Escaping The Wealth Illusion

Introduction

Ah, December. A month offering hope for many with Santa preparing his sleigh, the holiday season in full swing and a new year merely days away. It’s easy at this time of year to become distracted from what’s going on in markets: “yuck, numbers, that can wait till next month, pass the stuffing!”. But, for the discerning market participant it’s important to maintain focus through turkey season, for our sanity as much as anything, but also so we don’t miss anything important to how we shape our plans for the quarter ahead.

As we look back on December it was a month marked by significant movements in equities, bonds, and cryptocurrencies, coupled with some quite pivotal economic data releases that set the stage for the first quarter of 2025. In this article we’ll have a look at these and I’ll offer my views around what they might mean for us as investors. Has the time come for portfolio adjustment or is it bullish business as usual?

This is likely to be a lengthy one as we’ve a lot to cover, but hopefully you find value in this format as it’s something I intend to continue on a monthly basis.

Summary of Major Equity Markets

United States:

The S&P 500 experienced a notable sell-off in December, dropping ~4.4% from its high ($6099) to just below midpoint (0.5%) of its trading range at ~$5832. It rebounded strongly (+3.7%) before ending the month with further selling pressure. The selloff was primarily driven (in my opinion) by rising bond yields and a hawkish tone from the Federal Reserve despite their December rate cut.

This hawkish tone was important and one we should take note of certainly. I believe it to be the first signal of a pivot in Fed posturing. A soft pivot for sure as no actual policy changes were made, it was simply a verbal warning from Chair Powell that the asymmetry of the Feds cutting cycle alongside their doveish tone throughout was changing. But markets didn’t like it none-the-less and a repricing took place to reflect a slowing of rate cuts (from 4 to 2) for 2025, with a higher EoY rate expectation (up 50 bps to 3.9%).

In short, this was the market reevaluating the sustainability of high valuations in light of potential prolonged higher interest rates and the implication of higher, more sticky inflation as a result.

The Dow Jones showed slightly less volatility with a ~4% decline and the tech heavy NASDAQ continued to rise with a 2% increase on the month.

Also of note in December: Small-cap stocks underperformed with the Russell 2000 index declining by 5.1%. This also reflects sensitivity to interest rate changes, something which is systemic from a market perspective.

United Kingdom:

UK equities had a similar month, the FTSE 100 exhibiting textbook price action of a classic sell profile: Open, High, Low, Close. It did so for a loss of ~4.76%. The UK market has been largely sideways since May, trapped in a large range, so more sideways in December wasn’t overly surprising! The FTSE hasn’t historically been the place investors ran to for high return in comparison to our US cousins, but from a pricing perspective it does offer better value at present with valuations at a far more reasonable price to earnings ratio than the US which is, let’s just say, “overheated”.

Still, I don’t see investors flocking to UK companies in the short term. While the dividend yields can be attractive, the business environment in the UK under the new Labour government is most certainly not and I can’t see anything other than a tough time for UK enterprise into 2025.

Europe:

European stocks also suffered drawdown in December, with the MSCI Europe ex-UK index down ~3%. Political uncertainties in France and disappointing PMI data have contributed to this underperformance but a pretty confluent month with other major markets in all honesty.

Japan:

One interesting note for the month comes from Japan, where the TOPIX index put in a ~3% gain in the final third of the month after a brief drawdown in the middle third, a nice rebound to give it a +4.5% month overall, the outlier among the major market indices for December.

Bond Market Dynamics

US Treasuries

US 1, 2, 5, 10 & 30 Year Treasuries all reacted as one might expect to the comments of Fed Chair Powell, with yields rising across the board. With future rate cut expectation set lower by the Fed, one might expect a strong reaction from the Dollar and associated Fixed-Income assets and that’s certainly what we got to end the month. Could bond yields have bottomed (for now)? I think this more likely going into Q1 given the signal by the Fed that rates will fall more slowly than first priced in, 50bps slower in 2025 to be precise (if they follow through on the data shared).

