In the first Monthly Macro episode of 2025, William Blair macro analyst Richard de Chazal recounts the numerous events that have shaped the economic landscape since the start of the year. He explores the implications of recent executive policies, the Fed’s decision to hold rates steady, the unusual behavior of Treasury yields, and what these developments mean for the economy as we move further into 2025.

Podcast Transcript

00:22
Chris T
Welcome back, everybody. It's January 30th, 2025, and we're already a month into the new year, which is hard to believe. But again, given everything that has happened these past few weeks, I wouldn't bat an eye if somebody told me that we're nearing the half-year mark. William Blair macro analyst Richard de Chazal is here with me, ready to talk through the macro implications of it all. Richard, as always, thanks for joining. Always a pleasure to have you with me.

00:44
Richard D
Always a pleasure. I mean, certainly the last two weeks have, as you say, been super busy and it's going to be a long year. A long four years, for that matter.

00:54
Chris T
Seems so. So, to kick things off, first let’s tally off some of the big stories that have influenced markets and the economy since January 1st. President Trump was inaugurated on January 20th. Since then, we've seen a flurry of executive orders, many of which have potential economic implications. The Fed just yesterday made no changes to the Fed rate, which seems to be the potential trend for the long term.

We've got a new potential AI sheriff in town, which rattled markets just earlier this week. And of course, we're looking at new trade policies that are likely to feature the use of tariffs as a potential bargaining tool. In other words, there are seemingly many potential risks and uncertainties that could affect market returns in 2025. So, with all that said, let's maybe kick it off by talking first about yesterday's FOMC meeting.

What were the core takeaways and what are the potential impacts of the Fed staying flat in the near-term?

1:48
Richard D
Given everything that's been going on, I think the goal of the Fed, certainly at this meeting and probably the next few meetings, is really to take a back seat and try and make these FOMC meetings basically the most boring they can to get out of the limelight and not have President Trump tweeting at them at everything they do.

But aside from that, I think at this meeting, it was always going to be the Fed was going to do nothing. And I think just looking at the economic landscape over the last few months, I think we can see that growth is not collapsing. The unemployment rate is not shooting upwards. We saw initial jobless claims today were again hugely low.

We're actually seeing some of the leading economic indicators starting to sort of perk up a little bit. Maybe that's the manufacturing sector that's been in recession for the last two years and kind of coming out of that. And we just had fourth quarter GDP numbers come in. They were pretty solid at 2.3%, 3.2% on this sort of real private domestic investment measure. Real domestic activity is pretty good. So I guess from a growth perspective there really doesn't seem to be any screaming need for the Fed to be out there cutting rates again just yet. And then on top of that, over the last six months or so, any progress we've seen on inflation has kind of stalled out.

So, the CPI measure has been basically flat since June. The PCE measure has actually nudged up a little bit to 2.8%. I think for the Fed, the sensible decision was really to pause and let's see how the data plays out. And I think the message from Powell, at this meeting yesterday, was that the Fed is no longer going to be preemptively trying to get ahead of where the economy's going.

They've kind of done that. Now, they're just going to sort of sit back and be more reactive to the economic data, watch how it comes in, and if it gets worse, they'll cut more. If not, just continue to wait and see. So that was on one side. And then on the other side of things, of course, there's all this uncertainty about what's going on in Washington. The reality is that President Trump is proposing a bunch of economic policies that are potentially quite conflicting with their economic or inflationary impact. You've got policies like, tariffs and tax cuts, which could be potentially inflationary. You've got deportations, which could be stagflationary.

And then, sort of countering those, you have some disinflationary impacts which could come from deregulation, more energy production, and the DOGE, Elon Musk's Department of Government Efficiency. So, reality is, which of these is going to be the most powerful force? We don't know yet and the Fed doesn't know yet. And it's going to really depend on the timing and the extent to which any of those policies are pursued or how vigorously they're pursued.

I think the Fed's thinking is, ‘Let's do some scenario analysis of all of these things.’ We've got the space right now, in that we're not being heavily pressed by the economic data, so let's just see how this thing shakes out. If suddenly we're really wrong and growth really does start to deteriorate, rates are already at 4.5%. So we've got the space to cut. And if inflation starts to pick up again, we don't have to do so much of a course correction to get that back into line. So let's hold tight for now. And I think no one was really particularly surprised with that outcome and I think that's what we should probably expect for the next few meetings.

6:26
Chris T
How much will Trump's trade policies, especially the potential for tariffs, impact rate cuts moving forward? Will they be inflationary?

