FEAR

“The only thing we have to fear is fear itself” (FDR)

“Real power is, I don’t even want to use the word, fear.” (Donald J. Trump to Bob Woodward in 2016)

I fear the “word of the year” will be “fear”.

• President-elect Donald Trump threatened 25% tariff on all imported products from Canada and Mexico. The tariff would remain in effect until Canada and Mexico stop the flow of illegal drugs and illegal immigrants into the U.S..
• Trump seeks 60% additional tariffs on China.
• Trump threatened tariffs if EU doesn’t buy more oil and gas from the U.S..

Is all this a calculated bullying bluff seeking economic and/or non-economic gains, or a genuine shift toward economic isolationism under Trump’s “America First” program?

There is some real hip shooting here.

Canada’s main exports to the U.S. are energy, primarily crude oil, forestry products and cars.

• Canadian oil is the source of 24% of U.S. refinery output.
• The main car brands Canada exports to the USA are:

1. Ford
2. General Motors (GM)
3. Stellantis (including Chrysler)
4. Toyota
5. Honda

• Some 30% of U.S. lumber consumption is imported, most of it from Canada.

Increased tariffs would thus primarily hurt American companies and consumers. The U.S. currently imposes a 2.5% import tax on passenger cars and automotive parts from Japan.

Given the highly integrated nature of the auto industry, parts and components may cross Canadian-U.S.-Mexican borders as many as 8 times before final assembly.

The EU is already buying the lion’s share of US oil and gas exports, and no additional volumes are currently available unless the United States increases output or volumes are rerouted from Asia, another big consumer of U.S. energy.

China has had time to prepare for another round of tariffs tit-for-tat. Its reaction could be more assertive and effective this time around. In fact, it has already started with its recent measures on exports of critical minerals and drones and investigations on prominent companies such as PVH Corp. (Calvin Klein, Hilfiger) and Nvidia.

Fear is also a tool in U.S. politics, often used to threaten elected officials performing their civic duties.

“Any member of the House or Senate who votes for this outrageous spending bill deserves to be voted out in 2 years!” (Elon Musk)

“Chip Roy is just another ambitious guy, with no talent. By the way, how’s Bob Good doing? I hope some talented challengers are getting ready in the Great State of Texas to go after Chip in the Primary. He won’t have a chance! (Donald J. Trump)

FYI, Bob Good (R-VA) lost a primary challenge against a Trump-endorsed candidate in the June 2024 primary.

“Senator Rounds, you are up for reelection in 2026. If you vote against any of Trump’s nominees a primary challenge wouldn’t be hard” (Turning Point USA founder Kirk on X).

“Those who oppose reform will lose their primary/election. Period.” (Elon Musk)

“Being told Joni Ernst and Lindsay Graham are trying to end Pete Hegseth … Pete Hegseth is the redline. If you vote against him, primaries will ensue.” (Activists in Iowa writing on X)

The conservative group Heritage Action also announced last week that it would launch a $150,000 digital campaign targeting Senate Republicans in Alaska, Maine, Louisiana, Iowa, North Carolina, Kentucky, Indiana, Utah and South Dakota who are on the fence about supporting Trump’s nominees.

Congresspeople must now decide if they vote on the basis of what’s best for the country or what’s best for them personally.

“Can you image what the next two years are going to be like if every time that Congress works its will and then there’s a tweet? Or from an individual who has no official portfolio, who threatens members on the Republican side with a primary and they succumb?” Neal said in a fiery floor speech Thursday night.

“This institution has a separate responsibility based on the separation of powers,” he warned.

Musk didn’t like this at all, apparently, and replied in his new favorite way: a threat to buy Neal out of his seat.

“Oh … forgot to mention that I’m also going to be funding moderate candidates in heavily Democrat districts, so that the country can get rid of those who don’t represent them, like this jackass,” Musk wrote.

The ally of President-elect Trump made the comments in response to a clip of a floor speech from Rep. Richard Neal (D-Mass.), the ranking member of the Ways and Means Committee, who slammed Musk’s threat to primary Republicans if they supported an earlier bipartisan spending proposal this week.

There are no friends, no allies anymore. Only supreme objectives that must be achieved, any which way, no debating accepted.

