Making Sense: August Market Update

Making Sense

Monthly Market Update

Recorded on August 27, 2025

Amy: Hi, I'm Amy Thomas. I'm a strategist here at First Citizens Bank. Today is Wednesday, August 27, 2025, and I want to welcome you to our monthly Making Sense: Market Update series, where Brent Ciliano, our Chief Investment Officer, and Phillip Neuhart, Senior Director of Market and Economic Research, take a deep dive into what's happening in the markets and the economy. If today's discussion sparks questions about your financial plan, please reach out to your First Citizens partner or visit FirstCitizens.com to connect with one.

As always, the information you're about to hear are the views and opinions of only the authors at the time of recording and should be considered for educational purposes only. None of this information should be considered as tax, legal or investment advice.

Brent: Well, thank you, Amy, and good afternoon, everyone. Hope all of you are well. Phil, I can't believe that summer is effectively over, and Labor Day is literally right around the corner. Where did the summer go?

Phil: It's incredible. Weather's improving, though.

Brent: Yeah, yeah. I'm looking forward to the slightly colder weather even with my thin skin now that I've been down in the South. So we've got a lot to cover today, so why don't we jump right in, Amy?

We're going to start off as we usually do with a broad economic outlook. We're going to cover growth. We're going to talk a little bit about tariffs, Phil, inflation, monetary policy, the labor market, and a little bit about consumer spending. And then, certainly, we're going to get into a market update—the equity market's continuing to rise—and we're going to talk about where we are there.

We're going to talk about valuations, and we'll certainly going to—we have an updated forecast that we're going to be getting out to all of you, and we'll certainly talk about fixed income and investing for the long term.

So let's jump right in, and let's start with our broad economic mosaic here, Phil. At a high level, economic forecasts have weakened over the recent months. And when we sort of go through—let's start on the top-left field and let's talk about Real GDP growth in the United States. After putting up 2.8% Real GDP in 2024, economists forecast that we are going to do about 2.1% at the beginning of this year.

Phil: For full year 2025.

Brent: Full year 2025. And right now, expectations have moderated lower. We're now we're sitting at about 1.6%. So a significant change. So we're talking about almost a 24% change in growth expectations from the beginning of the year to now. If 1.6% ends up being the full-year number, you're talking almost a 43% change in growth from 2024 to 2025—so certainly moderation there.

An important component to Real GDP growth we've said for a long time is consumer spending and the labor market. When we talk about job creation, last year about 168,000 jobs per month. Economists came in thinking we're going to do about a 121,000 jobs per month. We've moderated lower to about 105,000 right now. That's probably a little bit lower right now. We've had 3-month moving average at only about 35,000 jobs, so we're seeing significant moderation in job creation.

Phil: And we'll talk about that more later, but clearly, we see some deterioration there on the revision side as well. Looking at inflation, also not great. Came in expectation of 2.5% inflation in 2025. Of course, there's been inflationary pressure from tariff on the goods front, and services has seen inflation as well. We're running closer to 3% now, whether you look at the headline or the core.

In terms of Fed funds rate, kind of flat—about 3.9%. We'll dig into that more in a moment. Recession probability we also are going to spend some time talking about—it has risen from 20% to 35%. Interestingly, it has not exceeded 50%.

And to that point, the question is, Brent, "Why are markets higher if we have so many red bars on this?" And I think you may have some perspective on earnings.

Brent: Well, and looking at that bottom-right box, right, you know, corporate earnings, profitability, revenue growth, margins—while certainly lower than the lofty expectations that you and I talked about at the beginning of the year, expectations for 15% year-over-year growth in earnings—what was we thought was a stretch goal. I mean, nice to see. But sitting at 10.3% as of today is still materially above the long-term average of 7.6%.

And we'll get into it a little bit when we talk about second quarter earnings and what we see for the full year. But the fundamentals underpinning this equity market rally are solidly focused on earnings and profitability.

Phil: Absolutely.

Brent: So let's get a little bit more under the hood, Phil, and talk about on the left panel here, let's talk about Real GDP growth. The dark blue bars are—actual the light blue bars here—are the consensus forecast. And you can see that potential growth rate and that gold bar is about 2%.

And what you can see is we had an actual year-over-year or quarterly contraction in the first quarter at about negative-50 basis points. We had a very strong first print on second quarter GDP at 3%. We have another print coming here soon. Survey data is about 3.1%, so that bar might get higher.

