Key Private Bank Investment Brief

Key Takeaways:

• Inflation is proving sticky. In a report issued last week from the Bureau of Labor Statistics, inflation at the consumer level rose 0.47% month-over-month in January, the fastest rate of change since late 2023. “Core” inflation, which excludes volatile components such as energy and food prices, rose by an equally alarming rate of 0.45%. On a year-over-year basis, inflation has risen over 3%, uncomfortably above the 2% target set forth by the Federal Reserve. That said, inflation at the producer level rose by a lesser amount, allaying some concerns.

• Consumer spending slowed in January. Retail sales fell 1.2% last month, according to data tabulated by the US Census Bureau. E-commerce activity and auto sales were especially weak, surprising forecasters on the downside. Cold weather and California wildfires are factors that likely contributed to the decline which could prove temporary, and year-over-year levels remained healthy, advancing by 4%, as wages, as we’ve noted previously, remain steady.

• The labor market remains solid. Initial claims for unemployment fell last week to 213,000 down from the prior week’s tally of 220,000, as recorded by the US Employment and Training Administration. We are watchful for any increase associated with the highly publicized government efficiency efforts, but thus far, we have not yet seen signs of such weakness show up in the data.

• Uncertainty is skyrocketing. Data assembled to measure economic uncertainty has surged higher, reflective of a considerable number of unknowns regarding trade policy, tax cuts, and other policies being pursued by the second Trump administration. Such uncertainty could weigh on the economy, but based on the latest GDPNow model maintained by the Federal Reserve Bank of Atlanta, economic growth is sound and CEO/CFO confidence is holding firm.

• Valuations remain elevated. Against the backdrop of surging uncertainty, valuations on most US risk assets are extended relative to their historic averages. Valuation comparisons on commonly used indexes are somewhat flawed based on the changing composition of the underlying indexes. To address this, Research Affiliates, an investment consulting firm, created a “current constituency” valuation measure which shows that US stocks may not be as highly valued as thought, but remain expensive. Valuations on non-US stocks are far less demanding which may explain their recent outperformance.

• Bottom Line: investors should remain overweight US assets, however, international markets still deserve representation within a well-diversified portfolio as do Real Assets which have also been outperforming (in the case of commodities) or showing signs of recovery (in the case of real estate). We also believe investors should continue to emphasize Quality throughout their portfolio.

Equity Takeaways:

• Against the backdrop of sticky inflation, a slowdown in consumer spending, and lofty valuations, equity markets continue to demonstrate great resiliency with the S&P 500 Index rising 1.5% last week. Small cap stocks were roughly unchanged (S&P 600 Index: -0.1%), while international stocks advanced (MSCI ACWI ex-US: +2.8%) for the week. Of the eleven US equity sectors, nine were positive, one was unchanged, and one experienced a small decline.

• S&P 500 aggregated earnings for the fourth quarter of 2024 have risen nearly 17%, far outpacing initial growth expectations of roughly 12%. Financials, Communication Services and Consumer Discretionary stocks have been the biggest contributors to the recent earnings momentum.

• At the same time, earnings expectations for the first quarter of 2025 and the full year continue to deteriorate but not by a worrisome amount. Overall S&P 500 aggregated earnings for 2025 are anticipated to rise 12.7%, a slight slowdown from the 15% earnings growth forecast established earlier this year. We continue to feel as if these estimates might be too high but feel as if earnings growth will still be positive in 2025 as ongoing economic momentum continues.

• We also believe that market rallies will broaden out in 2025, and this was on display last week with the equal-weighted Nasdaq-100 breaking out to a new high.

• Through mid-day Tuesday afternoon, the S&P 500 Index was fractionally higher. Mid- and small-cap stocks and international shares were also higher by roughly 0.5%.

Fixed-Income Takeaways:

• Despite concerns over higher inflation, bond yields were modestly lower last week, declining roughly 5 basis points (0.05%) across the yield curve. Credit spreads were little changed, and bond prices inched higher.