When did we see a similar movie before?

This time, the arms are fear and money.

It can work both ways, however:

In his Nov. 7 congratulatory message to Trump, Xi offered a veiled warning about engaging in economic fights with China. “History tells us that both countries stand to gain from cooperation and lose from confrontation,” Xi said.

About a week later, Xi used a meeting with President Biden in Peru to warn Trump not to challenge Beijing on major issues the two powers are at odds over, including China’s sovereignty claim over Taiwan, human rights, its party-state system, or what Xi calls China’s “right to development”—a reference to U.S. restrictions on Chinese access to Western chips and other technologies.

These “four red lines,” Xi told Biden, “can’t be challenged,” according to China’s official account of the meeting.  (WSJ)

In Peru, Xi inaugurated a deep-water port that will boost China’s trade with Latin America, adding to China’s significant investments in Africa.

In late 2024, while Trump was threatening tariffs to long-time allies such as Canada, Mexico, the U.K., the EU and Japan, often to achieve non-economic objectives, Xi met with leaders of 10 major international economic organizations, highlighting that, against the “America First” U.S. policy, China is taking “leadership for global economic stability, prosperity and openness, and opposes all forms of protectionism.”

The rapidly evolving area of artificial intelligence also displays significant differences between the U.S. and China. American companies such as Google, Apple, Amazon, Microsoft and Meta, are building closed LLM models to protect their current high market shares. Chinese companies are all into opensource models.

In AI, the cutting edge is reasoning models. There are currently 4 reasoning models in the world, OpenAI o1, DeepSeek, QwQ and Marco 01. The last 3 are Chinese, all roughly equivalent or superior (and cheaper to build and operate).

Sometimes, it almost gets funny…

In August 2020, the Trump administration argued that TikTok’s data collection “threatens to allow the Chinese Communist Party access to Americans’ personal and proprietary information”.

On August 14, 2020, Trump issued another executive order giving ByteDance 90 days to sell or spin off its U.S. TikTok business.

“According to the order, TikTok’s “data collection threatens to allow the Chinese Communist Party access to Americans’ personal and proprietary information — potentially allowing China to track the locations of Federal employees and contractors, build dossiers of personal information for blackmail, and conduct corporate espionage.”

The Justice Department has argued that Chinese control of TikTok poses a continuing threat to national security, a position supported by most U.S. lawmakers.

But just recently, national security suddenly took a back seat:

“I think we’re going to have to start thinking because, you know, we did go on TikTok, and we had a great response with billions of views, billions and billions of views,” Mr. Trump told the crowd at AmericaFest, an annual gathering organized by conservative group Turning Point.

“They brought me a chart, and it was a record, and it was so beautiful to see, and as I looked at it, I said, ‘Maybe we gotta keep this sucker around for a little while,’” he said.

Mr. Trump met with TikTok’s CEO on Monday. Mr. Trump said at a news conference the same day that he had a “warm spot” for TikTok thanks to his campaign’s success on the app.

It is unclear how Mr. Trump would go about undoing the TikTok divestiture order, which passed overwhelmingly in the Senate.

… or not so funny…

China has issued a directive to the country’s brokerage firms as it aims to change perceptions of its flagging economy: monitor speeches by top economists and fire them if necessary.

Chief economists at Chinese brokerages must “play a positive role in interpreting government policies and boost investor confidence,” the industry watchdog Securities Association of China (SAC) told its members last week, according to the state-run financial newspaper Securities Times.

However, if the individuals have “repeatedly triggered reputational risk over inappropriate commentaries or behaviors” within a certain period of time or caused “major negative impacts,” the company shall “severely deal with the person until termination of employment,” said the notice, without elaborating on the definition of inappropriate comments. (Source: asia.nikkei.com)

… or definitely not funny:

Trump signals plans to use all levers of power against the media

For many years, Donald Trump repeatedly threatened to sue the press but often didn’t follow through. When he did, he almost always lost.