But when I think about this overall, right, consensus believes that we're going to do about 1.6% Real GDP growth for this year, but 1.7% in 2026 and 2% in 2027. So the trajectory, if that were to hold, is this year might be the bottom—fingers crossed—as it relates to economic growth bottoming out and an acceleration in subsequent quarters.

Phil: And that ties into consensus recession probability, which we're showing on the right side here. This is just a survey of sell side or Wall Street economists and "What's the probability of a recession in the next 12 months?" Reminder, in the 2022, 2023 period—it skyrocketed to over 50%, and we did not have a recession.

What we have seen so far this year is, yes, some concerns around international trade, et cetera, have pushed recession probability higher as we showed in the last slide, but not north of 50%. So there's two options here. One, economists—and we've actually even seen that tick down recently as you can see—economists are feeling good as we get trade deals finalized. There's a little bit more certainty in terms of the path of the economy. Or maybe economists are a little trigger shy after getting it wrong in 2023.

Brent: That's right.

Phil: So we've seen it rise, but certainly when you look at a stock market that's up quite a lot this year, and you look at recession probability below 50% tied in with earnings, it starts to make a little bit more sense.

Brent: Yeah. So one thing that's been front and center, Phil, in the financial news media—and certainly market participants—is what's going on with the Fed, what's going on with monetary policy. So we're looking at the Fed funds rate and sort of that market-implied path. So where are we actually today? Right now we're at a midpoint about 4.33%. Expectations for this year are sitting at about 2.2 cuts. We'll see, what ends up happening.

Right now we're sitting at about an 87% probability of a 25-basis point cut at the September 17th meeting. Certainly, we had Chair Powell on August 22nd at his Jackson Hole speech sort of intimate that a cut might be coming. That's why you saw the markets react the way that they did. We saw bond prices rise, yields fall, equity markets do well. So the expectation is that we might get that cut.

Phil: And importantly, on that cut in September since last time we recorded, is we did get a weak labor market report, which we'll talk more about, and a big downward revision. So the truth is fundamentals in the labor market are just weaker than all of us market participants knew 1 month ago.

Brent: Yeah, and when you look further out, you have, 5.5 25 basis point cuts priced into year-end 2026. I think time will tell. There's been a lot of discussion, a lot of headlines about the composition of the Fed, right? What's going on? Chair Powell's term ends in February of next year. So a lot of noise.

Phil: May of next year.

Brent: Sorry. May of next year. Sorry. You know, understanding what might actually happen. So, again, we still believe that while you'll see, you know, change within the Fed voting members and the composition within the Fed, we do believe that there's independence there. We do believe that they will ultimately be data dependent, and the path of rate cuts from here will continue to be uncertain. But by and large, we'll be—we think—more data dependent than anything, maybe, politically oriented.

Phil: The Fed has a little bit of room to cut potentially here. Five-and-a-half cuts might indicate that something went wrong in the economy.

Brent: Exactly.

Phil: Imagine a labor market deteriorating. So we don't necessarily want to see 5.5 cuts because it might mean that something broke, and that's, of course, not what we want to see.

Brent: So what's going on outside of the United States from a monetary policy perspective? You can see the bar at the left. We have not had a cut since the December meeting of last year, right?

So we've been on hold this entire year—8 months in. Other areas of the world, whether I look at the EU, whether I look at the United Kingdom, Canada, all have seen headwinds to their broader economy, a modest deceleration in growth. We've seen the impact of tariffs, right, geopolitical uncertainty, and we've seen their governing bodies cut rates across the board. The one outlier has been Japan where we have actually seen a little bit of a better expectation for growth there. Certainly, some things that are going on, but they are a very export-intensive country.

So, again, that's somewhat of an outlier, but, again, they're far away from a comparison to the European Union or anywhere else.

Phil: Right. When you look outside of Japan, the real question is—"Is the Fed going to join the party in September?" It's looking like they will. We should point out we have another employment report and more inflation data between now and September. So anything is possible, but that is, of course, what futures are pricing.

