By Eric Parnell, CFA on February 10, 2025February 10, 2025 Another storm rolled across capital markets to start this week. This time, it was the shock headlines over the weekend that the United States would be instituting tariffs against its close neighbor trade partners Canada and Mexico, which cast doubt on the sustainability of economic growth across the region as well as the potential inflationary impact of such measures. But no sooner had countless gallons of virtual ink were subsequently spilled dissecting the specific implications of these tariffs than a delay was announced on implementation so that further negotiations could take place. This latest tariff shock highlights an important theme that analysts and investors should keep firmly in mind as we progress through the next two years. The noise is likely to continue coming fast and furious for the foreseeable future, but it’s much less about the details behind each and every headline. Instead, it remains all about the big picture. Market check. The U.S. stock market is a capriciously emotional beast. For example, a start up AI company in China effectively drops a Chat GPT knock off app in the Apple Store, and suddenly the largest company in the world by market cap and friends are shedding one-fifth of their value. Fickle and unpredictable to say the least. But in the current and foreseeable market environment, assessing the magnitude and sustainability of such emotional stock market swings can be useful in determining whether the financial media fuss is real or mostly bluster. And when it comes to the headline deluging new administration in Washington, the stock market is on net exuding a collective shrug at least so far amid the steady and sometimes shocking news flow. Consider the headline benchmark S&P 500 Index, which is shown in the chart above. While market volatility as measured by the CBOE Volatility Index, or the VIX, has indeed crept up slightly to the mid to high teens, the U.S. stock market has largely held it’s ground. And from a technical perspective, it remains very well behaved. This includes maintaining its post inauguration breakout above the downward sloping trendline dating back to the beginning of December and holding support at its short-term 20-day (green dotted line) and medium-term 50-day (blue line) moving averages. This is all good stuff despite the collective handwringing and AI related shocks in recent weeks. So while the market and political headlines are coming at a rapid fire pace, the overall stock market is taking the news fully in stride at least so far. The bigger picture. At the end of the day, the forces driving today’s stock market in early 2025 are no different than those dictating its direction since the calming of the Great Financial Crisis more than 15 years ago. The bottom line is all about the flow of financial market liquidity. If stocks are getting the liquidity oxygen they need, they will show the resilience to rise regardless of what Cabinet nominee may or may not be getting confirmed by Congress, what global land mass may or may not be annexed, or what trading partner may or may not be hit with tariffs. And by most measures including the recently lowered Fed funds rate and the still soaring prices of many leading cryptocurrencies, investors are finding no shortage of liquidity to redeploy into purchasing ever more financial assets. This leads to the key point that we as investors are well served to continue monitoring most closely in the days, weeks, and months ahead. What, if anything, are the forces that could stunt or altogether reverse this flow of liquidity in the months ahead. For if and when we arrive at such a juncture, it will be at this point that asset prices recoil in a more sustainable and portfolio damaging way. The most recent sustained example of such a liquidity drain was 2022. Following the flood of liquidity injected into the financial system in response to the COVID crisis, monetary policy makers spent the entirety of 2021 proclaiming that the eventually resulting inflationary signals were simply transient and would eventually go away. That is, of course, until they weren’t transient. For by early 2022 and by the time that Russia invaded Ukraine, the inflationary powder keg finally exploded and the U.S. Federal Reserve was forced to take swift and decisive action. This included swiftly draining liquidity by jacking interest rates by more than five percentage points and starting to shrink the balance sheet (Quantitative Tightening, or QT) that they had previously spent so many years expanding (Quantitative Easing, or QE). How did stocks respond to this sudden liquidity drain in 2022? None too well, as the S&P 500 fell by as much as -28% from peak to trough. And it wasn’t until the Fed and the U.S. Treasury had to get back into the game of injecting emergency liquidity once again in response to a sudden banking crisis in March 2023 that markets finally rediscovered their giddy up and resumed their climb to the upside toward new all-time highs. Putting this all together leads to the following overly simplistic but still relevant conclusions. Looking past all of the headlines and noise on a daily basis, if the financial system is receiving a net increase in liquidity, then stock prices are likely to rise all else equal. Conversely, if the financial system is experiencing a net decrease in liquidity, then stock prices are likely to fall all else equal. Quod erat demonstrandum (this is how mathletes talk trash when knocking out a bad a$$ proof – chalk drop). Monitoring the plug in the drain. So what then would be the primary culprit that could result in such a liquidity drain that could compromise the ability of stock prices to further their ascent at best and descend stocks into another bear market or more at worst? It would be the primary downside risk confronting capital markets for some time now. It is a renewed rise in the same inflationary pressures that pushed stocks into their most recent bear market a couple of years ago. So where do we stand on these inflation readings today as the new administration gets underway in Washington DC? The good news is that so far, so good. Roughly every two weeks we receive a latest monthly reading on inflation. The latest came just last week with the release of the Personal Consumption Expenditure (PCE) Price Index, which is the inflation reading that is most favored by the U.S. Federal Reserve when setting the course of monetary policy. The good news is that both the headline (blue line in chart below) and core excluding food and energy (orange line) inflation readings remain consistently below 3% on an annualized rate of change basis. This is the type of price stability in which the economy and financial markets can really thrive. However, it should be noted that the headline PCE inflation reading has been moving steadily higher since September and the core PCE inflation reading has been slowly drifting higher since May. Neither have risen to date with any magnitude that would cause any semblance of alarm. Nonetheless, these readings merit close attention in the coming months to see if they start to pick up in any meaningful way. Another useful reading worth ongoing monitoring on an ongoing basis in this regard is the 5-year breakeven inflation rate. This is a daily reading that measures the expected average annual inflation rate over the next five years implied by the spread between the 5-Year U.S. Treasury yield and the 5-Year U.S. TIPS yield. It is here where we are starting to see some potential cause for concern. After bottoming below 2.0% during the third quarter of last year, the 5-year breakeven inflation rate has since spiked higher to just above 2.6% in recent days, which is the highest reading since early 2023 when inflationary pressures were still coming down from 2022 peaks. While 2.6% average expected inflation is still a highly manageable number, if this reading starts spiking to levels north of 3%, then the concerns around potentially rising inflation are likely to start seeping into financial markets in a measurable way in the form of higher Treasury yields and lower stock prices. Bottom line. While the headlines out of Washington are likely to continue to come fast and furious for the foreseeable future, continue to monitor developments but resist succumbing to the noise. A well-constructed and broadly diversified asset allocation strategy is likely build to withstand any related short-term volatility. Instead, investor focus should remain on the bigger picture, and in the current environment the biggest picture remains monitoring developments on the inflation front. While these readings remain more than manageable today, risks are rising that pricing pressures could increasingly build to the upside. And if they rise far enough, it could start to pull the liquidity plug on financial markets. I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Please consult a tax or legal professional for specific information and advice. Compliance Tracking #: 693274