But Trump’s recent settlement with ABC News and a cascade of lawsuits and other complaints against media entities from him and his allies signal a ramped-up campaign from the president-elect. Together, the actions have spurred concerns that his efforts could drastically undermine the institutions tasked with reporting on his coming administration, which Trump has promised will take revenge on those he perceives as having wronged him. (…)

Trump said he planned to continue suing the press. “It costs a lot of money to do it, but we have to straighten out the press,” he said at a news conference at his Mar-a-Lago Club in West Palm Beach, Florida. (…)

ABC News’s decision to settle has sent shudders through the media industry and the legal community that represents it. (…) ABC and Disney executives decided to settle not only because of the legal risks in the case but also because of Trump’s promises to take retribution against his enemies. (…)

Disney’s ABC operates more than 230 affiliate television stations nationwide, some relying on the Federal Communications Commission for license renewals. Trump has repeatedly talked about pulling the federal licenses from television stations that broadcast news about him he doesn’t like and said last year that he plans to bring the FCC under presidential authority.

Disney and many other media companies are already planning potential merger activity that executives hope passes muster with the antitrust division of the Justice Department, which is poised to be run by Trump loyalist Pam Bondi. (…)

But legal experts say Trump has taken attacks on the press to an entirely new level, softening the ground for an erosion of robust press freedom.

“The Fake News Media should pay a big price for what they have done to our once great Country,” Trump posted on Truth Social in September in an attack on NBC News.

Experts in polarization said that Trump’s posture toward the press has eroded trust in the Fourth Estate. From the Oval Office, he can do even more.

“My concern is what he does when he has the power of the U.S. government in his hands,” said Liliana Hall Mason, a political science professor at the University of Maryland. “It looks to me like all the guardrails have been removed, and we are in for a presidency unlike any we’ve experienced before.”

Corporate officers need to balance their own personal political/moral inclinations with an objective assessment of what President Trump might do for the country’s economy and for their respective companies in a world where being friends or not can be more consequential than it normally is.

They also might reconsider some business practices after the murder of UnitedHealthcare CEO. The reaction to his killing has revealed a deep distrust of the health insurance industry and its treatment of patients in need of critical care.

Investors also need to try to objectively analyze the pros and the cons of a likely turbulent presidency. Some of the potential pros are easy to list:

• growth and profits could be lifted by deregulation and tax cuts, corporate and individual.
• improving the efficiency and productivity of government.

But so are the fears:

• tariffs: good or bad?
• immigration policies and labor availability and cost
• environment?
• foreign policy (America First, China, NATO, Russia-Ukraine, Israel-Iran-Palestine).

Amid much uncertainty, investor fear is understandably totally focused on equity valuations, with many indicators flirting with historically high levels while sentiment measures suggest rampant complacency, if not irrational exuberance.

Is the fear of heights justified?

The S&P 500 forward P/E has been above 20 during only 3 periods since 1957. One was neutral (July 1997-June 2002: –4% from start to finish), one was disastrous (May 2007-November 2008: –41%) and one was fantastic (April 2020-June 2022: +55%).

We can discuss at length the various possible explanations but at the end of the day it gets pretty simple: S&P 500 profits were flat in the first period, dropped 37% in the second and jumped 36% in the third.

Simple enough!

It gets even simpler if I add that each periods featured a recession, a mild one in 2001, a nasty one in 2008 and a very short one (3 months!) in 2020.

Lastly, each recession occurred after Fed tightening, and the Fed just finished tightening, or so it seems…

Chair Powell during his December 18 presser: “I think it’s pretty clear we’ve avoided a recession. (…) the U.S. economy has just been remarkable. (…) So, I feel very good about the economy.”

Investors see no reason to think otherwise at this time: in aggregate, Americans are wealthy, employed and spending merrily; the 500 bps rise in interest rates has had little effect on GDP growth and inflation seems to be in check amid a productivity boom that could last several years.

Comparisons with the dot.com era should be tempered by the fact that the S&P 500 is a fundamentally higher-quality index today: higher margins, better, well-established and profitable leaders and lower net leverage, non only debt-wise but also operationally as most of the leaders are asset light and generate large amount of free cash.

So what’s to fear?

• Tariffs. We don’t know how much, on what and when. And we don’t know the reactions. So we can’t assess the potential impact on growth, inflation and profits.