• Expectations for further interest rate cuts from the Fed have diminished with futures markets now only forecasting one rate cut in 2025 as calculated by Bloomberg. With this outlook of “higher rates for longer” money market funds continue to attract investor’s capital, with total industry assets nearly $7 trillion.

• As of mid-day Tuesday afternoon, bond yields were higher. Yields on the 2-year US Treasury note approximated 4.3%, and yields on the 10-year US Treasury Note approximated 4.55%, up 4 and 8 basis points, respectively.

Key Takeaways:

The labor market remains solid. Employment is softening, but not soft.

Non-farm payroll growth was +143,000 in January, a solid yet unspectacular number. Weather-related disruptions did not seem to affect the data last month. Wage growth remains sticky, implying that the Federal Reserve (Fed) will take its time cutting interest rates going forward.

The ratio of job openings relative to the unemployment level is normalizing, according to the US Bureau of Labor Statistics. Future wage growth may slow as a result.

Federal workers make up less than 2% of the entire US labor market, or approximately 3 million people, according to data from the Federal Reserve Bank of St Louis. Thus, despite headlines over layoffs within certain governmental agencies triggering concern, we don’t see this as an economic event as of now. Moreover, with approximately 74% of government spending allocated towards mandatory programs (e.g., Social Security, Medicare, Medicaid, other mandatory programs and interest payments), those seeking to aggressively cut spending may need to look elsewhere.

In the past three years, job gains have been driven by certain sectors: leisure & hospitality, private education, and health care. Weakness has been concentrated in technology, retail and manufacturing.

Fourth quarter 2024 earnings season is approximately two-thirds complete. Growth continues.

Since earnings season began, aggregated S&P 500 earnings-per-share growth in Q4:2024 has risen from 11.8% to 16.4%, according to FactSet. Thus, Q4:2024 earnings growth has been stronger than expected.

That said, the 2025 earnings outlook is weakening. Entering the year, full-year 2025 S&P 500 earnings estimates were expected to grow 14.7% over 2024. As of February 6, 2025, estimates are now for 12.9% earnings growth in 2025, according to FactSet.

The recent downshift in 2025 earnings expectations is the first inflection lower in this metric since 2022. When earnings growth expectations begin slowing, the stock market becomes more vulnerable.

Tariff talk has increased uncertainty around trade policy and economic growth.

Of the earnings calls held this quarter, slightly more than half included mention of the term “tariff” or “tariffs”, according to FactSet. The last time we saw such concern around tariffs was in 2018-2019.

In President Trump’s first administration, trade tensions appeared to escalate as the S&P 500 was strengthening, or near a local high, according to data from the Peterson Institute and Evercore ISI. President Trump appears to favor striking from a position of “high ground.” We acknowledge that economic risks may rise due to tariffs; however, given a vast array of unknowns (including how other countries respond, how specific companies may respond, how widespread tariffs might be, how long they might last, etc.), we advise investors refrain from making major adjustments to their portfolios.

Bottom Line:

Diversification remains a bedrock principle of sound asset allocation. Real assets, such as gold, have provided important diversification to portfolios in early 2025, with gold rising 8.6% year-to-date (YTD) through February 7, 2025. In addition, international stocks have outperformed their US brethren YTD.

We remain Neutral to Risk. Key Wealth remains a proponent of periodic rebalancing in accordance with long-term financial planning.

Stocks and bonds are once again moving together and have become positively correlated. Bonds may not provide their typical diversification benefits amidst continued strong economic growth and sticky inflation.

New Tools, such as alternatives, real assets, and hedge funds, provide additional important diversification in the current environment. These types of strategies can also offer downside protection during periods of market stress.

Equity Takeaways:

Stocks were mixed in early Monday trading. The S&P 500 rose approximately 0.6%, to 6062, while small caps fell approximately 0.3%. The tech-heavy Nasdaq 100 rose just over 1.0%. International shares were generally higher.