I’ll watch on with interest on this one as one of the knock on impacts of December yield increase was a steepening of the yield curve reversion and the actual reverting of one of my key indicators: the 10Y3M. Belief in a gradual economic recovery and the Fed achieving their soft landing, rather than an impending recession risk, has become majority thinking. Though notoriously hard to predict, the reversion of the 10Y3M allied with other data I track and right when people start to accept a recession isn’t coming is a red flag for me.

I think it is a fair assessment that we have 1-2 quarters from here of Bullish momentum, but I do still hold the view that recession risk is greater than most are willing to accept beyond that timeframe (more on this later).

UK Gilts

Despite expectations of gradual rate cuts, UK bond yields increased too, suggesting investor caution towards inflation risks and the Bank of England’s (BoE) stance on maintaining rates for longer. I also think there’s some unease in UK markets at the moment post the budget statement earlier in the quarter which most commentators, including the CBR, see as “anti growth”.

Eurozone Bonds

German Bund yields hit a yearly high, influenced by strong US economic data and expectations of ECB rate cut delays, reflecting a cautious approach to monetary policy easing in Europe.

Japanese Government Bonds (JGBs)

Yields dropped, influenced by global bond sell-offs and BoJ’s commitment to rate hikes, which might signal a continuation of accommodative policy from the BoJ.

Cryptocurrency Market Trends

Bitcoin had an early December surge into price discovery above previous ATH, before topping out and rolling back into range mid month. It’s been a very strong run for Bitcoin (and crypto in general) over the last quarter so a cooling off wasn’t unexpected here. As my colleague (and friend) at Crypto Caesar Capital has recently pointed out in his socials, seasonality for Bitcoin plays a role here too, with December into January often being a time we might anticipate some ranging.

For my taste I think a move somewhere into the $75k – $85k range by mid January (and I’ve been consistent in this for a while) makes sense when the current trading range is considered and the strength on the weekly chart of the move into it. Certainly if I were a buyer that would be the “sensible” area for me, based on current price being at a premium in relation to its range. This area still represents a premium of the range, but in bull markets it isn’t uncommon for BTC to have shallow (or even upwards!) corrective ranges and this area between 0.5% and 0.382% of the range wouldn’t be out of the ordinary.

Nothing in December moves Bitcoin out of bullish posture for me, simply a little pause for breath.

The other most notable December mover in the top 10 was XRP. Notoriously explosive when it does move, after doing nothing for eternity, it saw a 57% increase in 2 days to start the month before settling back inside range for the remainder of the month.

Key Economic Data Releases

Federal Reserve (Fed)

A 25 basis point rate cut was confirmed as expected, but more importantly it came with a hawkish tone, reducing expectations for half of the planned cuts in 2025. This adjustment might suggest a tighter policy than previously anticipated, impacting market liquidity. Certainly this is how markets reacted as we covered above.

CPI (both headline and core) came in on forecast while unemployment for November held relatively steady at 4.2%. NFP was above expectation, giving further signals that the labour market is strong. There are a couple of potential interpretations here, one being that a strong labour market with above expectation jobs being added and unemployment holding steady is a good sign for the overall economy and for the Fed’s targeted soft landing. The other is that a strong jobs market is likely to keep wage rise inflation at the forefront of economic thinking and this may be one of the reasons for the Fed cooling off their rate reduction plans.

Bank of England (BoE)

Rates were held steady at 4.75%, with inflation at 2.6%, indicating a cautious approach to further monetary easing. The unemployment rate rose to 4.3% and sentiment seems to be that this will likely rise further into H1 2025. This, along with positive dollar news covered earlier, impacted GBP valuation against USD (down to 1.25) with general UK market sentiment being negative.

European Central Bank (ECB)

No direct rate change was discussed, but market expectations for cuts were influenced by persistent uncertainties, notably tariffs and geopolitical tensions.