The most fearful thing about the coming tariffs brawl is that Trump is totally wrong about the history of tariffs:

September 2024 during a town hall in Warren, Michigan:

We’re going to use tariffs very, very wisely. You know, our country in the 1890s was … probably the wealthiest it ever was, because it was a system of tariffs. And we had a president — you know McKinley, right? You remember Mount McKinley? And then they changed the name. He was really a very good businessman, and he took in billions of dollars at the time, which today it’s always trillions, but then it was billions and probably hundreds of millions. But we were a very wealthy country, and we’re going to be doing that now.

Factchecking from various sources:

McKinley was not a businessman. He was a lawyer turned politician, elected to Congress in 1877 and only became president in 1897.

McKinley, the congressman, became chairman of the House Ways and Means Committee and was responsible for framing a new tariff bill. He believed that a protectionist tariff had been mandated by the people through the election and that it was necessary for America’s wealth and prosperity.

In addition to the protectionist debate, politicians were concerned about the high revenue accruing from existing tariffs. After the American Civil War, tariffs remained elevated to raise revenue and to cover the high costs of the war. By the early 1880s, the federal government was running a large surplus. Both parties agreed that the surplus needed to lessen but disagreed about whether to raise or lower tariffs to accomplish the same goal.

The Democrats’ hypothesis stated that tariff revenues could be reduced by reducing the tariff rate. Conversely, the Republicans’ belief was that by increasing the tariff, imports would be lessened, and total tariff revenues would drop. The debate would be known as the Great Tariff Debate of 1888.

“The Republican campaign orators and pamphleteers say that the various import duties levied by Congress are paid by the foreigners who send goods to America, denying that the price of any article which may be called a necessary expense will be increased to Americans by the operation of the new tariff law.”

The Tariff Act of 1890, commonly called the McKinley Tariff, became law on October 1, 1890. The tariff raised the average duty on imports from 38% to 49.5%.

“Let the facts, which are multiplying every day, tell who it is that pays the onerous tariff taxes. They will answer that the American people pay these taxes and that the burden of them rests most heavily upon the poor, inasmuch as there are very few of the necessities of life the prices of which are not increasing on account of the McKinley tariff.” (NYT)

The Act removed tariffs on sugar, molasses, tea, coffee, and hides but authorized the President to reinstate the tariffs if the items were exported from countries that treated U.S. exports in a “reciprocally unequal and unreasonable” fashion. The idea was “to secure reciprocal trade” by allowing the executive branch to use the threat of reimposing tariffs as a means to get other countries to lower their tariffs on U.S. exports.

The Tariff Act was a major topic of fierce debate in the 1890 Congressional elections. The tariff was not well received by Americans who suffered a steep increase in prices. The 1890 tariff was also poorly received abroad. Protectionists in the British Empire used it to argue for tariff retaliation and imperial trade preference.

Inflation was particularly high on what the NYT called “necessaries” such as farm products (+6-8%), textiles (+4%), metals and metal products (+6%), building materials (+5%) and “miscellaneous” (+11%) per BLS research.

In the 1890 election, Republicans lost their majority in the House with their number of seats reduced from 171 to 88.

In the 1892 presidential election, Harrison was soundly defeated by Grover Cleveland, and the Senate, House, and Presidency were all under Democratic control. Lawmakers immediately started drafting new tariff legislation, and in 1894, the Wilson-Gorman Tariff passed, which lowered US tariff averages.

Trump’s contention that the 1890s were “probably the wealthiest ever because it was a system of tariffs” also does not verify.

The U.S. experienced rapid growth after the end of the Civil War in 1865. Reconstruction, railroad construction and the related boom in farming and manufacturing carried the economy until 1892 when the unemployment rate reached 3.0%.

After exploding 70% between 1885 and April 1890, the U.S. equity markets became very volatile, losing 16% in the following 7 month before roaring back 33% until the end of 1892.

The Depression of 1893 was one of the worst in American history with the unemployment rate exceeding ten percent for half a decade. Equities lost 25% in the first 7 months of 1893, back to their mid 1886 level.

The National Bureau of Economic Research estimates that the economic contraction began in January 1893 and continued until June 1894. The economy then grew until December 1895, but it was then hit by a second recession that lasted until June 1897.