What about inflation expectations? We've spent a lot of time on these calls talking about the rate of inflation. We just showed it a couple slides ago. What about inflation expectations, market price? So not just surveys, but what are markets saying? If you look at 1-year inflation swap rate, which is a fancy way of basically digging into what the market is saying inflation's going to be, the 1 year has risen quite a bit this year. That's the dark blue line. It's at about 3.4%. What's interesting, though, is if you look longer term, which is the focus of the Fed, you'll hear Chair Powell mention the 5-year inflation rate. That is the 5-year inflation rate in 5 years.

Brent: Yeah. Sounds very confusing.

Phil: So in other words, let's just call it long term—it's long-term inflation expectations—that has really remained contained. It's a 2.5%. Yes, that's above the Fed's target, but really not a shock and awe number at all compared to long-term history. Pretty contained. So when you think about the Fed coming in September says, "You know, we're seeing some softening in the labor market," maybe they are cutting.

I think looking at that gold line is one of the keys, which is, yes, there's been concern of inflation expectations due to trade conflict, but long-term inflation expectations have remained contained. If this number were to rise, that's a problem.

Brent: Yeah, but I think it's important—what you're calling out is—I mean, the 50-year average in the United States is about 2.7%. 75-year is about 3.2%.

So, you know, while 2.5% is certainly higher than where we've been in the last 20 to 25 to years, we can easily function, and we've been able to be successful. Corporate earnings and profitability have been able to grow. People have been able to spend in an environment where it's been above 2%.

Phil: Absolutely. So what about tariffs? Something that we can't wait to not talk about consistently, but we feel like it is our responsibility to at least discuss. So we have seen a lot of trade deals come through, more certainty on that front.

Here's a study that our great analyst, Blake Taylor, pulled down. And what you'll notice is imported goods, we have seen inflation. What's interesting, though, is you saw that really rise in March. That was when a lot of the saber-rattling began—before Liberation Day, right?

Companies were hiking prices before a lot of the tariffs were even announced. And you've seen it creep higher since that time but really move sideways in recent months. I think this shows that, yes, tariffs rose sharply, but this flattening might indicate that we're at a better place in terms of the impact. But 3.2%—this is not annualized—is material. And we're seeing that in the details of things like the CPI report.

We mentioned, last month, coffee for you. One of your true loves. We've seen a lot of price inflation, footwear, et cetera. So it's not that tariffs aren't driving inflation. They are, but it's not everything, right? So what else are we watching in this study? The dark blue line. This is domestically produced goods that compete with imports.

So imagine you produce a good, your competitors import, and they have raised prices. What we're seeing is domestically produced goods—they're raising prices also. And this, by the way, I have heard directly from clients on the road that it's "Look. That's capitalism. You are going to see folks take advantage of it." Not rising to the same point as imported goods, but they're taking advantage of the fact that, "Hey, my competitor raised prices. I can raise prices a little bit as well."

Now, other domestically produced goods that are not in direct competition with imports—very low inflation. One percent if you annualize that, that's still quite contained. So we are seeing an impact. Now what we should point out is you say, "Well, why did CPI—why has it underperformed expectations for 5 of the last 6 months?"

Brent: Beautiful services, right? Remember, services is almost 70% of total consumption. So when you think about the balance there, most of that CPI number, right, is driven by the services component, right? And we're talking about the goods side of it, right? So there's that give and take across the board.

Phil: And it's something we have to all—I have to remind myself of this. When we're talking about tariffs, we're most often talking about goods. I understand some goods inflation could find its way into services. But the majority of what we spend on, which has changed through time, by the way, the majority of what we spend on is services. If services inflation is contained, overall inflation is going to be somewhat contained—even if certain goods are costing more.

Brent: Yes.

Phil: So something we've talked a lot about—and we recently received updated data—is "Okay, if the consumer is spending, something we've shown, you know, why is there so much frustration?" I sense it on the road. And the real answer is that it just depends on your income level, sadly, right? So one, if you look overall, that's the dashed line here. This is real spending. So adjusted for inflation, right? So we're taking out the impact of terrible inflation in recent years.

Brent: Including services, so it's goods and services.

Phil: This is everything. Overall, spending has risen in real terms, inflation adjusted. But you'll notice it's really pulled higher by that high-income bracket. Middle income also, at least recently, has seen recovery above the 2022 level.

But low income, yes, it has risen recently, but still basically flat with where you were a few years ago. So lower-income folks have not been able to increase their spending, adjusted for inflation. Of course, they're spending more because there's so much inflation. So, yes, when you look at the aggregate data, it looks pretty good. The details, though, do concern us, and we're seeing that play out in some data.