Manufacturing PMI remained in contraction, but services PMI showed expansion, highlighting a two-speed recovery.

Bank of Japan (BoJ)

Kept rates at 0.25% with a dovish stance, despite rising inflation, indicating a complex balancing act between supporting growth and controlling inflation. Core CPI rose to 3.1%, prompting discussions about potential policy tightening if this trend persists.

Emerging Risks

A few things of note this month, some quite persistent and some new additions based on December data.

Geopolitical Tensions

Alongside the long term issues (Ukraine/Russia and Israel/Palestine) we’re seeing increased friction in trade policies, particularly between the US and China. Regime change in the US is unlikely to help with this given the narrative around tariffs. However, new trade agreements like the USMCA 2.0 expansion brought some relief.

Inflation Concerns

Service sector inflation remains pretty sticky around the globe, which might delay rate cuts and keep markets on edge regarding monetary policy directions. This has certainly been evidenced recently in US and UK rate decisions and commentary by respective central banks.

Currency Fluctuations

A new one for December: a strong US dollar due to the Fed soft pivot on rate decisions could pressure emerging market currencies and affect multinational earnings. A stronger DXY often has an inverse correlation with risk markets and we certainly saw this during the post Fed jawboning reprice this month. The DXY is certainly something to keep a close eye on through H1 next year.

Assets of Interest Moving Forward

Not much new of note here, with the exception of Gold potentially being a consideration again as inflation and recession concerns start to rise.

• Gold: With inflation concerns, gold might continue its upward trend as a hedge, especially if real yields remain low or negative. I am in two minds here with the recent upturn in yields however it is worthy of consideration at this time IMO.
• Emerging Market Equities: Opportunities could arise in markets like India or Brazil, which are showing resilience or even growth in domestic demand. Large allocation here is risky, but consideration for a small allocation may be something worth consideration.
• AI and Tech Infrastructure: Despite recent corrections, the fundamental demand for AI capabilities in various industries suggests long-term investment potential. US valuations are very, very high at the moment, but sensible allocation here is likely a solid choice. Given the preference for index tracker funds, you may already be well exposed here, so treat with caution in your overall portfolio
• Cryptocurrency: Seasonality of December/January aside, we’re about to enter year 4 of the traditional cryptocurrency 4 year cycle. Whether this time will be different or not, I still believe there to be a minimum of 3-6 months of bullish upside capture available in this market with my base case for a Bitcoin top being around $157k (I have a bear and bull case lower and higher as well, at $125k and $209k). The Altcoin market I have a base case of around $3T with a bull case of $4T meaning a potential 3x from here. Time will tell, but I think a reasonable allocation here is warranted for my taste.

Potential Portfolio Adjustments

Diversification into Fixed Income

With yields potentially at or near a peak, locking in higher rates through medium-term to longer-term bonds might be an option for larger portfolios to lock in return. High-quality corporate bonds could also offer higher yield without excessive risk. I still believe there are 3-6 months minimum in Risk On bullish trend, so this is less of a concern for those happy with risk, more as a hedge for those with significant capital looking to preserve some profit for potential deployment later.

With inflationary pressure seemingly increasing though and the potential for further QE to stimulate growth in response to a potential recession in H2 2025 duration risk here is a definite consideration. I personally won’t be doing this, but it merited a mention IMO given the recent change in bond yields.

Currency Hedging

For those with international exposure, consider hedging against the dollar, especially if your investments are in regions where the local currency might depreciate. With the DXY posturing strength technically and the Fed signaling for higher rates for longer (net positive USD) any positions you hold in US equities (for example) that are denominated in local currency are likely exposed to higher currency risk through 2025, particularly H2 if (if!!) a recession does come and we see QE used to stimulate growth.