Estimates of annual real gross national product (which adjust for this period’s deflation) are fairly crude, but they generally suggest that real GNP fell about 4% from 1892 to 1893 and another 6% from 1893 to 1894. By 1895 the economy had grown past its earlier peak, but GDP fell about 2.5% from 1895 to 1896. During this period population grew at about 2% per year, so real GNP per person didn’t surpass its 1892 level until 1899.

Tariffs did not cause the depression but having lifted the general level of prices for necessities, they reduced discretionary income at an inopportune time.

BTW, the 1890s also coincided with the end of the Gilded Age, a period known for extreme wealth inequality.

***

The Smoot-Hawley Tariff Act of 1930 had a significant negative impact on the U.S. and global economy, exacerbating the effects of the Great Depression.

The Act dramatically reduced international trade:

• It raised import duties on over 20,000 imported goods, increasing tariffs from an average of 40% to nearly 60%.
• U.S. imports decreased by 66% from 1929 to 1933.
• U.S. exports fell by 61%.
• Overall world trade declined by approximately 66% between 1929 and 1934.
• At least 25 countries responded by increasing their own tariffs on American goods.
• Countries that retaliated against Smoot-Hawley reduced their imports from the United States by an average of 28–32%.
• Even countries that merely protested the Act reduced their imports from the U.S. by 15–23%.
• The Act highlighted the dangers of protectionist trade policies, leading to a shift towards free trade agreements in subsequent years.
• It resulted in a transfer of tariff-setting authority from Congress to the executive branch, as lawmakers sought ways to quickly reverse the tariffs.(!)

The fear is thus about the amplifier effect a tariff war could have if and when the economy slows.

But the amplifier is not what it used to be, particularly if higher tariffs are limited to goods, which now account for 31% of total personal expenditures.

By comparison, the late 1890s and 1920s saw a marked increase in the importance of goods in the American economy, driven by industrialization, technological innovation, and changing consumer patterns. While services continued to play a role, the production and consumption of material goods dominated economic growth and societal changes during these periods.

Other fears:

Apollo Management’s Torsten Slock has a list of 12 risks for 2025 markets (with my comments):

1- Tariffs coming (90% probability). Incoming Treasury Secretary Scott Bessent’s views on tariffs align with Trump’s overall strategy but suggest a more nuanced and potentially less disruptive approach to their implementation. His perspective may provide some reassurance to markets and trading partners while still maintaining tariffs as a central component of the incoming administration’s economic toolkit.

2- Nvidia earnings disappoint inflated expectations (90%): No doubt that will happen. But when? Hyperscalers are clearly in a race to secure positions in AI which is still in early adoption mode. KKR reckons that

the Magnificent 7’s Capex and R&D spending has increased to nearly 20% of total U.S. spend, compared to only 3.6% in 2011. The good news, though, is that Capex intensity is not so outsized that we think there is the potential for these companies to pull back in the coming quarters. While the absolute dollars spent today are massive relative to past cycles, capex intensity (relative to sales) does not look outsized.

Importantly, most of these companies run with negative net debt and they continue to show strong top line growth and healthy margins. As a result, we view this backdrop differently than what we saw during the telecom/technology bust of 2001. Our second point is that we expect more global expansion linked to AI in the coming years, especially in Asia. Asia’s data center footprint is a fraction of the U.S. footprint.

  

The likely explosion in AI inference demand could be constrained by energy availability.

Power availability has become a primary consideration in data center site selection and contributes to the uneven distribution of data centers globally, with fewer facilities in regions lacking reliable power infrastructure. In some areas, power unavailability is driven by limitations in interconnecting to the transmission grid rather than generation capacity.

As demand continues to grow, particularly driven by AI and cloud computing, addressing power constraints will be crucial for the industry’s sustainable expansion.

The Trump administration’s plan to deregulate energy production, transportation, and transmission to make America ‘energy safe/independent’ will no doubt help.

Chinese data centers used 130 billion kWh of electricity in 2022, and they are expected to use 380 billion kWh per year by 2030. To avoid breaking the carbon budget, the Chinese government’s set policy goal is to power new data centers with 80% green energy by 2025.

That’s a gargantuan shift from the status quo — 70% of the electricity currently consumed by China’s data centers is supplied by coal. Non-fossil-fuel energy sources are reportedly still prone to outages.

