Forest Capital 2025 Outlook: Trumphoria and the Bond Vigilantes
For those that rightly guessed this a market outlook report, not a Harry Potter novel, we hope you find our thoughts on the financial market outlook for 2025 helpful in your own assessment of what may transpire during the year. To summarize, we believe financial markets will vacillate between the euphoria of unleashed animal spirits as a result of expected deregulations from the incoming Trump administration, and the impact of “sticky” (i.e. higher than desired) inflation on bond markets’ willingness to continue to fund persistent US budget deficits. Known unknowns include: the probability of the imposition of select import tariffs; the effectiveness of the burgeoning Department of Government Efficiency (DOGE); political instability in the Middle East; US-Russia relations
and the ending of the Ukraine conflict; sputtering European and Chinese economies; and energy demand to meet increased computing needs of A.I. (from oil and gas exploration to the adoption of nuclear energy as a necessary long-term alternative).
While we believe either of these bookend scenarios will result in “higher for longer” US interest rates, the shape of the yield curve does hold some uncertainty. As long as “Trumphoria” rules the day, we expect a relatively flat yield curve with some downside in short-term rates coupled with longer-term rates at roughly current levels (the current differential between the 10-year US Treasury and the two-year notes is only 22 basis points). Were the “Bond Vigilantes” to lose faith in the Federal Reserve’s willingness to continue to whittle down inflation amid persistent and significant US budget deficits and a stronger US economy, we believe longer-term yields could get pushed higher, thus widening this differential materially.
Short-term rates down, long-term rates up. As the accompanying chart shows, continued Fed interest rate cuts have finally pushed short-term rates low enough to result in a normal yield curve (with short-term rates lower than long-term rates). The current yield curve is the result of these lower short-term rates (controlled by the Fed through its monetary policy) and long-term rates that have moved higher in the process (controlled by “the market” as investors balance the outlook for future economic growth and inflation). If you can picture a seesaw, the balancing point has been somewhere in the three-year maturity area, with yields to the left of that, lowering, while yields to the right, increasing.
Starting in the springtime of 2024, fixed income investors were faced with the reality that high short-term rates were on a secular decline. Even though for most of the year short-term rates were still higher than long-term rates, it became increasingly clear that extending bond maturities to “lock-in” attractive rates was the prudent strategy.
At Forest Capital our 2024 strategy was to extend maturities to the three-to-five-year maturity window. The reason for us not looking at longer maturities was the belief that long-term rates were simply not attractive enough (i.e. not high enough). As long as the US 10-year bond was at a yield lower than 4.5% we felt the risk vs. reward for extending maturities longer than five years was unfavorable – for every 1% increase in the yield of a 10-year bond, the price of the bond can decrease as much as 8% or more. Given the relatively modest yield pick-up from five-year maturities to 10-year, we didn’t believe that was a prudent risk-adjusted return potential. On the occasions when the 10-year exceeded 4.25% we added 5-7 year maturity paper to our portfolios.
Now that 2024 has ended with the US 10-year bond at almost 4.6% we believe that extending maturities beyond 5 years makes sense once again. As long as this yield is above 4.5%, we will be looking for opportunities to put capital to work, likely in the 6-8- year maturity window. If the “Bond Vigilantes” start ruling the day and push the 10-year yield to 5% or higher we brace for significant risk to stock prices, which appear priced for Trumphoria perfection.
Investors chased risky assets in 2024, pushing asset prices higher, from stocks to junk bonds, bitcoin and gold. Our concern about the stock market may be appreciated by looking at the somewhat busy accompanying chart which shows the relative yield of generally riskless assets (Treasury notes and bonds – blue line in the chart) and riskier assets (from the safest overnight bank lending rates, to corporate bonds, to stocks and all the way to junk bonds – the green line). Even though the riskless asset yields have increased in the last year (with the exception of short-term rates), risky assets have become more expensive (their yields have decreased), to the point that stocks’ earnings yield (the inverse of the P/E ratio of the S&P 500 Index) is lower than that of the 10 US Treasury (at 4.2%, versus 4.6% for the Treasury yield). Only investment grade corporate bonds are actually a bit more attractive than a year ago – which is in line with our comments above and our investment strategy for 2025.
For stocks to continue to outperform their long-term expected 10% or so annual appreciation rate from current levels, we believe it would take more than a prayer. The dividend yield on the S&P 500 is currently around 1.2%, meaning stock prices would have to appreciate more than 8.5% to get us close to a 10% total return in stocks. With US Nominal GDP (real GDP plus inflation) at around 6.1% and potentially trending lower, as well as struggling economic growth out of Europe and China, that appears to be a tall order in absence of Trumphoria delivering beyond the most optimistic expectations. We remind readers that not too many months ago markets were anticipating an outright recession or a soft landing – it now appears we were just “buzzing the tower”.
Putting it all together, we believe 2025 will be a “give back” year in terms of return, especially in priced-for-perfection equities. We are targeting portfolio returns in the 5.5% to 6.5% range for our fixed income portfolios, as we take advantage of yield curve shifts per our comments above. For equity portfolios we intend to remain well diversified across industries targeting below market volatility (as measured by beta) and valuation (as measured by P/E ratios and cash flow multiples), with a slightly above market dividend yield.
Please feel free to reach out to us with any questions or comments.
Dimitri Triantafyllides, CFA
Chief Investment Officer
dtriantafyllides@forestcapital.net
704-533-9876 (office)
This report is for your information only and is not an offer to sell or a recommendation to buy the securities or instruments named or described in this report. Additional information is available upon request. The information in this report has been obtained or derived from sources believed by Forest Capital Operating Company, LLC (Forest Capital) to be reliable, but Forest Capital does not represent that this information is accurate or complete. Any opinions or estimates contained in this report are current as of the date of the report and are subject to change without notice.