Sector Rotation

Moving towards sectors with lower cyclicality like utilities or healthcare, or those poised for growth due to regulatory or technological shifts may be an option. Again, with 3-6 months minimum remaining in an equities (and general risk on) bull market I think it’s a little too early for this approach and won’t be in my considerations for Q1, but again warrants mention given the hawkish tone change and longer term outlook. I think this likely a consideration that will stay on here till end Q2/Q3 time before I look at it seriously.

Cryptocurrency

If you have an appetite for high risk, consider risk reasonable allocations to cryptocurrencies with strong fundamentals or those likely to benefit from regulatory clarity. US based cryptocurrencies certainly appear appealing in light of statements from the incoming administration and the potential demand inflow this would bring, as well as those who have had ETF applications filed to use as a benchmark.

FWIW I’m not one who buys the chat on a strategic US Bitcoin reserve. I’ll perhaps cover this in a future article in it’s own right as there’s too much to go into here, but for the purposes of this discussion I think it’s far less likely at present time than many in the space who are excited about it. Bitcoin however, still remains the oldest, most trusted and least risk asset in the crypto market. It’s likely return from current prices (mid $90k’s) is in the region of 40%-60%, with a bull target just above 100% in the short term (within 12 months), but that still represents huge potential without taking on outsized crypto risk in nyetcoins and memes!

Equities & Risk On

In case I haven’t said it enough! I think we have 3-6 months minimum in this bull trend across the Risk On classes. My personal taste, for now, is to continue to allocate the majority of my capital here (along with cryptocurrency) and milk as much return as I can before I anticipate becoming more defensive later in 2025. I’ll review this again at the end of Q1.

Looking Ahead to Q1 2025

The next moves from major central banks will dictate much of the market sentiment, with investors particularly watching for signals on inflation control versus growth support. All eyes will be on the Fed at the end of January for the outcome of their FOMC meeting but it hasn’t been Powell’s style to flip flop quite so quickly so my expectation here is that we see a renewed statement of intent that matches what we heard earlier this month. The repricing has happened so markets should, outwith the general volatility we see intraday, be fairly stable as long as the message is what we expect to hear.

Regime change in the US from January 20th will be one to watch. A lot of posturing has happened since the election results were confirmed with DOGE and the implementation of tariffs for non US goods and services the two I’m most interested in going into 2025, with changes to digital asset (cryptocurrency) regulation a close third.

I’m maybe missing something but I don’t see the implementation of tariffs (from later in the year) as anything other than inflationary given the end impact for consumers is higher prices of goods and services in the US. I understand the argument around US industry, bringing manufacturing etc. back and increasing jobs and wages as a result, but for the life of me I don’t see (yet, I’m open to new data as always) how the outcome in either case is not higher prices for US consumers.

Afterall, the reason manufacturing moved in the first placed was (mostly) based on cost, bringing it back isn’t going to reduce said cost. Yes, increasing the price of imported goods via tariffs will potentially make goods manufactured at home cheaper than these imported goods post tariff application, but in my mind that’s a standardisation up, not down. The goods and services end up more expensive either way, which is inflationary and if the answer is “so do wages to help with this” then that’s a good old wage-price spiral starting out.

I’m also interested to see how DOGE approaches the government inefficiency problem. You’ll get no complaints from me about removing layers of unnecessary government oversight as I generally believe in less government interference in our lives rather than more and I certainly don’t think increasing the tax take to pay for a bloated bureaucracy is an answer. But I wonder if it will be a little more difficult than being sold at present. Governments tend to be better at protecting their own roles and creating bureaucracies than literally any other thing they ever do!

In general, from a markets perspective, I still believe we are in a bullish phase. I believe we have a minimum of 3-6 months, with a potential 6-12 months with a fair wind before the really defensive portfolio positioning starts. I will be watching the key indicators in Q1 to track where I believe we’re at in the market cycle but I anticipate the potential for good return continues through Q1 at a minimum.

For some context, here are the datapoints I use and why I believe them so important.

