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Abridged transcript - Damien's Market Update - January 2025
In last month's market update, I discussed the possibility of a Santa rally in December. While a Santa rally (defined as a positive December) did not materialize in the UK or the US, other global stock markets, including the Chinese CSI 300, enjoyed a positive festive period. The first few days of January saw most global equity markets attempting to start the year on a positive note, despite the lacklustre end to an otherwise strong 2024. However, most equity markets have begun to struggle as January wears on.
One unfolding trend to watch in 2025 is the rise in bond yields. Government bond yields have been climbing globally because investors now believe central banks will keep interest rates higher for longer to combat inflation. They're also demanding a higher rate of return for lending money long-term to governments because of the projected scale of government borrowing which theoretically raises the risk of default. The December low point in the 10-year US treasury yield of 4.15% was achieved on the day of the last US Federal Reserve meeting when it cut interest rates by 0.25%. Since then, the 10-year US treasury yield has surged as investors have reevaluated their view on the Fed's ability to cut rates in 2025. Or in other words, after the last rate cut investors' have become less convinced that there will be many more to follow. This rise in bond yields could eventually have a significant impact on equity markets, even sparking a crash, due to something known as Equity Risk Premium (ERP).
Imagine you have two investment options: a safe government bond and a potentially riskier investment in the stock market (represented by the S&P 500). The ERP is the extra return you expect to earn from the stock market to compensate for taking on that extra risk. It's calculated as the difference between the S&P 500's earnings yield (profitability of the stock market) and the 10-year treasury yield (return on a safe government bond). Historically, this number has been positive, meaning stocks are expected to outperform bonds over the long run.
Currently, this gap (the ERP) is narrowing, nearing zero, and even potentially turning negative. This means investors are essentially getting little to no extra reward for taking on the higher risk of investing in stocks. This unusual situation is driven by the recent rise in bond yields (as bond investors demand a bigger reward for lending money) and high stock valuations (fuelled by excitement around tech and AI). If this trend continues, it could signal that stocks are overvalued and due for a correction with investors shifting out of equities into bonds.
Analysts at Goldman Sachs and JPMorgan believe that when the 10-year US treasury yield hits 5%, bonds become increasingly attractive versus US stocks, and the likelihood of a US stock market correction grows. While Societe Generale agrees that a 10-year yield of 5% would push the ERP into "unhealthy territory," it might not inflict significant damage on the S&P 500. However, they argue that a clear buy signal for bonds will emerge as the 10-year yield nears 5.2%.
The point is that it is no longer just Trump's trade war threats, politics, economic data, or central bank policy that is concerning equity investors; bond yields are now starting to demand more of their attention, And if the bond part of your portfolio keeps falling it could soon start to hurt the equity part too.
If we do see more equity market volatility, here are some key levels to watch in the coming weeks, based on the insights from my latest technical analysis article published for 80-20 Investor members.
- FTSE 100: Right now the FTSE 100 is in a new sideways consolidation range between 8012 and 8360. It means that if the FTSE 100 gains enough momentum to break above this zone we could see another new all-time high. Conversely, a break below 8012, could lead to further downside and ultimately see the index head back into the previous sideways trading range of 7257 and 7730.
- S&P 500: After a strong upward trend, the S&P 500 found resistance around 6,000 and experienced a pullback. It has now formed a support level around 5,870. A break above 6,000 could see the index retest its all-time highs, while a fall below 5,870 might lead to further declines.
- Nikkei 225: The Nikkei 225 has been consolidating between approximately 38,000 and 40,000. A successful break above 40,000 could signal further gains, with the next target potentially being 41,500. On the other hand, a decline below 38,000 might suggest further downside, with some support potentially found around 37,000. Before I finish, I will just mention the old investment adage “as goes January so goes the year”.
Different interpretations of the adage exist. One interpretation, referred to as the January Barometer, states that if the stock market performs positively for the whole of January, it is likely to indicate positive returns for the stock market for the remainder of the year. In fact, since 1950, the January Barometer has now only been wrong 12 times, boasting an accuracy rate of 83.8% on the S&P 500, as reported by the Stock Trader's Almanac. Perhaps it’s something to bear in mind ahead of next month’s show.