6:34
Richard D
The answer is again, we don't know. I think of Trump's policies, tariffs seem to be the most prominent with potentially the biggest risk for inflation. And then, if we think about tariffs, are they inflationary? You know, maybe. Maybe not. In a normal environment, probably not all that much. Remember tariffs are just a tax. So is a tax increase inflationary? Not really. Remember, it's a price level increase. So on a rate of change basis, that tends to fall out after 12 months. So, this is not a situation of too much money chasing too few goods. To go back to Friedman, if you do the basic math here too, say you get 25% tariffs on Canada, Mexico and 10% tariffs on China. And then looking at the import share of those countries, it's about 44% in total. And then breaking them individually down with those tariff rates, you're probably looking at an 8.3% tariff rate on total imports. And then on top of that, consumers only spend about 11% of their total consumption on imported goods. So that dulls the impact. And then on top of that, you have whatever impact you get from a stronger dollar.

Then when the good comes into the country, the importer will probably take a little bit of a hit on that, absorb some of that. The wholesaler, the transporter, the marketer, the retailer and maybe only sort of 40 or 50% of that tariff that actually gets passed on to the consumer.

So the normal reaction function of the Fed is to kind of ignore it, just sort of talk about it. Maybe we’re aware of it and really do nothing and sort of look through it. But here's the catch, and here's what's different this time around, the Fed can only do that as long as those first round effects stay as first round effects and not move into second round effects.

And the way they can move into second round effects is one, if we start to see consumers longer-term inflationary expectations moving up. So Powell was talking about that yesterday in his press conference. He said of course the Fed's watching those closely. He said that longer term inflationary expectations are still rock solid, but near-term expectations have kind of ticked up a little.

And I think the problem there is that consumers are coming hot off the heels of the Covid inflation. So their nerves are still pretty frayed on that. If you get some tariff increases, and then consumers go to the supermarket and they're looking in their shopping trolleys, they're probably not thinking, ‘Ah the increase in price there, that's just a tariff that's going to roll over in 12 months.’ They're just thinking, ‘No way. This is just yet another, another round of inflation.’ So, if that does start to move those expectations, I think you will see a reaction from the Fed pretty quickly.

And I think the other risk is, of these second round effects, is if domestic companies start to see these tariffs and say, ‘Hey, that's a pretty good opportunity for a cheeky price rise here.’ Under the umbrella of these tariffs, they start to push up their prices to try and get some margin increased - the so-called ‘greedflation’ that we talked about in the past, and you haven't seen that yet. I thought it was interesting that a major consumer staples company just had their latest earnings out and their revenue I think increased by about 4%. And what was different in the fourth quarter was that most of that was volume and not price, whereas in the previous couple of years it would mostly be price and less volume.

11:17
Chris T
What is that indicative of? Is that consumers buying more product versus them upping price? Is that what you mean?

11:22
Richard D
Yeah, I think it's two things. So, consumers are in pretty good shape with low unemployment. They have the spending power and consumers are buying more, but then they're also pushing back on price. And I think that's what we've heard from a lot of companies over the last quarter. So, through the fourth quarter, companies were seeing consumers pushing back on price. They're not taking it anymore. And I think for a huge consumer staples good company, that's pretty indicative of the situation. I think it will be hard for them.

11:59
Chris T
Okay, so let's move the conversation over to Treasury yields, which have been doing some strange things this past month. One thing we've been seeing is an increase in longer-term Treasury yields at a time when the Fed's supposed to be easing any short-term yields that are coming down. It's kind of unusual, isn't it? What do you think is behind that and will it last?

12:17
Richard D
Yeah, I think it's weird. It's never encouraging when financial markets start acting in ways which theory would suggest they shouldn't, which unfortunately happens all too often. And I think what's been happening here feels a little bit like what former Fed Chair Alan Greenspan, back in 2005, famously called ‘the conundrum.’ Back then, ‘the conundrum’ was that the Fed was steadily increasing interest rates, but then the long end of the yield curve was actually coming down or flattish to coming down. It wasn't really responding. This time around, we're actually seeing the opposite. The Fed's been cutting rates, and the long end has been moving up.

So, what's happening? I think maybe a couple of things. First, I think the market through most of last year was pricing in a recession or something close to that. And I think as the economy continued to do well, and surprised to the upside, and as that sort of narrative kind of disappeared. Even with the Fed cutting rates, the long end of the yield curve started to take back that sort of overly pessimistic view, if you will, on the economy.

