Jessica Schmitt (0:04)
Welcome to Understanding Edge, where we explore the trends, challenges and opportunities shaping the fixed income markets. I'm your host, Jessica Schmitt, Director of Investment Communications, and today we're diving into the nuances of market volatility, tariffs, inflation and their impact on consumers and investors.
Joining us for this insightful conversation is Douglas Gimple, Senior Portfolio Specialist here at Diamond Hill, and the author of our monthly fixed income market commentaries that help break down these complex dynamics. Together, we'll explore the shifting landscape of 2025 and discuss how investors can adapt their strategies to better manage risk and seize opportunities.
Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights. Sit back, grab your cup of coffee or tea, and let's get started. Thank you for tuning in, and I hope you enjoy this conversation with Douglas Gimple.
Jessica Schmitt (1:03)
Hey, Doug, welcome back to the podcast.
Douglas Gimple (1:06)
Thanks for having me back, Jess, as always. It's a pleasure.
Jessica Schmitt (1:10)
Let's dive right in today. We're going to be covering your monthly market commentary and all things that have been happening in fixed income markets over the last several weeks. Your commentary was titled, Market Volatility in 2025: Tariffs, Inflation and the Consumer Impact. So, obviously, anybody who follows the markets knows that there's been a significant amount of market volatility thus far this year, and hoping you can kick us off with what have been some of the central drivers of that volatility.
Douglas Gimple (1:45)
Yeah, Jess, at this point, it feels like anything and everything is providing a reason for the market to experience some kind of hiccup. And the reactions in the fixed income markets have been substantial. Since the beginning of the year, the yield on the 2-year Treasury has shifted up or down by seven basis points in a day on roughly 17% of the trading days through March 25th, while the 10-year yield has done so roughly 22% of the trading days over that same time period. So, what's fueling these knee-jerk reactions? I looked at four areas, and they're not the only things, but I think they're some of the key drivers of some of this volatility.
First and foremost is inflation. Core inflation, which removes the more volatile components of food and energy, has been on a bit of a roller coaster ride, really, since the fall of last year. 2024 saw the year-over-year core inflation start at 3.9% and slowly come down to 3.2% in August of last year before we saw a slight reversal to 3.3% in September. So this level held through November then dropped to 3.2% in the final month of 2024, but we saw a slight uptick in January to 3.3%, which created some angst in the market. But that reversed once again when the February report came in at 3.1%, which was a somewhat pleasant surprise. So, it's that uncertainty around the potential impacts from the implemented and pending tariffs, which we'll talk about, as well as immigration shifts on inflation. So that's created even more uncertainty than usual when we see these reports, and they become even more and more meaningful because we want to see what the instant feedback is on inflation and where we've been and how it's impacting the markets.
The second area is the labor market. And the labor markets followed almost a reverse version of the path of inflation. So, while inflation has trended lower over the past several months, although with some of the aforementioned hiccups, the unemployment rate has ticked higher. Unemployment began 2024 at 3.8%, spent most of the year slowly climbing and finished at 4.1% after peaking at 4.2% in November. Similar to that up and down movement of inflation that I was talking about, the unemployment rate dipped to 4% in January before shifting a little bit higher to 4.1% in February. So that movement of the labor market and that continued uncertainty is plaguing the markets as well.
And then, most recently, is consumer sentiment. When the markets have settled into this uneasy relationship with the fluctuations in both inflation and labor, consumer sentiment really took the center stage over the past couple of months. The University of Michigan consumer sentiment survey focuses on three main areas: prospects for personal financial situation, prospects for the general economy over the near term, and then prospects for the economy over the long term.
The most recent report for February, released in March, showed a significant drop from the previous month's level and represents the lowest level since November 2022. February's reading of 57.9 marks the third consecutive drop, with the biggest consumer concerns focused on, as you would expect, uncertainty around government policy and inflation. And in fact, we look at the consumer year-ahead expectation for inflation, that jumped to 4.9% from 4.3% month-over-month, and it marks the fourth consecutive increase from December's level of 2.8%. So, the consumer is really starting to worry about tariffs, inflation, government cuts to programs and agencies, and it's creating the shift in spending behavior, and we'll talk about that in a little bit.