Brent: A hundred percent. And here's the darker side of that spending. And what we're looking at here is 90-day credit card delinquency rate. But before we even focus on that, you and I have showed slides as it relates to credit card usage and sort of that incredible increase that we saw in aggregate credit card usage. Now when you think about—

Phil: When inflation spikes.

Brent: When inflation spikes.

Phil: So if you live paycheck to paycheck, inflation spikes a few years ago sharply, what do you do? You access your credit card. And we did see that happen.

Brent: Yeah. And if your real wages haven't kept up with the prices, right, you start using your credit card. And where we are right now is we're seeing credit card delinquencies, near the highest rate that we've seen in quite a while, matching where we were kind of pre-Great Financial Crisis where you had that aftershock post the recession for the Great Financial Crisis where you had the unemployment rate was higher, labor market was not in great shape, and people were using their credit cards. So we're almost back at that point again. So we are starting to see signs of strain for consumers and their spending and their ability to continue to spend.

Phil: And really the key component there is the labor market, right?

Brent: Exactly. And you and I talk about it. If there is one statistic that we kind of tie to the health of the overall economy is the labor market and the consumer, right? Because 68% of Real GDP is consumption. Other 4% is housing. So a full 72% goes as consumers go. And if you have a job, you'll be able to actually spend. If you don't have a job, the likelihood that you'll be able to spend is far less.

And what we're looking at here is a 3-month moving average of jobs created. And you can see that red line is sort of that baseline to kind of keep U3 unemployment from rising higher. And you can see their trajectory on the far right here. And what's interesting is that those light blue bars where the report—pre-August 1st, right? We thought job creation was much higher than it actually was. Once that significant revision came in, the 3-month moving average of job creation has fallen all the way down to 35,000 jobs.

That is way below the level necessary to keep the unemployment rate from moving higher. So, again, we're going to get another report soon in September. We'll see what that actually looks like—certainly something the Fed will be focusing on. Dual mandate: price stability and full employment. We'll see how that affects monetary policy in September and beyond.

Phil: And to be clear, knowing what we know now in terms of the labor market, unless something changes dramatically in the coming report in September, the Fed definitely has room to cut. This is a real problem. So let's turn to the market. What are we seeing there? Not a problem. What we are seeing is really a incredible rise. So let's focus on US equities first.

Remember, we had the 19% drawdown from February 19th through April 8th. Since that previous all-time high, February 19th, the market is now up 5.6% from that level.

Year to date, it's up 10.6%. Again, there are a lot of concerns, but fundamentals—especially among very large companies, which drive much of the market—are still quite good. International developed, even better, up 25%. EM, emerging markets, I should say, up 20%. Aggregate fixed income is having a great period. Why? We'll talk about this more later. There's total return.

Brent: That's right.

Phil: Right? Municipal bonds, basically flat on the year, have lagged—

Brent: It's more technical. There's some supply issues. There's a lot that's come to market, more that's going to come in the second half. We believe that's sort of a temporary technical thing and, you know, prices should ultimately reflect the implied yield.

Phil: And some of that supply coming in the market, correct me if I'm wrong, is questions around federal funding, right?

Brent: Hundred percent.

Phil: So get your supply, get your bonds issued now—

Brent: Get ahead of what might be happening, absolutely.

Phil: Yeah, exactly. Just a little reminder history lesson. Since October of 2022, which remember we had 25% drawdown in 2022—feels like ancient history. The market is now up 89%. So to say that we haven't come a long ways, we certainly have. And you can see there that 19% drawdown, and the fact that we're trading near all-time highs.

Brent: One of the byproducts, Phil, of that 30% run up from April 9th to today is valuations, right? So while we talk about corporate earnings and profitability have been fundamentally robust, the equity market has risen faster than earnings at this point.

And what we're looking at here is the next-12 months, price-to-earnings ratio. So what that means in English is what is an investor willing to pay for the next-12 months of earnings, right? So when you think about where we are right now, we are sitting at one of the highest levels that we've seen post the COVID pandemic, right? So when you think about where valuations are, they are a little extended, by and large.

Phil: It's an expensive market.

Brent: It's an expensive market across the board. Again, but what's really important is while valuations are a key long-term metric, they are not a very good indicator of short- to intermediate-term performance. So I don't want our listeners to correlate where valuations are today and the immediate impact on the equity market over the next 3 months, 6 months or 12 months. It doesn't really work that way.