The S&P 500 has been in a tight range for almost three months. Headline news flow has been negative (tariffs), and stocks have still held up. Equities generally have a positive bias while credit markets remain strong (as they currently are).

The past two weeks have shown similar price action, with a strong gap down on Monday, followed by a grind higher throughout the week and a soft Friday. We believe this type of price action is indicative of a “buy the dip” mentality.

Volatility has peaked on Monday each of the past two weeks (January 27 and February 3). Volatility griding lower throughout the week also likely indicates investors buying the dip.

Sentiment is complacent. Investors are more worried about missing upside than protecting downside. The 10-day moving average of the CBOE Composite Put/Call Ratio dipped below 0.80 last week, a sign that investors are becoming overly optimistic.

Sentiment measures should not be used as market timing tools, but complacent or optimistic sentiment is usually a contrary signal. With earnings growth also slowing, we continue to expect a choppier market in 2025 compared to 2023-2024.

Fixed-Income Takeaways:

The 2-year / 10-year Treasury curve flattened last week, with 2-year yields rising relative to 10-year yields. Concerns that tariffs could put upward pressure on inflation while slowing long-term growth led to this move.

In early Monday trading, 2-year Treasuries were yielding 4.27%, 5-year Treasuries 4.32%, and 10-year Treasuries 4.47%.

The current Fed Funds rate is the target range of 4.25% to 4.50% and is expected to finish the year at near 4.00%. Expectations are for only 25-50 basis points of rate cuts for all of 2025. Consensus puts the first rate cut during the summer of this year.

Credit spreads remain firm, close to the 20-year tights we saw in November 2024. Credit markets are showing very little signs of stress – supply cannot keep up with demand for corporate credit.

Key Takeaways:

DeepSeek Recap: What just happened?

DeepSeek is a Chinese artificial intelligence (AI) start-up platform founded in 2023 that appears to have shown significant efficiency gains with their computing logic algorithms. Early last week, the stock market experienced significant volatility, concentrated in the semiconductor industry. The volatility was caused by concerns that DeepSeek’s efficiency gains could upend AI infrastructure investment.

Many questions remain, but DeepSeek is another example of the cycle of innovation. In our view, AI can be viewed as another computing “paradigm shift.” If we look to the earlier four eras of computing, a pattern emerges – exponential growth eventually flattens out in terms of unit volume as the technology is widely adopted.

At the very least, DeepSeek is a wake-up call for American tech dominance. Our AI thesis can be summed up with a quote by Bill Gates: “Most people overestimate what can happen in one year and underestimate what can happen in ten years.”

In a recent Key Questions article, we discuss AI in more detail. The long-term growth of AI presents a massive opportunity, but we are somewhat cautious on the near-term as stock valuations have already moved significantly higher. In addition to big tech companies, industrial infrastructure has been a significant beneficiary of the AI boom – the buildout is happening.

In the long run, AI could offset some of the effects of higher tariffs by increasing efficiency (boosting growth and lowering inflation in a positive supply shock). Secondary innovations of new technology typically spur broader economic benefits, such as new jobs, more productivity, and disinflation. Time will tell.

What tariffs were implemented?

On Saturday, President Trump announced the US would impose a 25% tariff on most goods imported from Canada (10% on energy), 25% on goods imported from Mexico, and a 10% tariff on goods imported from China. Tariffs are scheduled to go into effect on Tuesday, February 4, 2025.

Canada has responded with a 25% tariff on all US exports; Mexico and China are both vowing retaliation.

Imports from Canada, Mexico and China make up approximately 50% of all US imports, but the US is proportionately less dependent on trade than Canada, Mexico and China, according to UN Comtrade and the Council on Foreign Relations.

The impact of tariffs could be significant to both the Canadian and Mexican economies. Several investment managers we spoke with believe that tariffs, if implemented for an extended period, could push both Canada and Mexico into recession.

