Kyle's Monthly Markets Newsletter - February 2025

Welcome to my monthly markets newsletter. Every month I collect and analyze data on the economy and financial markets, and present that to our investment committee to aid our portfolio management decision making. My newsletter is a condensed version of the information we analyze to give you insight into the trends and opportunities we're observing.

Hello everyone,

First, if you’ve been following my monthly newsletter, I want to say thank you. You’ll notice this month’s will be different than the previous format I’ve been using.

I fulfill a few roles at Tableaux Wealth, the two main roles being a Financial Advisor and an Investment Analyst.

Previously my newsletter focused more on topics relating to being a Financial Advisor. Going forward, I will often focus the content of the newsletter to reflect more the work I do as an Investment Analyst.

Something I do every month is curate a presentation on economic data and trends in the financial markets that we use to keep us informed, stimulate discussion, and drive the portfolio management decisions amongst our investment committee.

The new newsletter format will reflect some of that process. Some months may be a condensed overview of what we covered and discussed, and other months may go into a deeper dive on just one of those topics. And, if you’ve enjoyed the more financial planning based content, I plan to continue to include that from time-to-time as well.

This is an aspect of what we do at Tableaux Wealth that I am deeply passionate about, and I’m excited to start sharing that process with you.

Thank you for joining me on this journey and I hope you enjoy it!

Let's jump in...

Economic Outlook

Growth Momentum

Monitoring growth momentum provides an indication of the strength and trend of the economy.

The Institute for Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) is a popular gauge of growth momentum in the economy.

Typically, the manufacturing sector is more cyclical than the services sector, so focusing on the manufacturing sector provides a better insight into the cyclical trend of the economy because recessions tend to start and end in the manufacturing sector.

Looking at the most recent survey, the Manufacturing PMI came at 49.30 (see chart: US ISM Manufacturing PMI & New Orders Index). While this indicates the manufacturing sector is still in a contraction (<50 = contraction, >50 = expansion) it is a positive sign that it improved from 48.4 in the previous month.

Additionally, the New Order Index, a survey about the expectation of new manufacturing orders over the coming month, came in at 52.50 showing an expectation of expansion and also an improvement from the previous month.

The New Orders Index is a leading indicator suggesting there could be further improvement in the Manufacturing PMI in the month to come.

Additionally, looking at the Philly Fed Manufacturing Future New Orders Index, which surveys purchasing managers about expected new orders over the coming six months, we see further indication of an expanding manufacturing sector (see chart: Philly Fed manufacturing Future New Orders Index).

Combining the data of the ISM Manufacturing PMI, ISM New Orders Index, and Philly Fed Future New Orders Index these surveys suggest a strengthening manufacturing sector, a positive sign for the economy.

Sentiment

Monitoring the sentiment of various population groups provides insight into the confidence and outlook for the economy and financial markets.?

Typically, we will analyze sentiment from a variety of groups including consumers, business leaders, retail investors, and professional investors.

Looking at sentiment among small businesses, we see sentiment sharply improving (see chart: NFIB Small Business Optimism Index).

Small businesses provide valuable insight because they are more affected by fluctuations in the economy, and other factors such as borrowing interest rates, than their larger counterparts.

Looking at the bond market also provides insight into investor confidence.

Looking at interest rate spreads for both investment grade corporate bonds and high yield bonds we can see that spreads are near recent historic lows (see charts: ICE BofA US Corporate Index Option-Adjusted Spread, ICE BofA US High Yield Index Option-Adjusted Spread).

Interest rate spreads express an outlook for business activity. The thought process is that when there is a positive outlook for businesses, bond investors will not require much higher returns, via interest rates, due to a lower perceived risk of businesses defaulting on their bonds.

Conversely, if bond investors were predicting a poor outlook for businesses, the spread between rates would be much higher, as they are demanding a much higher return for the additional risk they are taking.

With interest rate spreads near historic lows for both investment grade corporate and high yield bonds, the bond market appears to be expressing a positive outlook for businesses.

Inflation

Inflation is important to monitor as inflation not only affects investment returns but also central bank monetary policy decisions; price stability is one of two Federal Reserve mandates.

