculate or assume.

Wonderfully, the Fed’s own internal debate set the perfect backdrop for the IQ and its participants. Should we focus on the current macroeconomic data and its trajectory? Or should we estimate the impact of potential future fiscal policies coming from the new administration … as undefined as they are? 

And certainly, the rest of the world would also be impacted by Trump 2.0 policies, especially on tariffs and immigration. Like it was for the FOMC members, it was impossible for us to separate the coming economic trajectory from expectations of future fiscal policy, so we had to settle for a blend of the two. We focused on differentiating between those policies that could be implemented through executive orders from those that need to work their way through Congress.

As our discussion evolved, it became apparent to us that vulnerabilities exist both in the economy and in the markets. The period ahead will be a challenging balancing act for both monetary and fiscal policymakers, given elevated asset prices and slowing economies. Neither the markets nor the economy can likely withstand poor execution.

Macro backdrop

Following the September FOMC meeting, it appeared that the fed funds rate was on a direct path toward 3%. After the general election and the resulting Republican sweep, the markets recalibrated higher, toward expecting a 4% fed funds rate. Today, the markets are bracing for the potential of no further rate cuts from the current level of 4.25%–4.5%. The rhetoric coming from Trump 2.0 centers around four large-scale policies: fiscal stimulus (tax cuts), tariffs, immigration and deregulation. An extension of the Tax Cut & Jobs Act and deregulation are seen as supportive for growth, while tariffs and immigration policies are expected to raise prices and unbalance the labor market, pushing inflation higher.

The sequencing and magnitude of these policies are unknown, making their impacts difficult to model. In addition, the Republicans only hold slim majorities in the Senate and House, so it’s not clear whether any fiscal policy that exacerbates the deficit will succeed in getting passed. Nevertheless, the direction of these policies more broadly is concerning for the direction and level of yields—both in the bond market and at the Fed.

We believe that the primary driver of stimulus—the extension and expansion of tax cuts—is unlikely to see the Senate chambers until the end of 2025. While lawmakers’ actions will likely include extending the existing act, they could also eliminate taxes on tips and overtime. Other proposals have included lowering the corporate tax rate for domestic manufacturers and raising the threshold for state and local tax (SALT) exclusions. 

Day one executive orders may encompass some combination of the tariff, deregulation and immigration agendas. But even then, it could take up to a year before these policies are deployed. Committees have to be formed; research has to be performed and proposals put forward. The market, on the other hand, seems to be pricing all this in as though it will come to pass quickly in Q1 2025.

Fed policymakers can speculate about fiscal policy and then speculate further about its impact across the economy but in the meantime, they will still have to manage monetary policy based on their assessment of the existing data. We believe the current level of rates is a good resting spot. The path to further rate reductions will be motived by developments in the labor market. There are enough measures of inflation that evidence the significant gains made toward achieving the Fed’s 2% inflation target, but the labor market shows some signs of frailty. If unemployment moves to a new cycle high of 4.5% or more, that will likely cause the committee to adjust rates lower. Otherwise, the Fed rests and waits for fiscal policy details.

Scenario expectations

We raised the probability of Above Trend Growth to 40%, from 20%, at the expense of Below Trend Growth (soft landing), which we lowered to the same level: 40% (from 60%). We had to appreciate that while the economy is on a path to a soft landing, broad measures of inflation have stalled above the Fed’s 2% target, unemployment near 4% is still low relative to history and fourth quarter U.S. GDP is expected to remain well above trend. Further, animal spirits from Trump 2.0 could raise the confidence of businesses and households, leading them to keep spending. 

We also equalized the probability of Recession and Crisis, to 10% (shifting 5% from recession to crisis). High real rates, a slowing economy and wide range of potential policy initiatives create a premium on execution. Particularly worrisome to us would be a trade war or other geopolitical events. The group was also concerned about the slowdown in growth outside of the U.S., especially in China and across Europe.

Risk

Given the robust state of the current economy, the greatest risk is that additional fiscal stimulus is delivered but is ultimately not needed, resulting in a reacceleration in inflation. There is a lot of money already sloshing around in the system, so any further stimulus that leads to a growth and inflation shock would inevitably be followed by a Fed rate hiking cycle. Markets are most unprepared for this.

Other risks include poor implementation—in the form of more aggressive tariffs that result in retaliation, immigration policy that significantly disrupts the labor market, dysfunction in Congress due to small majorities in the House and Senate or a drawdown in equities that widens credit spreads.

Strategy implications

The group favored sectors and markets that would do well in risk-on environments—loans, high yield and emerging markets—while views on duration and the Fed were more neutral. There was a lot of discussion on corporate credit. While credit spreads are at the narrower end of historic ranges, the group appreciated that the outlook for revenue and EBITDA growth remains healthy. Banks and midstream energy companies were our favorites in investment grade. For below investment grade, we judged the combination of high yield bonds at a 7% yield, and bank loans at yields of 8%–10%, to be irresistible to both investors and plan sponsors.

Securitized credit remains a stalwart in our portfolios. A fully employed consumer with solid real wage growth has created an environment of stability in this market. Credits linked to rental income from single and multi-family residences should continue to benefit from the structural housing shortage.

Emerging market debt also garnered some support. The market has seemingly been abandoned for years and the threat of tariffs looms ominously. The group saw value in a basket of lower-rated sovereign and corporate credits with significant carry, and some room for appreciation in local markets where central banks are still cutting rates, independent of the Fed. 

Closing thoughts

The prospect of policy action is not the same as actual policy deployment. A lot of work must happen first. In the meantime, the Fed must continue to curate the soft landing with an eye towards the evolution of fiscal policy. We have already seen what sloppy communication creates. In the meantime, there are plenty of bonds at higher yields to add to our portfolios.

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