Phil: Yeah. Well, you'll hear folks say the market is expensive or cheap versus the average. But look how seldom the market trades at the average P/E ratio. The truth is it can stay cheap for a long period.

Brent: That's right.

Phil: And it can stay expensive for a long period. So it doesn't tell you much about tomorrow, but it does tell you that, "Hey the market's certainly not on sale."

Brent: That's right.

Phil: It's an expensive market. But there's some fundamentals potentially backing that valuation.

Brent: Yeah. And just like we talk about, Phil, the labor market being the linchpin for the broader economy, corporate earnings and profitability, revenues, margins are the backbone of this equity market rally that we've seen. And we've said that time and time again. So where are we right now?

The estimate for this full year, as we covered earlier, is sitting at about 10.3%. This second quarter, which just ended, was a solid quarter. We ended up at about 11.8% year-over-year growth for the quarter. The estimate back in June thirty was 4.9%. You had 81% of companies beat on earnings and revenue. So you had a very, very solid corporate earnings quarter.

Phil: So, yes, the biggest companies are pulling us higher, but there were a lot of companies outperforming contained expectations.

Brent: Yeah, and where are expectations for next year? Sitting at a still lofty 13.3%. Again, time will tell whether or not that gets revised down, but whether it's 10.3%, 13.3%—relative to the long-term average—significantly higher. And I thought what was a very interesting callout in analyst calls for the second quarter is 87% of companies have reduced their mention of recessions in the second quarter analyst calls versus the first quarter.

So that slide that you covered as it relates to recession probability, it's being supported by what corporations are actually saying in their analyst calls.

Phil: You're getting the sense that, yes, there was distortion in the spring. Folks in management trying to figure out the impact of tariffs and trade wars. But you're starting to get the sense, particularly service-oriented companies, they're getting back to work. And there might have been a pause, but business is getting done.

Brent: And real quickly, the next-12 months operating margins and, again, operating margins are highly correlated to multiples, right?

So, again, look at where we are. Again, this isn't trailing. This is the next-12 months estimate of operating margin sitting at 17.9%. So, again, the estimate where we had bottomed out earlier is continuing to rise, which is a great sign.

Phil: Yeah, you're near all-time highs. You saw a little tick down with concerns around trade, but we're back to near all-time highs. If the question is, "Why is the market expensive?" I would point to this chart.

Brent: The fundamentals are there.

Phil: The fundamentals are there. Doesn't mean the market can't see volatility, but the fundamentals are there. And speaking of those fundamentals, you are seeing upward revisions, right? This is just showing a 3-month average of revisions to S&P 500 earnings.

We saw a big takedown in the spring because there's so much uncertainty. And if you're an analyst covering a company, you're trying to understand "Over 100% tariffs on China, what does this mean?" Well, we have a little bit more certainty now. Our revisions have recovered sharply. So fundamentals are there, and I think it really helps to explain the market's performance year to date.

What about our price target? We update this every quarter or so. We are upping our price target. This is a forward 12-month price target on the S&P 500 to 6,800. That's up 5.5% to 6% from where we closed on August 25th.

The truth is when you look at the—and I won't go through the details of what we do—but we look at earnings, what they are next-12 months and also months 13 to 24 and multiple. And really the truth is those upward revisions and bringing in another quarter of data as time moves forward brought our numbers home.

Brent: Exactly. We aren't just, you know, wetting our finger, holding in the air, and just saying, "Hey, because of the momentum in the market, we're raising our price target." No, this is the fundamental side of expected earnings as we roll to that next quarter is really driving that.

Phil: And we saw upward revisions to quarters coming as we showed in the previous slide. So we're upping to 6,800. I kind of describe that as a cautiously optimistic price target, Brent. It's not up in a straight line. We've talked about volatility. We've seen some bumps in August, but the market continues to recover. We're entering a seasonal period where sometimes the market throws a bit of a fit. That's okay.

That's why our price target is up, mid- to upper-single digits versus a dramatic move. Another thing I would point out is we still have asymmetry between our bear and bull case. There is more downside to the bear. The upside is the bull. Why is that? A lot of that is valuation.