?Looking at the most recent inflation reports, we see that although inflation has largely come down from the recent peak inflation 2022 it has begun to pick back up more recently (see chart: Inflation: CPI, Core PCE, and PPI).

Of particular interest in this chart is PPI. PPI is the Producer Price Index. PPI typically is seen as a leading indicator for consumer prices as goods producers experience price changes before ultimately passing those changes onto consumers.

While this is attention grabbing, we can see that consumer inflation is not much different than the Federal Reserve’s expectation at this time based on their most recent Summary of Economic Projections (see chart: Inflation: Core PCE vs Fed Projection).

My interpretation here is that while inflation is somewhat picking back up, this current level of inflation is not outside the expectations of the Fed, however, it is certainly worth keeping a close eye on as a reverse from the current Fed rate cutting plan could disrupt financial markets.

For now, we’ll just continue to monitor.

Labor Market

Maximum employment is the other Federal Reserve mandate, in addition to price stability.

So, it is important to monitor trends here as it affects monetary policy decision making as well.

First, looking at the Job Openings and Labor Turnover Survey (JOLTS), we got a mixed bag of data.

On one hand, job openings exceeded economists' expectations (see chart: JOLTS Report). An increase in job openings is a positive sign for the labor market, as open positions can be filled by unemployed job seekers.

On the other hand, layoffs increased, hires decreased and quits decreased (a signal of deteriorating worker sentiment).

However, like inflation, the unemployment rate is not much different than Federal Reserve expectations (see chart: Unemployment Rate vs Federal Reserve Projection).

While this mix of labor data isn’t shocking, because restrictive Federal Reserve policy negatively affects the labor market, it will be important to continue monitoring the relationship between Hire data from the JOLTS report and the unemployment rate.

Hires typically leads unemployment (not picture), so further decreases in hiring could result in the unemployment rate rising.

?Further deterioration in the labor market could force the Fed to speed up the easing of monetary policy.

Consumer Strength

Consumer strength is also an important indicator of the health of the economy, as consumer spending is highly influential on the growth of the economy. In the third quarter of 2024, consumer spending made up the largest component of GDP growth (see chart: Components of GDP).?

A popular metric for analyzing the strength of the consumer is based on household borrowing.

Households will typically borrow more money to continue spending habits when they run out of savings. Prior to recessions, you usually see an increase in household borrowing.

Looking at the Household Debt Service Ratio (a measurement of household borrowing compared to income) we can see that although rising, it has not yet reached a more concerning level of 12%+ (see chart: US Household Debt Service Payments as a Percentage of Disposable Personal Income). ?

My takeaway here is that the consumer strength metrics are not expressing any strong concerns about the strength of the consumer and economic growth outlook.

Liquidity

In my opinion, liquidity is one of the most important factors when assessing the economic outlook.

Liquidity, in this context, is essentially the amount of money circulating the financial economy.

As more money enters the economy, investors have more discretionary funds to invest in riskier assets and chase higher returns.

Because of this, returns on assets like stocks, gold, and digital assets like Bitcoin are more sensitive to liquidity.

Liquidity is influenced by various monetary policy and fiscal policy mechanisms.

We can monitor liquidity through tracking the money supply and the various mechanisms that affect it.

One way to monitor the money supply is through M2 money supply. If we look at the M2 money supply of G7 economies and China, we can see that the money supply continues to rise as it did throughout 2024, and for the most part, 2023 (see chart: Liquidity: G7 plus China M2 Money Supply).

In addition to the money supply, as I mentioned earlier, looking at the various mechanisms of liquidity can create a forward-looking view for liquidity.

What we are looking for here is whether policy changes look to be forecasting increases or decreases in liquidity.

One of those mechanisms is the Federal funds rate, which is set by the Federal Open Market Committee (FOMC) of the Federal Reserve. The FOMC began cutting the Federal funds rate in 2023. We can see that both the FOMC and the market project continued rate cuts in 2025 as they did in 2024 (see chart: The Fed and interest rates).

Progress on inflation and further deterioration of the labor market could clear the path for the Fed to further rate cuts.