Nonetheless, it is estimated that the scale of China’s data center market reached nearly 250 billion yuan in 2023, and is expected to reach the trillion level in 2025.

Nuclear energy is seen as a necessity in meeting green energy demand in the 2030s.

Over 30 governments are collaborating with the IAEA to incorporate nuclear power into their energy strategies. Currently, over 60 new reactors are under construction worldwide, and 300 more are in the planning/proposed phase. China is committing $440 billion to the construction of 150 new reactors, which will add 150 gigawatts (GW) of capacity over the next 15 years. This expansion surpasses the total nuclear capacity built worldwide in the past 35 years. (KKR)

3- US economy reaccelerates and animal spirits come back (85%): Have animal spirits left?

4- M&A/IPO activity rebounds (75%): Not a risk, a certainty.

5- Fed stops talking about r-star (70%): Is anybody really listening?

6- US inflation accelerates in Q1, driven higher by a strong economy, tariffs, restrictions on immigration, and seasonal factors (40%): Productivity and low oil prices could save us all from this real threat. Tariffs will likely be raised gradually and “responsibly”. Trump should know he was elected because the lower income segment of the population hated the recent inflation bout. He will seek to protect his very slim margin in Congress in the next midterm elections.

7- Fed raises interest rates in 2025 (40%): Productivity could save us all from this real threat.

8- US 10-year interest rates move above 5% before mid-year (40%):  Productivity could save us all from this real threat.

9- Probability of a recession in Germany (40%): Manufacturing is in a deep recession and December new orders posted the sharpest drop in three months. Can services save the economy amid political chaos. Services employment has been cautiously cut since July, and new business has been shrinking slowly since September. If this trend continues, a recession in this sector seems likely per S&P Global. But with negotiated wages up 8.8% in the third quarter per the Bundesbank, real wages are strong. But Germans are not Americans when it comes to consumption.

10- China outright recession in 2025 (33%): Me: zero percent. But probably below 5% growth given the nature of the problems. On Dec. 24, missed by many, Reuters informed us that

Chinese authorities have agreed to issue 3 trillion yuan ($411 billion) worth of special treasury bonds next year, which would be the highest on record, as Beijing ramps up fiscal stimulus to revive a faltering economy. The plan for 2025 sovereign debt issuance would be a sharp increase from this year’s 1 trillion yuan and comes as Beijing moves to soften the blow from an expected increase in U.S. tariffs on Chinese imports when Donald Trump takes office in January. The proceeds will be targeted at boosting consumption via subsidy programmes, equipment upgrades by businesses and funding investments in innovation-driven advanced sectors, among other initiatives, said the sources.

11- Fiscal crisis in US (10%): Does anybody care about the U.S. fiscal challenges?

12- Probability of US recession (0%): On jan. 2, 2024 I wrote: “I don’t have a crystal ball but my sense is that solid consumer and construction spending will keep the economy humming, with the risk tilted on the high side. I would be surprised if core inflation rests outside of a 3-4% range.” Right on growth, surprised on core PCE inflation (2024 range 2.6-3.1%, 2.8% in November).

Still no crystal ball but solid consumer and construction spending will keep the economy humming, with the risk tilted on the high side. Inflation between 2.5-3.5%.

Other fears: geopolitics, oil, USD: unpredictable at this time.

Bear fear anybody?

Strategists have rightly learned that stocks usually go up, and the average outlook in Bloomberg data is always positive. But the average point estimate is rarely particularly insightful and frequently proves a total flop. (…) strategists on average were relatively bullish throughout the dot-com bust and ahead of the 2008 financial crisis. More recently, they expected a relatively good year in bear-market 2022 and failed to foresee the go-go years of 2023 and 2024. Go figure. Strategists just don’t have crystal balls, and they sure can’t predict recessions or pandemics. They’re a collection of fallible humans trying to deliver on an impossible task. (Bloomberg’s Jonathan Levin)

• KKR says that “we are just over two years into the recovery, compared
  to an average of around 5.5 years.” In 1968 and 1973, the Fed was aggressively tightening to fight inflation, leading to recessions in 1970 and 1973-74.