And then finally, geopolitics. I believe this aspect of the financial markets has ramped up exponentially since November's election, ranging from ongoing tariff battles, developments in the Ukraine-Russia conflict, instability in the Middle East ramping up once again, and the shifting relationship between the US and the rest of the world. And I guess the last point that I would make with geopolitics and overall the volatility that we've seen in the markets is this noise that we're hearing about confidential and top secret chats that are being shared with editors in chiefs of magazines, which is a real big concern and I think can have significant fallout. Just today, the actual texts were all released with redacting some of the names, but I think we're going to see some more fallout there and that's going to create, again, more uncertainty and instability in the financial markets.
Jessica Schmitt (7:07)
Okay. We definitely have a lot going on. Let's circle back to inflation for just a minute, Doug. As you mentioned overall, despite some hiccups, inflation has trended downward, but it remains elevated above the Fed's long-term target. So, how do we balance that with the Fed's relatively cautious policy approach right now, or what seems to be relatively cautious, and what might we expect from the Fed going forward?
Douglas Gimple (7:34)
Well, Jess, this is where things can get very interesting very quickly. One of the things that I didn't mention regarding some of the volatility in the markets is the Federal Reserve. And the reason being is that they've been rather predictable, and they've made sure that what they say is closely matching what they do or don't do.
And we had the most recent meeting of the Federal Reserve last week, and they held the line not only on rates but on the projection for action through year-end. Heading into the meeting, the dot plot, which again shows what each member is expecting from a rate decision going forward. The dot plot showed two 25-basis-point reductions for the Fed by year-end. This didn't change with the new release, and though there was some shift amongst the members regarding their outlook, it really wasn't enough of a change to influence the expected number of cuts by year-end. And I think we can continue to see this transparency from the Fed regarding the potential for any action on rates. But I was a little bit surprised that they broke out the word transitory once again in reference to potential inflation impacts from tariffs. Given the stigma that word has garnered relating to the Fed missteps a few years ago, I would've thought they would've broken out the thesaurus to come up with a better term. Maybe they could have used temporary or fleeting or short-lived, but really, I digress, let them work on their word choices.
But to your point, Jess, I think we will continue to see caution from the Fed as there are just too many variables that can impact the trajectory of the economy and rates. One thing that I would note if listeners are reading or watching financial news, then you're hearing more and more about stagflation, which is a period of high inflation combined with high unemployment. Think about the late 1970s and early 1980s, but based on Google trends, searches for the word stagflation have ramped up in recent weeks as the term is showing up more and more in various articles and essays across the internet.
Are we headed into the 1970s, the most notorious period of stagflation? Highly doubtful. While inflation is higher than the Fed's target, it is only slightly so and it has shown some signs of easing, although it's been very slow. And while unemployment levels have climbed a bit, the economy is well below what economists would consider the natural level of unemployment, which really is anywhere from, let's call it 4.5% to 5%.
Stubborn inflation that may climb if tariffs deliver higher prices for a variety of consumer goods, combined with an increasing unemployment rate, could push us toward this kind of stagflation-type environment. How could the Fed react? Based on the prior period of stagflation, the Fed would most likely choose to attack inflation by raising rates aggressively to slow its progress. But as we know, every time is different. So, I think more so the Fed would just have to adjust as things develop, and that's part of their job, really, is not to jump the gun, but to kind of react to the data that they have, not the data they think may be coming.
Jessica Schmitt (11:09)
Okay. Well, let's talk about the word of the month, which seems to be tariffs, very much so in the market news. Tariffs, Doug, have historically been an economic disruptor in various ways. And so, how do you think the current tariff measures differ in both scale and scope compared to previous periods or previous tariff wars, and how are they contributing to this market uncertainty?
