Overview
The fourth quarter of 2024 unfolded amid heightened market volatility, with a notable surge in risk assets following the election. While certain sectors saw strong momentum, persistent challenges such as rising interest rates, inflationary pressures, and a tight labor market remained prominent. Despite these headwinds, the broader market showed resilience, supported by optimism in risk assets. As the year closed, it became clear that risk management and a discerning approach to asset selection would be essential in navigating an already optimistic market and stretched valuations.

Topics of Interest
Yields and Inflation: As the market entered the fourth quarter of 2024, expectations surrounding interest rates and inflation shifted. U.S. bond yields rose sharply as the Federal Reserve tempered its outlook for rate cuts. While inflation had cooled from the 2022 peaks, core inflation remained persistently high. This pressure led to a rise in real rates, particularly on longer-dated bonds, which continued to climb in Q4. The yield spread between 2-year and 10-year treasuries (often referred to as the 2s/10s spread) steepened, further pressuring valuations across both government and corporate bond markets and leading to a decline in prices. The Fed’s adjusted outlook signaled that tighter financial conditions are likely to persist.

Valuations: Credit markets, including both investment-grade (IG) and high-yield (HY) bonds, have shown stretched valuations. While spreads over Treasuries have compressed in certain sectors, this narrowing has not been fully justified by the likelihood of slower economic growth and unexpected risks. While rising treasury yields have been the driver of spread compression, the risk-reward balance in the credit space generally appears less attractive.

Equity valuations also remain elevated, with various valuation metrics trading above historical averages, particularly in growth sectors. Despite market volatility, equities, especially in tech, continue to trade at high multiples, which could be vulnerable in a slowing economy or if earnings growth falls short of expectations. With valuations stretched, a more selective approach to equities and asset allocation is warranted. A more attractive risk-adjusted return opportunity can be found in credit markets for full asset allocation investors. Credit should provide better downside protection than equities and non-interest rate sensitive assets can help diversify bond allocation risks and reduce overall volatility.

Economic Data: Throughout the quarter, key economic data indicated that the risks of a broader slowdown remain present. While employment data has shown resilience, consumer sentiment and spending have softened, and industrial production numbers are beginning to reflect a cooling global economy. More troubling, the ISM Manufacturing index has remained in contraction territory, which can be a leading indicator of economic challenges ahead. This data highlights the rising risk of a more protracted economic deceleration. In addition, as central banks globally maintain tight policy stances, the lag effect of these measures may begin to manifest in growth data, suggesting that the coming quarters may prove more challenging for both equity and credit markets.

Strategy
As we see the level of compensation per unit of risk declining, we have continued to enhance our portfolio diversification process. This includes reducing exposure to overvalued assets, altering our asset allocations, and using creative portfolio management techniques to reduce total portfolio risk. We favor income-producing assets as a buffer to potential volatility and have taken steps to enhance downside protection. We are particularly focused on securities with unique structural features that we believe will improve our risk and return profile looking ahead.

We view maintaining liquidity as more critical now than it has been in recent years. Liquidity provides flexibility to remain agile during periods of market volatility and dislocations, allowing us to capitalize on relative value opportunities and engage in tax-loss harvesting when appropriate.

Outlook
Looking ahead to 2025, we remain cautious about the risk-reward tradeoff in both credit and equity markets. Household stock ownership continues to rise, with investors seemingly chasing returns at unattractive prices driven by FOMO (fear of missing out). While there are always areas for opportunity, valuations do not justify the forward-looking risks. As central banks continue to prioritize inflation control and a new administration takes office in the US, the potential for more uncertainty about interest rates, growth, and the direction of the economy remains. This environment will likely continue to pressure both valuations and corporate earnings, particularly in the credit markets, where we are hopeful for more attractive opportunities in 2025.