But then I think the other thing is, if we break down the Treasury yields into its component parts, I always find that's a pretty good way of sort of figuring out what the message is in the bond yields. And that bond yield, or bond yields generally, they break down into a real yield, which really reflects the real economic growth. So, a part of that was scaled back. There's an inflation premium. So that's the extra reward that investors demand for the risk of inflation being higher than what they're actually expecting. And then there's this sort of term premium, which is kind of a residual, or it's the risk that investors demand for taking on longer duration or longer maturity debt.

So instead of rolling over a bunch of T-bills for ten years or two-year notes for ten years, they just buy the 10-year T note, but they want a little bit of an extra premium for doing that. And one of the things which we've seen over the last few weeks was that the real yield moved up as that economic news was a bit better. The inflation term premium really didn't move all that much and we can see that in TIPS yield. So, it wasn't as if investors had this huge reassessment of where inflation was going. But where we did see a lot of change was through this term premium. And unfortunately, it's not what we call a readily observable variable in the market. We have to estimate it. So there's no exact measure of it. Probably the most common one to look at is from the New York Fed. You can get that on their website or just look it up on your Bloomberg, the ACM term premium. And that seems to have been causing a lot of the increase. So the question is, what's causing that? Do you want to know?

16:13
Chris T
I do want to know. Yeah. What is causing that? Tell us, Richard.

16:18
Richard D
I think, unfortunately, it's hard to know for sure, as with most things in economics. But yeah, I think it's probably down to a few different things. And first I'd say it could be because we've had a lot of discussion recently about government debt, the size of government debt and deficits, how Trump's come in talking up a big policy platform but it's not quite clear how the deficit's going to move from an unsustainable 5-6% back to a more sustainable 3%.

And then remember, at the start of the year, we also had more talk about debt ceilings and government shutdowns and all that kind of thing. And then there's also this issue of Treasury issuance, where the Treasury over the last year or so has been issuing a lot more T-bills than coupon debt. And at some point, probably later this year, they're going to have to twist back and issue more coupon debt and that could be starting to weigh on the longer end of Treasury yields as fears of big issuance coming down the pipeline are there.

Another reason, though, could be because we've seen a shift in foreign buyers. So, going back to Greenspan's ‘conundrum,’ what was sort of driving that was the emergence of this Bretton Woods II arrangement whereby foreign central banks, like China, were basically buying a lot of U.S. dollar denominated debt Treasuries because they pegged their exchange rates to the dollar at call it ‘grossly undervalued exchange rates’ in order to stimulate their growth and get things moving.

The buyers of that treasury debt back then were what we call price insensitive buyers. They didn't really care what yield it was they were buying the debt for because they weren't buying it for yield. They were buying it just to manipulate their exchange rates. And what I think has maybe been happening more recently is that what we've seen is maybe a regime shift where we've seen the stock bond correlation or the correlation between stocks and bonds shift from positive to negative. It had been negative from around 2000 really up to a couple of years ago. This is important because I think that correlation was based on the prevailing inflationary regime at the time. So in an inflationary regime like the 1970s or 1980s, which is dominated by supply shocks, where the main inflationary driver could be energy prices or supply shortages or that kind of thing, you had a positive correlation between stocks and bonds. That is, higher inflation was bad for stocks. It was also bad for bonds as it meant, you know, rates would have to go higher. But then that kind of changed through the 1990s and 2000s and up until recently where we've been in this disinflationary regime where there's been secular stagnation or kind of this, deficiency of demand. And that was kind of the driving force of inflation, where inflation risks were sort of more tilted to the downside. So in that regime, that would actually give you a negative correlation between stocks and bonds, where inflation could actually be good for stocks and bad for bonds, because inflation wasn't a major problem. A little bit of inflation was good for profits. And guess what? It wasn't going to be so bad that the Fed would have to really jack up rates really high and crush stocks.

So that's what I think drove that negative correlation between stocks and bonds and what that crucially did was it allowed equity investors to start using bonds as portfolio insurance for their equity portfolios. Which in turn, meant that they were another entity that was buying bonds, not for the yields, but for the insurance that those bonds provided, that negative provided.

They didn't really care to a certain extent what the yield was. So again, they were price insensitive buyers. And potentially what we've seen now for the last year or so has been a flipping where the stock bond correlation has changed, maybe because we're in a new inflationary regime for the inflation risks now are less tilted to the downside and maybe a little bit more tilted to the upside than they were. If you have more price sensitive buyers, so foreign central banks may be buying less than what they were, they've been buying a lot of gold recently. Households are suddenly less dependent on bonds for a negative premium. They're actually starting to demand a slightly higher term premium, which in turn has helped to bring up that term premium.

22:08
Chris T
Okay. Got it. If it's a change in the term premium, what does that mean for investors? And, you know, are we seeing a regime change in the investment landscape?