A survey of current predictions indicates very low probabilities of a recession in 2025. J.P. Morgan’s David Kelly offers his basic scenario and details all the uncertainties around it to conclude:

It should be stressed that all of this is highly speculative. We do not know the details on any of these policies or how aggressively the new administration will pursue them. That being said, on a very rough forecast, none of this spells disaster for the economy or markets in the short run and equities could directly benefit from a further reduction in the corporate income tax.

However, it does suggest that, barring a recession, long-term Treasury yields and mortgage rates are more likely to drift up than down from here. Moreover, further weakening our already stressed public finances adds long-term risk to any investment scenario.

• The decennial cycle says 2025 will be great. The chart below depicts the pattern of the DJIA by decade from 1897 onward, showing the average pattern of all years ending with the same digit.

Dow Jones Industrial Average, 10-year cycle, since 1897

Source: Seasonax

As can be seen, the stock market does appear to be following a 10-year cycle. In the first half of the decade – i.e., in the years ending in “0” up to the years ending in the digit “4” – stocks posted almost no gains on average; by contrast, they tended to rally significantly in the second half.

DJIA stocks delivered an exceptionally strong average performance in years ending in the digit “5”. The average gain amounted to 26.8%. This corresponds to more than one third of the entire average 10-year return! However, in years ending in 7, strong slumps frequently occurred.

Another fear of heights: profit margins

The S&P 500 forward profit margin rose to a record 13.6% during the December 19 week. That’s a full percentage point above the Q3-2024 actual profit margin of 12.6%. We expect that President Trump will cut the corporate tax rate again from 21% to 15% later next year, which should boost the profit margin by at least half a percentage point. His cut in this rate from 35% to 21% in early 2018 boosted the margin by a full percentage point. (Ed Yardeni)

KKR argues that

Outside of the top 12 mega-cap Tech/AI stocks, operating margins are actually still below pre-COVID levels. Given the combination of above-potential GDP growth, strong labor productivity, and deregulation, we see ample room for improvement.

We continue to view the revival in labor productivity growth as the ‘secret sauce’ to a more durable earnings recovery, as it raises potential GDP and facilitates higher non-inflationary growth. Businesses can invest more without overheating the economy and pay workers higher wages without degrading margins, so long as better productivity keeps unit labor costs contained. This backdrop is a ‘Regime Change’ from the post-GFC ‘secular stagnation’, when productivity slumped to multi-decade lows on the back of tepid aggregate demand, tame inflation, and low rates.

In a world of slow inflation, nominal revenues necessarily grow slowly and margins become more significant contributors to profit growth. This Topdown chart reflects non-tech companies’ margins problems and largely explains the rising concentration in the S&P 500 index.

Productivity does not seem to be equally distributed…

Fear the panda bear?

It looks like equity investors care less and less about the bond market. The 100bps jump in 10-Y yields to 4.6% since mid-September came along a 10% jump in the S&P 500 Index.

Treasuries investors are worried about something that high yield investors are ignoring. A strong economy is good for profits and leveraged companies, but not so for inflation, particularly with higher tariffs coming.

Some fearmongers argue that China is setting up its response to a Trump tariff attack, selling part of its large holdings of U.S. Treasuries. But China’s holdings of Treasuries peaked in 2016 (Trump?) and have steadily declined since, having found strong appetite for safe greenback investments in Europe after the Brexit vote (June 2016) and the official exit in January 2020.

Looking at Ed Yardeni’s chart above, Treasury investors should be more concerned of the USD going forward than of China.

That said, we must admit that the USD currently finds little competition fundamentally from other major currencies, does it?

  

  

(Ed Yardeni)

Fear the Fed feeding the bear?

Jay Powell says “We don’t guess, we don’t speculate and we don’t assume.”

But they move. In the same year, the Fed switched its focus away from inflation to the labor market, only to realize that labor demand was still strong and that inflation was still a problem.

Mohamed El-Erian in the FT calls it the flip-flop Fed: “ in just the past five months, the Fed’s actions have ranged from no cut (end of July), to a jumbo 0.5 percentage point “re-calibration” cut (mid-September), to a 0.25-point cut amid a seemingly “nothing-to-see-here” pace (early November), to the upending of earlier forward policy guidance and economic interpretations (mid-December).

