Slow and Unsteady

Many investors believed that the strong employment report last week would drive a more hawkish monetary policy: Persistent strength in the labor market drove significant market action, sending equity markets down and interest rates up. There was even more emphasis on the inflation data we received this week. 

With its dual mandate of maximum employment and stable prices, the Federal Reserve is now more focused on prices, with slow and unsteady progress on inflation toward the 2% policy target. After the release of relatively benign Producer Price Index (PPI) results, the Consumer Price Index (CPI) data took on even more significance. And investors heaved a big sigh of relief following the CPI release, which indicated that we continue to make slow progress toward the target, and, importantly, that we are not backsliding. Core CPI, which excludes the volatile food and energy components of headline CPI, rose only 0.2% for the month, bringing the year-over-year pace down to just below 3%. That said, as we look over the last 3 to 6 months, core consumer prices have been trending quite a bit higher than the 2% Fed target, so it is likely the Fed will want more evidence over the next several months that inflation is trending more firmly and consistently toward that target. In sum, we are short of the goal.

The bond market took solace in the U.S. inflation data, and the relief was manifest in the decline of the 2-year Treasury yield — the tenor most sensitive to changes in monetary policy expectations. In reaction to the relatively hot labor market data last week, some investors had begun to extend their expectations for the next Fed rate cut from early summer to September, and we have seen those expectations change again in light of the constructive inflation data. That policy-sensitive 2-year yield had risen to 4.4% last week — a significant increase from the 2025 starting yield of 4.25% and a clear deviation from the September 2024 low of 3.5%. The more recent data, which was better than expected, has driven the 2-year yield down to 4.27%.

The longer end of the yield curve, and specifically the 10-year Treasury yield, has borne the brunt of the market’s anxiety, with yields rising fairly consistently in 2025 to a peak of nearly 4.8% — all in the context of a stronger growth outlook, a lack of meaningful progress on inflation and policy uncertainty. This pressure has been somewhat alleviated by the recent inflation data and the market’s recalibration (again) of the forward path of interest rates: The current yield of roughly 4.6% reflects the updated perspective. However, we can anticipate more volatility in the longer end of the yield curve with the new administration: This is not only due to some of the policy measures that may exert heavy influence on growth and inflation expectations, but also owing to the incoming Treasury Secretary Bessent and plans to extend the duration of U.S. Treasury issuance, which would reverse a course set by current Treasury Secretary Janet Yellen to issue at the shorter end of the yield curve. 

We remain shocked by the scale and scope of the devastation in Los Angeles, mindful of the tremendous human toll that these fires have taken. In addition to the most immediate impacts to people and property, investors are now beginning to assess whether there may be a broader financial impact on the health of state and local finances.

Our municipal bond team indicates that municipal bonds have historically performed well in the wake of disasters, given that states have access to state aid as well as FEMA funding, which reimburses at least 75% of emergency costs to local governments and to uninsured or underinsured households and businesses. In addition, on January 9, President Biden announced that the federal government will cover the costs of wildfire response efforts, including debris removal, shelter and salaries for first responders, for 180 days. Importantly, tax revenues typically hold up very well immediately after such events: Sales tax receipts tend to grow as rebuilding occurs, and income tax receipts recover as job losses are potentially offset by new job creation in the rebuilding effort. Property tax valuations are often reassessed on long lags, however, and payment delinquencies can rise. Some small issuers face more acute challenges.

For example, single-site bonds such as leases or single site nursing homes and charter schools can be more challenged: We hold few of these in investment grade portfolios, preferring issuers with larger and more diverse tax and revenue bases. However, there are some larger issuers with material exposure to the wildfire events, including the largest utility district in the area: The L.A. Department of Water and Power. We do not anticipate material adverse credit movement in these bonds given the monopoly power of the utility. While there could be potential slowdowns in payments due to the number of impacted customers, we note that this utility maintains adequate liquidity. 

In managing municipal bond portfolios for clients, we always stress diversification as a primary risk management tool. Our portfolios are highly diversified across sectors, revenue streams and geographies — even in state-specific mandates, we hold bonds broadly across states like California. We have a dedicated team of analysts who are charged with fundamental analysis of each credit, and our teams of portfolio managers, along with their credit research counterparts, will be closely monitoring conditions in Los Angeles going forward.

The U.S. Q4 2024 earnings season kicked off this week with the major banks reporting. We often view these results as an important lens into the health of the overall U.S. economy — corporate America as well as households. J.P. Morgan reported record annual profits in Q4, Goldman Sachs posted its best quarter in three years, and Citigroup had a profitable quarter versus a loss in 2023, and now has plans for a stock buyback program. Analyst expectations for broad Q4 results are quite positive, with a year-over-year advance in S&P 500 earnings anticipated to land at 11.7% — this would represent the best results in three years. Historically, most companies have tended to beat estimates, which suggests that aggregate results may top even this optimistic forecast. According to FactSet, the S&P 500 Index’s actual earnings growth rate has exceeded the estimated earnings growth rate at the end of the quarter in 37 of the past 40 quarters. The only exceptions were Q1 2020, Q3 2022 and Q4 2022. Additional analysis suggests that actual earnings growth may hit 14% this quarter.

In addition to the potential upside surprise in results, we note that earnings for the S&P 500 will be more balanced this quarter, and even more balanced as we move through 2025. In 2023, the MAG7 aggregate earnings growth topped 30% while the aggregated earnings of the remaining 493 stocks in the S&P 500 actually fell 3%. There has been a significant headwind to broader earnings results as certain sectors have faced particular challenges: For example, Energy and Industrials/Materials have reported negative earnings throughout 2024. We anticipate those trends will reverse and create some nice tailwinds this year. By Q4 2025, we anticipate positive results across all sectors of the S&P 500, with double-digit earnings growth in 9 of the 11 sectors.