Douglas Gimple (11:41)
We're still early in the tariff game, if you will, with lots of announcements about tariffs, implementation and then removal and then adjustments, etc. So it's really hard to calculate what kind of impact they could have on the overall economy. It's going to take some time. 2019 taught us that tariffs can be very disruptive to the economy and can impact its ability to supply goods or services, but there's a difference between our current situation and 2019.
Back in 2018 and 2019, core inflation was essentially in line with Fed targets, ranging anywhere from 1.8% to 2.4%, and an average level of about 2.2%. While current inflation, as we've discussed, is kind of stuck north of 3%. The 2018 trade war leaked into 2019, but the Fed was in a position to lower rates in response to that market stress, which is kind of different than where we are right now. With stubborn inflation and a potentially weakening labor market, the Fed would really be hard pressed to justify lowering rates solely as a response to the uncertainty brought on by tariffs. And remember, that's not part of their job. Their job is the labor market, inflation and financial stability to a certain degree.
So, what have we seen so far on the tariff front? 25% tariffs on both steel and aluminum, which are, as we know, key components in not only car production, but a variety of other industries. In 2018, the initial tariffs for these markets were 25% on steel and 10% on aluminum. So already we're seeing a little bit of a difference there, specifically on aluminum.
And then really there are the proposed but not yet realized tariffs, such as the potential 200% retaliatory tariff on European liquor and wine in response to Europe's 50% tariff on US whiskey, which itself was in response to the escalated tariffs on steel and aluminum. So, they can keep feeding on each other, but by comparison, in 2018, there was a 25% tariff placed on German wines. So, it looks like these are much broader approaches, but it's not just the tariffs, it's also the impact from the rhetoric that's really coming from the White House towards our neighbors to the north, for example, that can impact the markets.
Threats of Canadian annexation by the US have infuriated Canadians so much so that they're looking to other destinations to spend their vacation dollars, for example. According to the US Travel Association Trade Group, Canadians made 20.2 million visits to the US in 2024, and a reduction of just 10% could mean $2 billion lost in spending in the US. Canadian airlines have reduced seat capacity to the US by roughly 6.1% for April, May and June compared to their January schedules — really at a time when you would expect to see them ramping up their capacity.
Arrivals from Canada dropped by 9.4% and 11% for Las Vegas and New York City airports, respectively, in February. So, you combine the drop in travel with this buy-Canada movement for groceries and other retail purchases, and it's not just tariffs that we need to worry about, but this cratering of the relationship with our closest neighbor as an example.
Jessica Schmitt (15:18)
Okay. You also touched on consumer sentiment, Doug a little bit. So I want to dive in there a little bit further, and you discussed some shifting behaviors already in spending. How are these changes influencing or how will they influence the broader economy, and what should investors take away from some of these trends that we're starting to see?
Douglas Gimple (15:45)
In the commentary, I referenced a couple of specific instances of consumer behavior shifts, and I'll recap those really quick. So, Walmart CEO Doug McMillan shared that consumers are showing stress behavior, and it's indicated by shifting to smaller purchases at the end of the month as their money is running out sooner than in prior months. Sales to low-income guests at McDonald's were down double digits in the fourth quarter compared to a year earlier, and the fast food industry overall has seen a sluggish start to the year. And it's not just the lower end of the economic spectrum that's tightening the belt. It's the luxury market, which is feeling the pinch, with sales falling 9.3% in February from a year earlier, accelerating from the drop of 5.9% in January.
The slowdown in consumer spending is really being felt across the markets with a reevaluation of equity markets, as we've seen, as well as an adjustment to projected GDP for 2025. The Federal Reserve Bank of Atlanta released their most recent estimate for first quarter GDP at -1.8%, which is actually a slight upgrade from the prior estimate of -2.1%, but well below what we saw in the fourth quarter of 2024 of positive 2.3%. Now, this negative number should be taken with a fairly sizable grain of salt as there are a lot of assumptions baked into the analysis: the quarter's not even done yet, and we won't have a clear understanding of the first quarter economic performance until we're well into the second quarter. The takeaway for investors, to paraphrase portfolio manager Mark Jackson, is that many things could happen, and many things will, and really to be prepared for the uncertainty that comes with that.