It's an expensive market, right? So for us, when we run our numbers, that is what we get in terms of bear and bull case. Bear case, of course, is recessionary-type scenario. Bull case would be analysts are way too conservative, and we see really dramatic earnings growth.

Brent: So let's shift gears away from equities, and let's talk about the fixed-income market. Let's look at the Treasury yield curve. The dark blue line here is where we were at the beginning of the year. The gold line is where we are now.

And what you can see very, very clearly is inside of 10 years, we sort of call that the belly of the curve—so we're thinking that 2 years through 7 years is really the belly—we've seen yields fall pretty significantly relative to where we were at the end of last year.

And, again, when yields fall, bond prices go up. So we've seen a steepening of the yield curve. What's very interesting is that when I look at 20 years and 30 years, we've had little to no movement over the—I mean, we've had some volatility.

Phil: Right.

Brent: But by and large, relative to where we started the year, we have seen very little movement on the longer end of the curve, which is more of a referendum on the secular fiscal policies in our country. We see that not just in the United States, but outside the United States. We've seen yields in the long end of the curve move, whether we're looking at, you know, broad Eurozone, UK, Japan, et cetera, et cetera, Germany, we've seen yields higher on the longer end of the curve, which is a broader referendum on fiscal policy globally.

Phil: And inflation expectations. There's a lot that feeds into that term premium.

Brent: Inflation expectations, all of that. Where we look at the very short end of the curve, right? We talked about monetary policy, where we go from there. We would expect that those yields ultimately do come down as we start to cut rates here. The magnitude of the cuts will drive where this goes. And remember, market participants set the yields in the market, not the Fed, right?

We'll follow monetary policy, but again, you have market participants that are buying and selling that actually drive this. But, again, a continued steepening in the yield curve.

Phil: Yeah. There's certainly an argument that the front end or those short-term rates come down as the Fed cuts, of course, things like the 1-month or 3-month, all the way out to the 1-year. But there's also an argument that those longer-term rates don't move that much, which unfortunately is not good news for those waiting for mortgage rates to fall, for example. But there's a lot that goes into those long-term rates that is not just the Fed's overnight rate.

Brent: The Fed's not controlling the 10-year Treasury.

Phil: They are not.

Brent: Right, market participants are. So let's look across various other fixed-income sectors here, Phil. And you and I have talked about this for a while now. The yield to worst, which is nothing more than that yield to maturity adjusted for the optionality of some of these bonds, is a great indicator of forward expected returns, right? Because most of the returns of fixed income are compartmentalized inside of the coupon that you get within that individual bond.

So as you run your eyes down the list, let's look at the broad US taxable, Aggregate Bond Index, right? 4.5% is significantly higher than where we were 18 months ago, 24 months ago. And I run my eyes down the page. Municipal bonds sitting at 3.9%. And the 35% tax bracket, that's a 6% tax equivalent yield. If you're in the highest tax bracket, 37% plus 3.8% Medicare surcharge, you're at about 6.6% yield tax equivalent for municipal bonds.

Even something like investment grade corporates at almost 5% and high yield at 7% is pretty darn good relative to the expected return over the next 5 to 10 years for US equities, right? So balance in portfolios, we think, is going to matter over the next 5 to 10 years. And, again, fixed income is offering a very good entry point.

Phil: Much more viable asset class than it was when the 10-year Treasury was at 1% or sub-1% in 2020. Now there is yield to be had. And speaking to that point, Kyle Murphy, one of our colleagues, did some analytical work for us on if you look at the aggregate bond yield, right? So what is that yield in a given moment? Yield to worst as we were just mentioning.

Is that a predictor of forward return? How much return capture is there? When I say forward return, this is total returns. This is your coupon and any price change. And what you'll notice is yield to worst through time, of course, was much higher in the early 1990s. And if we took this back to the 1980s—

Brent: I'd love to get an 8.5% yield to worst.

Phil: There was inflation, though, you have to remember that.

Brent: That's true.

Phil: But what you'll notice is most of these blue dots are around the yield to worst, right, over the duration of the aggregate bond at that moment. So let's say the duration's 5 years—5% at 5 years. How much of that did you capture? What you'll notice is you capture either more of it, right, above 100% with those dots above the gold bars here or around the direct capture, right?

Brent: It's a pretty good indicator.