1. 10Y3M Yield Curve Inversion:

The 10-Year Treasury yield minus the 3-Month Treasury bill (10Y3M) spread, which inverted in early 2023 and has been a significant concern for me ever since, appears to have bottomed out and reverted in December. Historically, an inverted yield curve by this measure has preceded each of the last eight U.S. recessions by about 6 to 18 months, signaling investor expectations of economic slowdown. The current situation, where the curve has reverted, suggests the market is anticipating economic downturn. There are other datapoints which support this, like the increase in Money Market funds as capital cycles into safe harbours awaiting opportunity and I’ll touch on this later.

2. Unemployment Rate:

Unemployment, which bottomed out at 3.4% in mid-2024 after a robust post-COVID recovery, has shown signs of stabilisation. In the last 8 US recessions there has NEVER been a scenario where unemployment bottomed, the Fed Funds rate topped and the 10Y3M reverted and a recession DIDN’T follow. Maybe it is different this time, but that’s a risk I want to manage (and those are the 6 most dangerous words in investing!)

Furthermore, the Sahm rule, an indicator used to confirm US recessions based on unemployment shows that when the three-month moving average of the unemployment rate is at least 0.5 percent higher than its lowest point in the previous 12 months, the economy is in the early stages of a recession. In 2024, it went beyond this mark (briefly) before reverting.

3. Fed Funds Rate:

The Federal Funds Rate, having climbed to a peak of 5.50%, has since dropped to 4.5% after a 25 basis point cut in December. This follows a pattern where the Fed typically pauses or reverses its rate hikes when inflation begins to sustainably decline towards the 2% target or when economic growth shows signs of slowing. A top in the Fed Funds Rate often precedes economic policy shifts that could either stave off or precipitate a recession, depending on the effectiveness of the monetary policy. As above, this is one of 3 key indicators combined that, when triggering together, generally is a strong signal of recession within 6-18 months.

Historical Context:

The early 1980s saw a similar scenario where the yield curve inverted, unemployment was low, and Fed rates were high before a significant recession hit. This was the Paul Volcker era.

Before the dot-com bubble burst, the yield curve inverted, unemployment was at a low, and the Fed had begun easing rates. The recession that followed was mild but marked by significant tech sector corrections.

Preceding the Great Recession, these indicators again aligned with a prolonged inversion, low unemployment, and high Fed rates before a sharp downturn exacerbated by housing market collapse.

Impending Leadership Change and Economic Plans

Does the new regime offer some hope that it may be different this time? Well, the honest answer is “no-one knows, maybe”. A cop out, perhaps, but I think it’s a genuine answer and that’s what I prefer to be, genuine. As I’ve mentioned above, the new regime’s advertised policies on the surface appear inflationary, which won’t help the Fed in their battle against inflation or their hopes for a soft landing.

Some items of note which may have an impact include:

• Tax Reforms: Potentially lowering corporation taxes to spur investment, which could stimulate economic activity but also risk inflation if not coupled with productivity gains.
• Infrastructure Spending: A significant increase in infrastructure spending is proposed, which historically has had mixed results on immediate GDP growth but can boost long-term productivity.
• Regulatory Adjustments: There’s a promise to review and possibly ease regulations in key sectors like finance and energy, aiming to unlock capital but with potential risks to financial stability if not managed carefully.

As I hinted at above, the combination of these policies with the current economic indicators could either mitigate recession risks by stimulating demand or exacerbate them if inflation reaccelerates or if the policies lead to an overheated economy. The effectiveness will largely depend on how these fiscal measures align with the Fed’s monetary policy, particularly if the Fed decides to maintain higher rates for longer to combat inflation.

The Presidential hotseat has no control nor influence over monetary policy decisions at the Fed and vice versa, they’re separated for good reason. So there may be some interesting times ahead as the two try to out maneuver each other in the hopes of achieving their own goals.