Jessica Schmitt (17:37)
Okay. Well, let me ask you specifically about our fixed income team here and how you guys are adjusting portfolios to reflect current risk metrics. What specific strategies or sectors are you guys focusing on in order to manage some of this consumer-related exposure, especially in light of all this uncertainty?
Douglas Gimple (18:03)
As concerns ramp up around the viability of the consumer in the face of economic uncertainty, we look to shore up our portfolios’ overall exposure. It's important to note that we're not stating that the consumer is in trouble, just that we've seen some cracks are starting to form in certain parts of the market, and we'll take action to adjust the portfolios accordingly. This can mean anything from shifting allocations higher up in the cap structure to shorten exposure to a pool of assets or move on from positions that have performed very well over the past call it 12 to 18 months, as this spread tightening has been occurring in the securitized market.
We cannot predict the direction of rates. We've talked about that many, many times. We can't predict tariffs, and we can't predict geopolitical events or any of the other outside factors that can impact capital markets. So, we'd rather make adjustments based on incoming market data and insights into the various sectors in which we invest.
What does this mean to the underlying portfolio? It means a focus on higher quality positions, further up in the capital structure, and well-structured deals with strong credit support.
As we've heard about some of the impacts on the consumer, which we've talked about. Something to keep in mind is that investments that provide exposure to consumers come with a very important component for investors, which is credit support. Credit support, which is also known as credit enhancement, is part of the inherent structure of these various types of deals, and it's used to mitigate some of the losses that occur in these deals.
And look, no one is perfect in underwriting loans. And when these deals are put together — whether it's autos, consumer unsecured, credit card — they're done so with a presumed level of acceptable loss. Credit enhancements, such as overcollateralization, excess spreads, subordination and reserve accounts, are an important part of the structuring process and help to provide some protection for investors. The degree of which depends upon where in the capital structure one invests.
These credit enhancements are in no way a guarantee to protect against loss, but they provide some comfort that there are mechanisms in place to help mitigate losses in a loan portfolio that may be part of a securitization.
Jessica Schmitt (20:31)
So for investors grappling with all of this, Doug, tariffs, inflation, market uncertainty, what advice do you offer to help them adapt or evolve their strategies in 2025, and what should they be most mindful of in the months ahead?
Douglas Gimple (20:52)
Well, it's important to remember that everyone in this business, investors and clients alike, should be focused on the long term. There will always be periods of disruption in both equity and fixed income markets that create angst, but at the same time create opportunities. Whether it's the regional bank crisis of 2023, the early days of Covid, or even the rate reset in 2022 that created such havoc in the fixed income markets. As painful as 2022 was for investors in the fixed income markets, it's brought us to the current state where fixed income now provides some significant yield, especially relative to pre-2022, and that helps to mitigate the impact of these volatile days.
Prior to 2022, fixed income had very little cover from an income and a yield standpoint. Yield levels today can help to stabilize a portfolio despite some of these shifts in rates that we're seeing on a day-to-day basis. Investors need to be mindful of that long-term focus and remember that periods of volatility or uncertainty, while sometimes scary, also provide opportunity for those investors that remain nimble and focused on the markets.
Jessica Schmitt (22:11)
Okay. Well, thank you, Doug. Those are all the questions I have for you today. We really appreciate your insights and for joining us yet again. Always a pleasure to have you.
Douglas Gimple (22:20)
Thanks, Jess. It is always a good time.
Jessica Schmitt (22:24)
All right. Well, before we close out, I do want to mention that Doug and our portfolio manager, Arthur Cheng, our newest fixed income team member, will be doing a live podcast on Tuesday, April 29th at 2:00 PM Eastern Time, with a focus specifically on the high-yield market. So don't miss out on this opportunity to hear directly from Arthur. Registration details are live on our website now on our homepage, and then of course, Doug and I will return in May for another podcast update.
In the meantime, please visit our website at www.diamond-hill.com to read Doug's full commentary and keep an eye out for our quarterly update, which will be available in late April. Until next time, take care.