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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation Report for 05/05/2025. I'm Phil Adler. The mood has changed on Wall Street since the beginning of the year. Confluence Chief Market Strategist Patrick Fearon Hernandez joins us today to discuss evidence that stormy times may be ahead for US stocks. First, Patrick, it seems so long ago now, but remind us what market expectations were like back in January.
Patrick Fearon-Hernandez:Well, hi, Phil. Thanks for having me on the program. To answer your question, we were pretty optimistic about the economy and the markets at the beginning of the year as many analysts were. For The US economy, we expected continued expansion with no recession. Although we acknowledge that still elevated interest rates and moderating labor demand would lead to slower growth and an increased risk of recession.
Patrick Fearon-Hernandez:And I would note that this forecast did encompass tariffs and other trade barriers signaled by Trump during and after last year's election campaign. Against this backdrop, we also expected bond prices to be fairly steady, and our base case was for a 10.5% rise in the S and P 500 price index. That implied that the index would stand at about 6,735 at the end of twenty twenty five. However, our modeling suggested there was also plenty of room for even stronger growth. Needless to say, Trump's trade policies and economic policies have come in much more aggressive than just about anyone expected, which has helped push stock prices and many other aspects of the financial markets lower.
Phil Adler:And is it fair to say that tariffs are not the only reason for the change in market sentiment, but management of the tariff rollout also played a major role?
Patrick Fearon-Hernandez:Exactly. Whether you're talking about the massive tariffs on China or the relatively lower tariffs on other countries, the tariff rates being discussed are pretty substantial. They could definitely affect trade and economic activity, but the really striking thing has been the chaotic on again, off again nature of the tariff announcements. The administration has announced big tariffs only to pause or rescind them days or even hours later. And on top of that, different officials have given different reasons or explanations for the tariffs and have made contradictory statements about their scope, purpose, and planned length.
Patrick Fearon-Hernandez:This may well be part of president Trump's strategy, but it has definitely created massive uncertainty and frozen corporate planning. The uncertainty and the risk that frozen spending will spark a recession has also helped push down the value of risk assets, especially stocks.
Phil Adler:Well, in your report, you discuss three indicators that appear to be bearish for US stocks. First, US treasury yields. And I'd like to camp out on that a bit. The ten year yield is at the time of our recording lower than where it was back in January, but higher than it was in early April when it slid to just over 4%, four point zero one %. What's behind the sell off since early April in treasuries?
Patrick Fearon-Hernandez:Well, given when yields started to back up and various pieces of evidence that foreign investors have recently started to sell treasuries fairly aggressively, we think the sell off reflects selling by US and foreign investors. US investors are probably more focused on the erratic policy making by the White House. But more concerning, it looks like foreign institutional investors have become highly uncomfortable with the way The US is treating other countries. It looks to us like foreigners are starting to question the value of The US as a safe haven that would protect their investments with the rule of law and consistent economic policies. For example, it would be no surprise if foreigners are especially worried about the Trump administration taking political control over the Federal Reserve.
Phil Adler:Are you expecting treasury yields to continue to rise as demand from foreign institutions continues to decline?
Patrick Fearon-Hernandez:That's certainly one concern that we have. And within the treasury universe, I would say we're especially concerned about foreigners dumping longer term treasuries, such as thirty year obligations. The resulting rise in long term interest rates could be a negative for The US economy.
Phil Adler:Well, time for a conspiracy theory. Do you think foreign governments may have gotten together or at least implicitly agreed on a steady sell off of treasuries to put pressure on the administration and its tariff policy?
Patrick Fearon-Hernandez:Oh, I think that's certainly a possibility, and I've heard that theory from one top official, actually. But whether the foreign selling stems from a general panic about US stability or from a deliberate government led attempt to influence US policy, it still reflects a certain flight of capital out of the treasury market and other US markets. Given that The US markets have been driven so heavily by foreign inflows for many years, this capital flight may mark a sea change in the way the global financial markets work.
Phil Adler:Patrick, there must be a point where higher treasury yields would attract investors regardless of US tariff policy. What is that point, you think?
Patrick Fearon-Hernandez:Well, it's easy to think that, but don't be so sure. Remember that while the big US trade deficit essentially emits dollars out onto the global markets, those dollars, by definition, get recycled back into The US markets via the capital and financial accounts. Much of that flow back into The US markets goes to purchase treasury securities of various maturities. If the tariffs are successful in dramatically closing The US trade deficit, it could cut off many foreigners from their supply of dollars. So they would find themselves unable to buy many treasuries even if the yields are attractive.
Patrick Fearon-Hernandez:Indeed, the loss of foreign buyers could drive treasury yields even higher.
Phil Adler:Is a Federal Reserve interest rate cut likely to bring treasury yields down and improve the outlook for US stocks?
Patrick Fearon-Hernandez:It still looks like the Fed will cut rates again this year, maybe two or three times, but the path of interest rates will likely be shallower than previously expected. With the threat of higher inflation from the tariffs and the reduction in domestic and foreign treasury demand, the Fed policymakers are likely reluctant now to cut interest rates too quickly, and continued high interest rates will likely remain a headwind for stocks at least in the very near term.