Lowering interest rates increases liquidity. As interest rates come down it becomes cheaper to borrow money. Increases in borrowing increases the M2 money supply.

In addition to interest rates, the Federal Reserve is able to affect liquidity through use of the Federal Reserve balance sheet. This is a technique used less frequently but is arguably a more direct way of affecting liquidity.

This mechanism is called Quantitative Tightening (QT) or Quantitative Easing (QE).

Quantitative Tightening is a restrictive monetary policy in which the Federal Reserve reduces the holdings on their balance sheet, which in effect pulls money out of the economy, reducing liquidity.

Quantitative Easing is, the opposite, a permissive monetary policy. In QE, the Federal Reserve increases the holdings on their balance sheet which puts more money into the economy, thus increasing liquidity.

In response to the COVID-19 pandemic the Federal Reserve enacted QE in 2020 and 2021 in attempt the stimulate the economy.

However, in 2022, due to rising inflation, the Federal Reserve began QT, in addition to rate hikes, to draw money out of the economy and fight inflation (see chart: The Federal Reserve balance sheet).

QT, as I explained earlier, reduces liquidity. However, the Federal Reserve is forecast to end QT in 2025.

So, if we combine lower interest rates with ending QT, this suggests a positive outlook for liquidity to increase, creating a positive environment for those assets sensitive to liquidity.

Financial Markets

Next, we'll take a look at the financial markets.

Stocks

First, looking at stocks.

The S&P 500 had two back-to-back years of 20%+ returns (2023: 24%, 2024: 23%). Those returns were primarily driven by a group of stocks referred to as the “Magnificent 7” (see chart: Magnificent 7 performance and earnings dynamics).

This has led many to ask two questions:

1) Can the stock market continue positive returns? and

2) Can the Magnificent 7 continue to be so magnificent?

A major driver of stock performance is earnings growth. So naturally, we’ll want to look at earnings growth to get an idea relating to the above questions.

Based on forward looking estimates of earnings growth, we notice two things:

1) The Magnificent 7 stocks are forecasted to have 21% earnings growth in 2025, and even more encouraging

2) The rest of the S&P 500 forecasts an increase in earnings growth from 3% in 2024, to 13% in 2025 (see sub-chart: Earnings Growth).

?On another positive note, S&P 500 minus Mag 7 stocks saw profit margins increase throughout 2024 (see sub-chart: Profit Margins).

While it is very difficult to estimate stock market performance over the near term, the combination of a positive economic outlook and a forecast of earnings growth across the entire S&P 500 paints a positive outlook for US large cap stocks.

But what is the outlook for stocks outside of the S&P 500?

In recent years, small cap stocks have, for the most part, underperformed their large counterparts. But if we look at forecasted earnings growth for small caps in 2025, we see a suggestion to the contrary.

While small caps had negative earnings growth in 2024, forecasted earnings growth in 2025 is projected to be more than 3x large and mid cap stocks (see chart: Small caps, mid caps, and large caps. sub-chart: Earnings growth).

While forecasted earnings growth looks positive across US stocks, two main themes have caused some to be skeptical about forward returns:?

1)?Valuations, and

2) The stock market being at or near all-time highs.

First, on valuations.

Yes, across large, mid, and small caps the price-to-earnings ratios are above their 20-year averages (see chart: Returns and valuations by style). This suggests stocks are currently over-priced based on their 20-year average.

I have three main takeaways from looking at this chart:

1) Yes, over time stock valuations should revert back to their mean. However, just because stock valuations are high, doesn’t necessarily mean they are going to quickly snap back to long-term averages immediately. There are more factors that affect stock returns than just valuations, so I don’t want to make investment decisions based solely on this one piece of data.

2) Particularly looking at large caps, the S&P 500 is highly concentrated in the top companies due to the outperformance of the Mag 7 stocks. These companies are high quality and highly profitable. As an investor you should expect to pay more for higher profitability, higher quality stocks. So based on current make up, I’m not surprised P/Es are elevated as these few stocks make up such a large component of the S&P 500.

3) Looking at small caps, small cap stocks are also above their 20-year average P/E, but not as much as large caps. A higher forecasted earnings growth and less stretched valuations raises my interest in small caps.

