You may have heard financial pundits say the stock market follows the bond market, and in many ways they are right. The correlation between interest rate movements on the 10-year treasury and the broad stock indices is as strong as ever. It works like this. Rates go up on the 10-year treasury, bond and stock prices go down. Rates go down, bond and stock prices go up. While this correlation isn’t perfect, we believe it’s so strong right now because inflation remains stuck above the Federal Reserves’s target of 2% and that factor is still the biggest threat to economic stability.
We spotlight this crucial insight because, in our view, it serves as the primary force steering both stock and bond markets today. However, the directionality of interest rates remains very opaque thus contributing to a sideways, volatile market. The good news is the balance sheets of the main central banks continue to decline and move closer to the 2019 levels prior to the global money supply expansion of roughly 40% that occurred in 2020-2022.
The M2 measure of the money supply which is the Fed’s estimate that includes all the cash people have on hand, plus all the money deposited in checking accounts, savings accounts, and other short-term saving vehicles such as certificates of deposit (CDs), has also dropped below the linear trend. It has also stabilized in terms of direction and is now growing at a historically normal rate.
Both the balance sheet reduction and money supply stability should be downward forces on inflation with interest rates to follow, and as mentioned above should serve as tailwinds to the markets.
2025 Allocation Changes
As we work our way through the first quarter of 2025, earnings have remained a key focus and have stayed within and slightly higher than estimates. This has been the case since the current bull (up) market started in October of 2022 and as we know, corporate earnings drive performance over the long term.
Stock Changes
We see financial sector stocks, particularly banks, and the energy sector as well positioned. The information technology sector not only benefits from continuing investment in the build out of AI infrastructure, but also from a potential recovery in everyday enterprise information technology spending as outsized investments in information technology purchased during the COVID era may need upgrading or replacing. For these reasons, we have increased our sector allocations to the financial and energy sectors and remain overweighted in technology.
We remain underweight international equities versus the U.S. market, which benefits from higher exposure to innovation relative to foreign markets. While valuation levels in European markets are attractive, economic growth remains stagnant in the region for now. Much uncertainty remains in Emerging Markets around the strength of the U.S. dollar and potential new tariffs and as a result we have eliminated our exposure here completely.
The U.S. stock market remains concentrated in a few names with the top 5 accounting for roughly 30% of the total weighting. They account for the majority of return as well and something we will continue to monitor.
Fixed Income
With the uncertainty surrounding interest rate movements continuing this year, we added a floating-rate senior bank loan fund that has very little duration and therefore small interest rate sensitivity. This will complement the other bond funds that should increase as rates eventually come down but serve as a ballast during volatile periods.
The rest of the bond portfolio remains concentrated in investment grade domestic areas with diversification across the yield curve (short, intermediate, and long). Our structured bonds have consistently outperformed traditional fixed income and will continue to be allocated within our alternative category.
We deeply appreciate your unwavering trust and extend our warmest wishes for a joyful and prosperous March to each of you.