Phil Adler:Well, turning to your second indicator, the dollar. How has it performed since January?
Patrick Fearon-Hernandez:Well, the dollar's value against a wide range of currencies has weakened throughout this year. But as with treasuries, the trend accelerated and became especially pronounced in early April. I don't think it's an exaggeration at all to say that the greenback has been in a sharp sell off. The Fed's broad US dollar index shows the dollar has lost about 4.1% of its value since inauguration day, and the sell off has been even sharper against key developed country currencies such as the euro.
Phil Adler:I thought, Patrick, the new administration welcomed a weaker dollar to help out US exporters, but I guess tariffs wiped out any advantage that that might have created.
Patrick Fearon-Hernandez:You're right. Trump and his top officials have suggested they want a weaker dollar to make US exports more competitive and to reduce US demand for foreign imports. However, it looks like they aren't focusing on the negative aspect of the foreigners selling off dollar assets and depreciating the greenback. If the dollar falls too fast, it would signal that foreigners are dumping US assets and boosting the risk of unwanted price inflation.
Phil Adler:Your third indicator is the price of gold, which is near record highs. How rare and how powerful is this combination of rising US bond yields, surging gold prices, and a declining dollar?
Patrick Fearon-Hernandez:Well, this overall combination of rising bond yields, declining dollar, and surging gold prices is pretty rare. After all, such a combination of trends points to declining faith in The US and dumping of US assets. The rise in gold prices is especially illustrative since it suggests the yellow metal is now seen as a more secure safe haven than treasuries or the dollar. In contrast, treasuries and the dollar have historically been seen as safe havens on par with gold. Again, all this points to at least some level of concern about US stability.
Phil Adler:Well, because of this new environment, confluence has revised its recommendations for the model portfolios that you manage. Remind us, Patrick, of the key changes for three years looking out.
Patrick Fearon-Hernandez:Well, because of all these changes, our second quarter strategy adjustments were actually pretty substantial. For example, since the rising uncertainty and backup in bond yields will increase the risk of a recession, we reduced our exposure to the more aggressive sectors of The US stock market. We cut our allocations to small and mid caps, generally shifting our exposure more toward high quality large caps and intermediate term investment grade bonds. We also shifted our US equity exposure to overweight value stocks over growth stocks. Importantly, we also allocated a meaningful portion of our portfolios to foreign developed market stocks again.
Patrick Fearon-Hernandez:Finally, in the commodity space, we eliminated our position in uranium since any recession that comes would likely push down energy commodities of all kinds. And, of course, as discussed earlier, we modestly increased our exposure to gold in some of our portfolios.
Phil Adler:Well, I imagine market momentum and investors playing catch up might accelerate these new trends. How difficult would it be to reverse them?
Patrick Fearon-Hernandez:Well, sadly, we're concerned that the erratic on again, off again nature of the tariffs to date has already trained global investors not to believe in any short term reversal of the policy. In other words, no matter what the administration says going forward, there will likely be a big part of the global market that doesn't trust that any stability will be lasting. It seems that global investors are now extremely suspicious and cautious about US policy, and that will make it hard to reverse these market trends.
Phil Adler:We opened our discussion, Patrick, by suggesting stormy times are ahead for US stocks. I wanted to ask about foreign investors in The US stock market. Have have you detected a major sell off by foreign investors of US stocks?
Patrick Fearon-Hernandez:Well, these are still early days. So I would say that we're still looking for convincing evidence of that. For example, we've seen anecdotal reports that big money managers are shifting their asset allocations from The US to foreign markets similar to our own moves. In any case, the foreign pullback in the treasury market would certainly be consistent with the idea of a foreign pullback in US stocks as well.
Phil Adler:And where are they placing their money instead?
Patrick Fearon-Hernandez:Again, it's a bit early to know for sure, but the run up in foreign stock values and gold would suggest that those asset classes are getting at least some of the funds. And note that after foreign stocks lagged for so many years, their valuations are relatively low and competitive. That will probably help to further encourage the shift into foreign stocks.
Phil Adler:Finally, Patrick, would you agree that none of this appears to bode well for The US consumer?
Patrick Fearon-Hernandez:Yes. Even though we've been focused here on the impact for financial assets, factors like the rise in bond yields and the falling dollar could potentially hurt consumers as well. For example, the rise in bond yields could well discourage firms from investing as much as they otherwise would, which would mean weaker hiring and slower wage growth. Rising bond yields would also probably boost consumer lending rates, including mortgage rates. Meanwhile, the weaker dollar would likely make foreign imports more expensive on top of the impact of the tariffs themselves.
Patrick Fearon-Hernandez:Added to the uncertainty we mentioned earlier, all these forces play into our greater sense of caution and our desire to derisk our portfolios this quarter.
Phil Adler:Thank you, Patrick. The title of this week's report is US capital flight and implications for investors, and you can find a link to the written report on the Confluence webpage, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.