What will be the impact of tariffs?

Tariffs are a negative supply shock. Prices rise, while demand falls. Inflation will face a one-time hit, but growth will fade more over time as demand slows. Job losses may rise, and tax revenues should increase, but no one really knows.

S&P 500 earnings may also be negatively impacted, as well as market multiples (market participants may become more risk averse), but no one really knows the impact.

The US dollar is likely to rise, while interest rates may fall. We will continue to watch credit spreads closely for signs of stress, but to this point the credit markets remain calm.

An escalating trade war could drive investors to safe-haven assets, such as gold, while potentially weakening demand for oil.

Equity Takeaways:

Stocks were lower in early Monday trading. The S&P 500 fell approximately 1.8%, to 5929, while small caps fell approximately 2.4%. The tech-heavy Nasdaq 100 fell just over 2.0%. International shares were broadly lower, while the US dollar was sharply higher.

Last week’s sharp rebound off Monday’s DeepSeek selloff was a positive sign, in that the lows were set on Monday and the rest of the week was strong. The market comes into this week from a position of strength.

The next few days of trading will tell us a lot about the health of the underlying market. It is too early to make snap decisions about the long-term impact of tariffs.

S&P 500 earnings growth has slowed over the past few weeks. Guidance has been below expectations, which has driven negative earnings revisions – a cautionary signal.

On balance, the stock market broadened out in January, a positive sign. Within the eleven S&P 500 sectors, the technology sector was the weakest in January, and the only sector showing negative absolute performance for the month.

Another sign of underlying market health – Initial Public Offerings (IPOs) have accelerated. The IPO index recently moved to a two-year high relative to the S&P 500, a sign that the bull market remains healthy.

Fixed-Income Takeaways:

Treasury yields fell 5-10 basis points across the curve last week. The Federal Reserve (Fed) held short-term interest rates steady last week, as expected, at their FOMC meeting. The current Fed Funds rate is the target range of 4.25% to 4.50%.

In early Monday trading, 2-year Treasuries were yielding 4.23%, 5-year Treasuries 4.30%, and 10-year Treasuries 4.48%.

Market participants believe tariffs could put near-term upward pressure on inflation, which could slow the pace of Fed interest rate cuts. The next rate cut of 25 basis points is not expected until July 2025.

The difference between US and Canadian bond yields has moved to its widest level in more than 25 years. Pressure on the Canadian dollar has pushed Canadian bond yields higher.

Credit spreads remain resilient. High-yield spreads moved slightly wider last week, but the move was nothing out of the ordinary. Corporate credit investors remain sanguine even in the face of heavy supply. Spreads were slightly wider in early Monday trading.

Key Takeaways:

What is DeepSeek and why is it attracting so much attention?

DeepSeek is a Chinese artificial intelligence (AI) startup founded in 2023. Its new model (a.k.a. R1, released last week) has reportedly performed exceptionally well at significantly lower costs than its rivals.

The details on the underlying model are sparse. It is unclear how much computing power is needed to run DeepSeek models; however, it does appear that DeepSeek has released significant innovation into the marketplace.

The AI world is in a state of shock this morning. Mega-cap technology stocks are under significant pressure, as the industry is experiencing a large capital expenditure cycle whose benefits are being called into question. Investors are concerned that the new DeepSeek models could upend the sector with their efficiency. We will be watching this area carefully for investing implications. At first blush, we don’t think the dominance that America’s technology companies have enjoyed for the past ten-plus years is over; but it is possibly facing renewed competition, and we continue to believe investors are best served when maintaining a diversified portfolio.

The Trump administration sprang into action last week. Economic data was light.

Last week, unemployment claims remained low, S&P 500 earnings nudged higher, and bond yields were little changed. Home prices continued to reach record highs, but home sales finished 2024 at the slowest pace since 1995.