22:16
Richard D
Potentially, yeah. I mean I think it could be a really, really big deal. I wrote a note on this recently called, “Looking for Return Diversification,” and I think what that negative correlation between stocks and bonds resulted in was effectively the boom in the 60-40 portfolio, where basically you had a bunch of investors that said it was kind of a no brainer to stick 60% of your assets in S&P 500 passive ETF and then the rest 40% in treasuries and you had a nice balanced portfolio. And nothing particularly wrong with that, but now if that correlation has flipped and the stock bond relationship is positive again, so you're not getting that same level of portfolio diversification, you need to get your diversification somewhere else. And what does that mean? Well, I think it means that you have to start looking across other asset classes like commodities or private markets or emerging markets, but maybe not even as exotic as that.

Maybe you can get, diversification within the equity market itself. So looking at different sectors within the market or even across the size or market cap spectrum as well, which is one reason, actually, why we like the smid-cap area at this point because we think it's attractively valued. A lot of bad news has been priced in. We think it's going to give you some return diversification if you stick to the quality end of that. So I think that's interesting. I did see a quote recently which said, if you don't hate at least one part of your portfolio, you're not diversified enough. And I think there's probably some truth in that.

24:14
Chris T
Ain't that the truth? Yeah, right. We only have time for one more question. Maybe you can answer this quickly, but you recently wrote about expectations for what kind of market return you might expect to see this year. What are you thinking there? You know, are we going to get a third year above 20% returns or will these grey swan events like the recent DeepSeek announcement, for example, you know, rain on the parade?

24:35
Richard D
Great questions. I'm not going to pretend like I have a great answer for what the market is going to be. But I think as it's the start of the year, and we always do look at turn expectations for the year. And I think it's always a fun exercise to kind of build that from the bottom up, at least from a macro perspective.

And I think the exercise I usually do is say, okay, what is your total return made up of? It's made up of a dividend yield. It's made up of inflation, real earnings growth, and then whatever happens to your PE multiple, you get some P compression or expansion in that in that PE ratio. And if you look at the dividend yield today that's about 1.3%. You know, add to that inflation 2.5-3%. And that's kind of the easy part. Things get a little bit more difficult when you start to think about earnings growth and what you get on the multiple. And in terms of earnings growth, analysts I think are pretty optimistic at the moment. They're forecasting 12 to sort of 15% EPS growth this year.

As we know, analysts always start too optimistic and then over the course of the year those estimates get kind of whittled down. Maybe a more realistic estimate, looking at sort of, on average, how much that gets chopped over the course of a year is something like 9% or 6- 6.5% after inflation. And then the big question is what happens to your PE multiple?

And that's a function purely of investor optimism. It's a reflection of their expected future growth for how much they're willing to pay for it. And the problem here is, at the moment, that multiple is pretty high. So the current forward multiple is 22.2x on the S&P 500, which is kind of high by historical standards. So the average is about 16-17x. So to me, that sort of suggests well there's not actually a lot of room there for further multiple expansion. And then if you start to factor in some potential multiple compression, unfortunately, that sort of compresses your return quite quickly. But I think if we put it all together, what the message is that you're probably not going to get much multiple expansion this year. Your turn is going to be mostly driven by the real earnings growth. You get a little bit of help from inflation and the dividend. The multiple could be a bit of a headwind. So if we subtract some off that, you're talking about maybe 5 to 8% return. So it's not bad. You know, it's nothing like we've seen over the last couple of years.

Just to answer the DeepSeek part of your question because that clearly hit the market out of the blue this last week. We'll see how this plays out. Something feels a little bit off in terms of how much money they've actually claimed they spent training this thing.

28:00
Chris T
Yeah, it does feel a little a low.

28:02
Richard D
It feels a little low and you don’t know where they're getting their source data from, etc. But, even that aside, it does seem to represent maybe the first scratch in the armor for some of these big tech companies. And if we assume it's true, it is pretty good news in the sense that you could see it as a huge leap forward for productivity. It means suddenly you're able to produce a lot more with a lot less, a lot less energy, a lot less money costing you to get that. So that's a huge saving of productive resources. Which in turn, means that AI could be an even bigger game changer for productivity going forward than it was already going to be. And that could happen much faster because your adoption rates could actually be much higher. So pretty fascinating stuff and I look forward to seeing how it plays out.

29:09
Chris T
Well, this should be a pretty interesting year ahead is what it sounds like. Richard, thank you again. As always, it's been a blast chatting with you. I appreciate you taking the time and we will chat again the same month, probably a little sooner.