He also notes the rising divergence within the FOMC:

The updated “dot plot” of economic projections of policymakers shows a striking range of estimates for where the Fed should take rates by the end of this cycle, from under 2.5 per cent to almost 4 per cent.

A persistent lack of strategic policy anchoring helps explain the current policy confusion. The Fed became excessively data-dependent after its big inflation mistake in 2021-22, when it wrongly assumed price spikes were transitory. As a result, policy goes in whatever direction the latest data is blowing, leading to about-turns.

The Fed risk is that, in spite of evidence that the U.S. economy is strong and strengthening, interest rates are set to be cut another 50bps amid already easy financial conditions.

Productivity is better be very present because demand is. Corporate CFOs are pretty upbeat, not about to rein in spending and wage and price increases:

It’s rare that the Fed cuts interest rates when profits growth is as strong as it currently is. Because profits growth spurs employment and capex, the combination of the Fed cutting rates and accelerating profits could provide a very powerful boost to the already strong economy.

Deglobalization will probably spur secular inflation because production will move from more efficient to less efficient locales. Tariffs, if enacted, will likely add to shorter-term inflation because of the lack of domestically produced substitutable goods. Tariffs could stymie overall economic growth as would a large and sizable consumption tax, but higher prices would precede and could actually cause weaker economic growth.

If we are correct and nominal growth proves stronger than is current consensus, then the Fed might have to reverse course and raise rates during the second half of 2025. Such a reversal might increase market volatility because most economic forecasts currently suggest the Fed will continue to cut rates throughout 2025 and into 2026.

The current market is at least somewhat speculative, and speculation thrives on excess liquidity. If the Fed were to shift to a tightening bias, investors might see some of the markets’ risk-taking fervor subside. (RBA)

But profit growth is not that strong outside of Tech and Communication Services. These 2 sectors are expected to show combined earnings up 22.6% in 2024 on revenues up 12.8%. The other 9 sectors combined: +4.1% on revenues up 3.0%.

Yet, analysts see the same 9 sectors earnings up 11.8% in 2025 on revenues rising 11.7%. Most of this growth is expected to come from Health Care (+20.8%) and Industrials (+19.8%).

One has to wonder how analysts are incorporating the potential Trump administration policies on health care costs and import tariffs at this time.

FYI, in March 2024, analysts expected Health Care revenues to rise 13.5% in 2024. It now looks like +8.3%, but they are expecting +13.4% in 2025.

Industrials revenues were expected to grow 11.2%. It now looks like –3.9%, but they are forecasting +14.7% for 2025.

I would not bet much on these 2025 numbers…

My word of the year? Caution!

Sentiment reflects itself on valuation.

Since the 2022 lows, the S&P 500 Index forward earnings are up 13% and the forward P/E 47%, from 15.4 to 22.6. In effect, increased valuation is responsible for some 70% of the Index appreciation since the 2022 low. A repeat is doubtful.

Meanwhile, the forward P/E of the S&P 500 Technology sector rose from 20 to 30 times (+50%) and that of the Comm. Services rose from 15 to 20 times (33%), meaningfully contributing to the increase in the total Index P/E.

Using Ed Yardeni’s data, virtually all of the total S&P 500 P/E advance since the 2022 low came from the “Megacap-8”.

Can sentiment get any better?

Sentiment is worrisome because investors appear to be universally very bullish. In some cases, even historically so. Equity allocations are high, portfolio betas are high, and investors are shunning diversification for concentration.

The Conference Board’s Consumer Confidence Survey shows individual investors are the most bullish they’ve been in the roughly 40-year history of the survey. Diversification is no longer viewed as a risk-reduction tool, but rather as a hindrance to performance. That could be a precarious sentiment backdrop given the potential for increased volatility in the 2nd half of 2025.

Asset managers are also very bullish. CFTC data shows that asset managers have the second most extreme net-long position in the history of the data. Although these data are not necessarily useful for market timing, it does further support the notion that investors are very bullish.

Such universal bullishness among both private clients and institutions should be a cautionary note for any investor with even a small contrarian streak. (RBA)

The only sure prediction: it won’t be a tranquil year.

Happy and healthy new year.