President Trump released a series of executive orders upon assuming the Presidency. Market participants breathed a sigh of relief when no immediate tariffs were announced, but we believe tariffs are a question of “when”, not “if”.

As of January 25, at 10:00am ET, in his first week in office, President Trump had issued 51 executive actions according to whitehouse.gov and data from CNN. The past 10 presidents signed an average of 266 executive orders per four-year term, or 66 per year according to the Federal Register.

Areas of executive action focus included immigration, government employment/personnel efficiency, energy, trade, and AI/crypto.

For context, federal workers make up less than 2% of the entire US labor market (approximately 3 million people). Of those, 60% work in the Department of Defense, Department of Veterans Affairs, and the Post Office.

Approximately 74% of government spending is allocated towards mandatory spending programs (Social Security, Medicare, Medicaid and interest payments). It may be difficult for the incoming administration to significantly cut spending.

Volatility is common in the stock market. Investors should stay focused on long-term results.

In the past 45 years, the S&P 500 has posted an intra-year decline of 14% on average. The index posted a positive year 76% of the time during this period, showing that patience is generally rewarded.

The largest market drawdowns typically occur during recessions. As noted in recent weeks, US economic growth remains solid and unemployment claims remain low. The data does not show signs of an imminent recession.

Bottom Line:

We remain Neutral to Risk. The rally in the S&P 500 off the late 2022 lows has led to one of the strongest two-year periods in history, and it would not be surprising to see a pullback. Key Wealth remains a proponent of periodic rebalancing in accordance with long-term financial planning.

Stocks and bonds are once again moving together and have become positively correlated. Bonds may not provide their typical diversification benefits amidst continued strong economic growth and sticky inflation.

New Tools, such as alternatives, real assets, and hedge funds, provide additional important diversification in the current environment. These types of strategies can also offer downside protection during periods of market stress.

Equity Takeaways:

Stocks fell in early Monday trading as investors began to digest the DeepSeek news referenced above. The S&P 500 fell approximately 1.65%, to 6002, while the tech-heavy Nasdaq 100 fell approximately 2.75%. Small caps were essentially flat. International shares were mixed.

Prior to this morning’s selloff, the S&P 500 was in the midst of a strong bounce-back rally. Near-term support is likely in the 5700-5800 range, which corresponds with the early January lows.

Fourth quarter 2024 earnings season has begun and is off to a solid start, but it is still too early to draw any decisive conclusions. Many of the S&P 500’s largest companies have yet to report.

The S&P 500 remains expensive with a price/earnings (P/E) ratio of approximately 22x. When the market is expensive, air pockets can develop amidst uncertainty, and we saw such an event play out this Monday morning.

Breadth is another area of concern. The NYSE cumulative advance/decline line did not make a new high during the latest rally, implying that the recent rally was driven by relatively narrow leadership.

Fixed-Income Takeaways:

Treasury yields moved slightly lower last week and were falling again in early Monday trading. Investors were moving towards the safety of Treasuries on Monday as technology shares sold off.

In early Monday trading, 2-year Treasuries were yielding 4.22%, 5-year Treasuries 4.35%, and 10-year Treasuries 4.54%. Yields were 6-10 basis points lower across the curve.

The Federal Reserve (Fed) will meet this week with the press conference on Wednesday and is expected to leave the Fed Funds rate unchanged. Inflation remains above the Fed’s long-term target of 2.0%, and tariff policy could put upward pressure on prices. The current Fed Funds rate is the range of 4.25% to 4.50%.

Investment-grade (IG) corporate bond spreads widened about 3-5 basis points in early Monday trading but remain at very tight levels. Trading activity remains robust, and investors continue to show high demand for the sector. The ease of trading has increased, which has been another tailwind for corporate bonds.

Private credit remains an attractive diversifying asset class. Over the past 20 years, private credit has delivered higher returns than both the high-yield corporate bond and leveraged loan indexes, according to data from Bloomberg, Morningstar, and Morgan Stanley.