US market update:                      Four months after the presidential election

Immediately following the election, we observed a pop in US equity markets. Market reaction expressed expectations that the incoming administration’s policies would be particularly beneficial to US companies relative to non-US companies. We see the effect of this in Exhibit 1 where we see a jump in both the large-cap Russell 1000 index and the small-cap Russell 2000 index. Equally interesting is that the small-cap index outperformed the large-cap index during this period until mid-December, with the inference being that the new administration’s policies would increase US economic growth and protect domestic companies. As smaller-cap stocks have higher domestic revenues than their more global large-cap peers, this led to enthusiasm for small caps. 

On the downside, the jump in equity markets was accompanied by a jump in expected inflation. Exhibit 2 shows the breakeven inflation rates for the FTSE US Government Bond 1-3 year and 7–10-year indices, which indicates investors’ expectations of inflation over those time periods. From the rise in breakeven rates, we infer that the new administration’s policies were expected to push inflation up both in the short term and the longer term. However, that sentiment did not dampen equity market enthusiasm much. After the immediate post-election jump, inflation expectations were stable until close to the end of the year.

To a large extent, the macroeconomy over the last couple of years has been dominated by the spike in inflation that began in 2022. Central banks around the world raised policy rates to combat inflation. US inflation peaked in 2022 after which it began to decline. US inflation proved to be quite sticky above the Fed’s 2% target, but by Fall 2024 many market economists thought inflation was responding to monetary policy without a shock to US economic growth from tighter monetary policy. The Fed began its rate cutting cycle in September with a 50 bps cut, as can be seen in Exhibit 3, which shows the US policy rate alongside the yields for the 1-3 year and 7-10 year government bond indices since June 2024. The longer timeframe here provides useful context. When the Fed paused hiking rates with declining inflation, yields moved lower between June and September in anticipation of these Fed cuts. But when it kicked off its monetary easing cycle in September, yields actually rose, as robust US economic growth and the stickiness of inflation forced investors to recalibrate their expectations of how quickly and deeply the Fed would cut rates. Some economists proposed that the Fed had cut too much, too quickly. 

The Fed held another meeting shortly after the election and cut rates by another 25 bps on 7 November. Both short- and long-term government bond yields stopped rising shortly thereafter and started drifting back down, perhaps reflecting the bout of general optimism seen after the election. However, into December, we start to see rates creep up.

At the time of the December Fed meeting, we can see that the 1-3 year yield started to flatten out, but a gap opened up between the 1-3 year and 7-10 year yields as the longer-term yield continued to climb. This is consistent with the jump in inflation expectations seen in Exhibit 2 in that it seems the market recalibrated its expectations to incorporate a “higher for longer” view of policy rates. This view was supported by the Fed’s comments indicating that it would go on pause after December’s cut, which quickly became billed as a “hawkish” rate cut by market participants. 

While expectations of future Fed rate cuts did seem to change quickly, actual expectations of inflation did not start to rise until about the end of the year. Exhibit 2 shows that the 1-3 year breakevens hit a low on 19 December (right after the Fed cut) but only began climbing rapidly in the new year. By 20 February 1-3 year breakevens were at about 3% while 7-10 year breakevens rose to about 2.5%, perhaps tying the change to the current administration’s four year time frame. These market-based measures of inflation expectations have been supported by recent surveys of US consumers that also indicate that consumers’ inflation expectations have risen.

The latest shift in sentiment in this four month period appears with the 21 February release of the University of Michigan’s Survey of Consumers that reported an almost 10% decline in US consumer sentiment and their short-term economic outlook. More than half expected unemployment to rise in the coming year. While inflation expectations had already been worsening, as we have seen above, the fall in economic growth expectations (compounded by other indicators such as the February flash PMI indicating the US services PMI fell into contractionary territory) seemed to have an immediate impact on the stock market. As we saw in Exhibit 1 above, the large-cap Russell 1000 had continued to hold up through the beginning of the year. However, as Exhibit 4 shows, driving the Russell 1000 was the mega-cap stocks in the Russell Top 10 index. And after the release of the Michigan consumer survey data, both the Russell 2000 (Exhibit 1), the Russell Midcap index, and the gravity-defying Russell Top 10 index saw a sell-off. 

The relative robustness of the US economy had been one of the supports for the Fed keeping policy rates high in the face of higher inflation. However, with the new pessimism seen in US consumer sentiment surveys and other macroeconomic data, some economists now believe that the reasons for the Fed to cut its policy rate switched from the “good” reason of declining inflation to the “bad” reason of slowing economic growth. Exhibit 3 shows the slide in both short and long rates in the period after the release of the consumer survey data with the backdrop of rising economic concerns.

Macro, equity and fixed income data paint a picture of shifting market sentiment over the four months since the US presidential election from market optimism to growing inflation and economic pessimism—a very different consumer and investor outlook.