
January 12, 2025
A key fear we have had for the performance of risk assets has been that the correlated rise in US Treasury yields and dollar strength has reached the point where it starts to break stuff (see “the dollar wrecking ball” last week). While a backward-looking labour market figure should not be the most important catalyst, the unambiguous strength of the December report likely reinforces the current prevailing bias in markets. As Shahab Jalinoos at UBS noted recently, phases of US dollar strength can persist, and we should not necessarily expect mean reversion despite the 10% gain over the past quarter.
Sometimes it is important to take macro news flow at face value. The December US employment report was unambiguously strong relative to expectations. Payroll growth was above consensus, and the unemployment rate was surprisingly low. Although labour market data lag growth, it is challenging for the Federal Reserve to justify further additional rate cuts in the near term. Of course, the interest rate markets responded and priced out easing in 2025 (when will they price in hikes?). The resilient labour market data also coincides with persistence in service sector inflation (above trend) and a potential reacceleration in headline measures following a period of disinflation.
Clearly it is important to note that the outlook on inflation and growth could vary widely in response to policy, especially the fiscal impulse from the incoming administration. Outcomes could vary depending on how and when the policy agenda is implemented. From our perch there are obvious (and well appreciated) downside risks. As Gerard Minack noted, it will be easier for the new Administration to implement the market un-friendly elements of the Trump agenda first – increased protectionism, destabilising alliances, and reduced labour supply.
For markets, the context is that US equity risk compensation is extremely poor. In addition, a secular risk is that AI (a major contribution to recent returns) does not deliver enough to meet euphoric investor expectations (we also worry about that in the context of the Asia supply chain). US equity out performance has been warranted for at least 14 years by superior earnings growth. However, recent excess returns have increasingly been driven by valuation re-rating. Absolute valuation has exceeded the 1999/2000 on some measures (price to sales, chart 1 below).
Chart 1

In addition, the interest rate and US dollar appreciation has parallels to that episode as well. Imagine if the dollar index rises to 120 on the DXY? The implication for the potential reduction in dollar liquidity and rise in cross asset volatility. We note that 1-month EURUSD implied volatility has increased from 5% since September 2024 to 8.7% but remains well below the high experienced in major episodes (it could easily double from here).
It is clearly easier to say that the market is vulnerable to a major correction than trade that observation profitably. In recent years it has generally paid to fade weakness. Yet the additional element today is crowded market concentration, positioning, and beliefs. While the major US technology companies are net cash on balance sheet and have strong profit margins, companies with longer duration cash flows are vulnerable to high interest rates and the impact of dollar strength on foreign earnings.
We would also note that there are positives from the incoming Administration’s agenda. The deregulatory push, tax cuts, energy policy and fiscal consolidation could lead to improvement in productivity and a better growth-inflation trade off than is priced or feared. We would also emphasize that valuation and growth expectations are considerably less euphoric in Asia and EM (our equity exposure is 10 times earnings, net cash on balance sheet and 15-25% consensus EPS growth). Further weakness and dollar strength is an opportunity to allocate capital in this region for USD investors. As we often note, it is important to think symmetrically about risk.
Comments