The New World

I think it’s also right to note that we live in a new world of QE, something that only gained widespread adoption (outside of Japan) post the 2008 GFC, the last major recessionary event that the indicators I track were useful in. With debt levels spiraling and essentially every western nation outside of Norway technically bankrupt, does QE impact our outlook here?

Yes, I think it does. There is a very real potential that in a recessionary environment the fed simply turns on the good old money printer to stimulate the economy into growth, with the net effect being that asset prices inflate alongside goods and services and wealth inequality gets worse, people get poorer and the problem, on paper, can be argued away.

This outcome is obviously net positive for those of us who invest in assets, but we are, I’m afraid, in the minority. It means the poorest get poorer, the middle disappears entirely and we return (over time) to a 2 class system of have’s and have nots. Think the Hunger Games. Our job is to make sure we end up with enough to be in the Capitol, but it’s a pretty terrible outcome for most.

I think this is likely the approach the Fed would take and it’s why, despite my view that a recession is more likely than not, I’m neutral on the effects for our purposes as investors. In the new world of QE, after a short, sharp correction across markets, the potential exists that we quickly return to an inflationary environment of QE which is net positive for asset markets and net negative for goods and services.

Money Market Moves

Investor Considerations

With these indicators and policy shifts, markets might experience increased volatility. Investors might consider diversification: spread investments to mitigate risks, including into sectors less sensitive to interest rate changes or downturns like utilities or healthcare. Maybe also consider bonds with different maturities to benefit from potential yield curve normalisation or further inversion if economic conditions worsen. Gold and other safe havens are also worthy of consideration as a hedge against potential inflation or economic uncertainty.

Personally, I consider cryptocurrency to be a Risk On asset. It has always acted like one in line with equities and despite the “Bitcoin as a store of value” nonsense I would fully expect it to react in the same way as other risk on assets. Initially this would be downward pressure, returning to upwards pressure if the Fed return to QE and inflation spirals again. Liquidity is king for Risk On assets.

Given the historical context and current signals, while a recession isn’t guaranteed, preparing for economic cycles, including potential downturns, remains prudent. This might mean balancing growth with defensive strategies in portfolio construction. In conclusion, while the current economic indicators suggest a complex picture with historical precedents for concern, the change in U.S. leadership and their economic plans as well as the new world of QE introduce variables that could alter traditional outcomes. Monitoring how these elements interact will be crucial for investors in the coming quarter and something I will be watching closely.

Conclusion

December 2024 was a month of recalibration in financial markets as we witnessed first hand the interplay of economic data, policy jawboning from the Fed and market psychology. All told it instigated a repricing of inflation and fund rate expectations globally as well as giving the DXY Dollar a shot in the arm.

All major markets with the exception of the Japanese TOPIX had some level of decline and bond yields around the major economies saw an upturn due to inflationary pressure returning and a hawkish tone from major central banks. In the US the 10Y3M yield curve reverted in December, a datapoint of real note for me and one I will continue to monitor alongside other recessionary measures. But I remain convinced that QE will be used to get the US out of any recession and that the liquidity injection it brings to asset markets could be hugely positive, despite fears of a wider “great depression” type collapse. I haven’t mentioned this previously as it’s not a risk I take seriously at the moment, but one I will, as always, review as we go.

As we transition into 2025, the prudent investor will maintain flexibility, keep abreast of global economic cues, and perhaps most importantly, understand that in this interconnected world, no market exists in isolation. A US recession in H2 would be net negative for most and a return to QE in the US when other major economies are tightening could have severe implications for currencies battling against the Dollar. There is a real possibility, in this scenario, that the US finds itself with a 100-200bps delta between it’s own rates and those of the other major economies.

The strategies outlined here aim to navigate this landscape with foresight, balance, and an eye towards both preservation and growth of capital. Risk Managers first and foremost, protecting what we have is our primary goal, then we look to grow.

Thanks for reading and “lang may yer lum reek”.