Jason's World

Welcome again to the Twilight Zone, where good is bad and bad might be good. Friday’s strong U.S. jobs report has sent markets into a tailspin, underscoring the current economic narrative where robust data can be detrimental to stock valuations, contrary to conventional wisdom.

The U.S. economy added a staggering 256,000 jobs in December, pushing the unemployment rate down to 4.1%, a figure lower than most economic forecasts anticipated. However, in a striking demonstration of how markets have lost their strongly straightforward relationship with traditional economic indicators, the jobs report has triggered a significant sell-off across major indices. The Dow Jones Industrial Average plummeted by nearly 700 points, and both the S&P 500 and Nasdaq experienced significant declines, led by major tech stocks like Nvidia, which fell 6% this week, and 3% today. Investors, bracing for potential shifts in Federal Reserve policy, are interpreting this as a signal that the Fed might not cut interest rates as aggressively as hoped. The 10-year Treasury yield climbed to its highest level since 2023, signifying the ever increasing concern over the duration of elevated interest rates. The prognostications according to CME FedWatch show that most likely scenario for 2025 is now only one rate cut. This shows how the specter of interest rates have been embedded in market psychology in our current post-quantitative easing, post-cheap money world.

While this phenomenon may seem counterintuitive to casual observers, it has been informed by a long history of bull markets being ended by high interest rates that expose vulnerabilities in underlying business models. In 2000, as interest rates rose, the dot-com bubble burst as borrowing costs increased for fledgling tech companies, causing many of them to go under, and as investors pulled away from risky companies, causing the Nasdaq to drop 80%. Elevated interest rates helped create the conditions for the global financial crisis by causing the collapse of subprime mortgages. And as the artificial intelligence rally stretches on, with the NASDAQ nearly doubling within the past two years, structural concerns have emerged about the sustainability of asset valuations as the post-quantitative easing era enters its third year. Nvidia has reached a P/E ratio of more than 50, which is higher than the majority of major tech stocks. Other tech stocks have also reached extreme valuation multiples, like Palantir, which once was valued as high as 400 times earnings, and Carvana which is now valued at more than 22,000 times earnings.

Incoming policies from the new administration may potentially add another layer of uncertainty. President-elect Trump’s tariff plans, though allegedly watered down, still threaten to increase prices at a time where Americans have been reeling from soaring costs in the past 4 years, and have voted to put Mr. Trump back in office amidst the strain of soaring costs under the Biden administration.

However, if predictions in the past were correct, we’d be in a recession by now and the Dow would be at 20,000, not 40,000. But logically we are in a moment where the knife could fall at any second, because as history shows, even though catastrophic predictions might fail sometimes, bull markets don’t last forever. Therefore, to navigate this uncertain terrain, Instead of fretting about when the bubble will pop, consider high-yield bonds as a defensive measure to provide a degree of portfolio stability and growth even if market conditions deteriorate significantly. At current yields, U.S. Treasury bonds might appear to be the obvious safe-haven choice for investors seeking stability and reliable returns as it always has been. However, recent displays of political brinkmanship in Washington and historically high peacetime deficits have introduced an unprecedented new dimension of risk. The repeated debt ceiling confrontations, government shutdown threats, and growing partisan gridlock over fiscal policy have begun to challenge the long-held assumption that U.S. government debt represents the ultimate risk-free investment.

Debt ceiling showdowns, even when ultimately resolved, creates periods of market uncertainty that can lead to price volatility in Treasury securities. The growing federal deficit, combined with political resistance to either spending cuts or revenue increases, raises questions about long-term fiscal sustainability. These political tensions have already prompted rating agencies to react, with Fitch’s downgrade of U.S. credit rating in 2023 serving as a stark reminder that America’s creditworthiness isn’t immune to political risk.

Any perception of increased political risk could lead to reduced demand for Treasury securities at auctions, potentially pushing yields higher and prices lower. This dynamic becomes especially relevant when considering that major foreign holders of U.S. debt, particularly China, might view American political instability as an opportunity to diversify their holdings away from U.S. securities.

For investors, this evolving risk landscape suggests the need for a more nuanced approach to fixed-income allocation. Rather than viewing Treasuries as the default safe option, investors might consider building a more diversified fixed-income portfolio that includes high-grade corporate bonds, municipal bonds (which offer tax advantages), and perhaps even select foreign government bonds from stable economies. This approach helps mitigate the specific risks associated with U.S. political dysfunction while still maintaining exposure to relatively safe fixed-income investments.

Furthermore, the traditional relationship between Treasury bonds and equity market volatility – where Treasuries typically serve as a hedge during stock market downturns – might become less reliable if political risk becomes a more significant factor in Treasury pricing. This potential shift in correlation patterns adds another layer of complexity to portfolio construction and risk management strategies.