And finally, to move on to the second source of skepticism, investing near all-time highs.

If we look at the historic data, the stock market being at or near all-time highs is not a compelling argument to avoid investing in stocks.

Looking back at returns in the S&P 500 from 1988 through 2024, we see that returns from investing at a new all-time high vs investing on any day do not produce meaningfully different outcomes (see chart: Investing at all-time highs).

My conclusion here, the stock market being at an all-time high on its own is not reason enough to avoid investing in stocks.

When discussing investing in stocks I always encourage investors to maintain a long-term mindset and exercise the three keys to building wealth: consistency, discipline, and patience.

However, for those who are interested in a more short-term outlook: looking at the economic data, forecasted earnings growth, potential for earnings growth to broaden out beyond the Mag 7, my personal thoughts on current valuations, and the data on investing at all-time highs, the outlook for stocks is not keeping me up at night.

Bonds

In my opinion bonds have been telling a more interesting story.

Since normalizing for the most part last year, the short end of the US Treasury yield curve is still slightly inverted (see chart: Yield Curve).

Also, of note the spread between the 2y and 10y yield is about 0.3 percentage points, lower than the long-term average of 0.86 percentage points. So, investors really aren’t getting much term premium in the form of additional compensation for the added risk of investing in longer-term Treasuries.

Looking at just the 10-year interest rate, it has climbed over the past six months (see chart: 10 Year US Treasury Rate).

There are a few possibilities of what changes in the 10-year rate could be expressing:

• future Federal Funds rate and rate cut expectations,
• the expectation of inflation rising,
• a positive economic outlook, or
• long-term concerns about the national debt

My guess is that it is mostly a combination of the first 3 mentioned.

Although long-term concerns about the national debt may, at this time, be the least influential, it is certainly an issue we are keeping an eye on as we think it could affect the long-term outlook on US Treasuries.

Expanding beyond Treasuries, we do see some good opportunities across the fixed income market.

Across the fixed income sectors pictured below, yields are at, or in most cases, higher than their 10-year averages (see chart: Fixed income yields).

For investors looking for an allocation to fixed income, there are opportunities to lock in above average yields.

Overall, minimal compensation for increased duration makes me prefer staying on the short end of the yield curve.

For investors looking to add fixed income, there is opportunity to lock in above average yields across multiple sectors.

Alternatives

Looking over the previous 3 months, Bitcoin continues to lead some other popular alternatives (see chart: 3m Returns: Gold, Commodities, Real Estate, and Bitcoin).

And something else interesting about Bitcoin is the set up we're seeing with the ISM Manufacturing PMI.

Historically, Bitcoin has its strongest returns when the Manufacturing PMI crosses above the 50 threshold and prices peak sometime within a few months of the peak in the Manufacturing PMI cycle (see chart below).

Also, I think gold has been one of the most interesting markets over the last year.

Gold posted strong returns over 2024 partly due to increased buying from Central Banks (see chart: Gold Set to Extend Record Rally, Goldman Sachs Says).

In an attempt to reduce reliance on US Treasuries and the US financial system, other centrals banks have been buying gold as an alternative.

?Additionally, some other trends create a potentially positive outlook for gold, mainly:

• Its properties as a hedge against inflation as some speculate that the incoming administration’s policies could cause a rise in inflation, and
• Historically gold's price has followed the M2 money supply

?Looking further out, gold could continue to be an attractive alternative to US Treasuries if concerns over the national debt continue to grow.

I think this makes gold a worthy contender for investors looking to hold return drivers beyond stocks and bonds.

Summary

Economic growth and sentiment appear to be trending in a positive direction, and consumers appear well positioned.

Inflation climbed slightly but isn’t nearing concerning levels, and the labor market is showing signs of further potential deterioration.

Liquidity also appears to be trending positively with projected rate cuts and a forecasted end to QT in 2025. It will be important to continue monitoring inflation and the labor market to develop the outlook for the Federal Reserve’s monetary policy.

I think these economic conditions set an environment that favors risk assets.

Thanks for reading this month. ?

Disclosures

Informational purposes

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

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