Phil: What the exceptions are that 2017, 2018, 2019. Well, why is that? Because you had two of the worst years in the early 2020s in the Aggregate Bond Index that pulled down that forward return. But that is the historical exception. What you'll notice here is generally when yields are at these levels, your forward return—yield is a pretty good predictor of forward return.

Brent: Yeah. And you'll see, and we don't have it here, but you've seen significant duration extension. Like if I looked at the duration of the Ag Bond back in the early 1990s, it was significantly less than the 6.3 years that it is right now. So if you think about where we are and the reasons why those three blue dots are below the yield to worse is obviously the inflation environment that we had. The significant hiking cycle, which was the most significant in a long time.

Phil: And rates moving up very rapidly.

Brent: Rates moving rapidly, right. So, again, you have to ask yourself, "Where am I today in the cycle? Are rates going higher or are they going lower?" And, again, not over the next 3 months, 6 months, or 12 months—over the duration of that holding. So, again, the duration of the bond right now is about 6.3 years. So what are we likely to see from a rate-trajectory perspective over the next 6.3 years? Time will tell. But by and large, we believe that the starting yield to worst is a very good indicator of your expected total return over that duration horizon.

Phil: So we can't talk about term premiums—we showed the yield curve, the idea that longer-term rates have been pretty anchored. And look, the Fed cut last year and long-term rates rose, didn't fall. Well, what is in the term premium, right? And all term premium is is a fancy way of saying "What do investors demand, in terms of yield, for longer duration bonds for that term they own it?"

Well, a big factor, of course, is the federal budget deficit. Here, these numbers are negative. Why is that? We've run a deficit pretty consistently with one exception in the late 1990s. And then we're showing the average deficit by decade, right? And what you'll notice is in recent decades, it's been a lot higher, right?

And the forecast here, which of course is just a forecast, the numbers can change dramatically. But the forecast is that deficits persist. And, of course, when you're running a deficit, that continues to grow the debt of our economy, assuming this number remains negative.

Brent: Yeah. And, you know, we've run deficits for a long time. I think the important thing is that making sure that as we continue to finance that shortfall. So in essence, what this is effectively telling you, if you think about this relative to your own personal budget—I'm spending more than I'm bringing in, perpetually, right? So at the end of the day, having to finance, to your point, raises the debt. But most importantly, we have to make sure that the underlying implicit-financing cost stays in a reasonable range.

And certainly with yields and rates higher, a significant amount of debt being financed, the underlying cost of interest expense as a percentage of our fiscal deficit continues to rise, and it's at a pretty significant level—something that we're going to be watching to make sure that at the end of the day, it's manageable.

But the problem is when you have a huge amount of debt, even if rates fall, mathematically you still have a very large amount of nominal interest expense relative to that fiscal expenditure. So, unfortunately, it's like having a big credit card bill. Even if your rates go down, you're still underwater.

Phil: Yeah, this remain remains a challenge, and the way it plays into the economy is keeping rates higher, which, of course, impacts borrowers.

Brent: So you and I have been getting a lot of questions because the market is just ripping. "Hey, Phil. Hey, Brent. Should I step out of the market? Do I need to change my allocation? Should I maybe time things a little bit here? Because you talked about valuations being lofty, et cetera, et cetera."

So this is one of our favorite slides. So what we are looking at is investing $10,000 over a 30-year period of time, right? So January of 1995 all the way through December of 2024. And, effectively, you are looking at a total of roughly 250 trading days in a given year, right, times 30 years. That's about 7,500 trading days. So if you did put a hypothetical $10,000, Phil, into the S&P 500 over those 30 years, and you went fishing for 30 years and you didn't even look at it, your $10,000 would grow more than 13x to $131,000. That's just incredible growth.

If you look at that next bar to the right, if you missed only 5 of the best days out of those 7,500 trading days, you had 37% less dollars. If—God forbid—you missed 10 of those 7,500 best trading days, right, you would basically have 54% less. So you might ask yourself, "Well, what's the probability of me missing some of the best days?"

Look at the box on the right. 48% of the S&P 500's best days occurred during a recession. Another 28% of the S&P 500's best days occurred in the first 2 months of a bull market when no one knew it was a bull market.

So a full 76% of the S&P 500's best days occurred when you'd never want to be an equity investor. And if I tie all this back to what we just went through—here's a great real-world example of volatility clustering. We had a 10.5% drop this year on April 3rd and April 4th, followed up by a 9.5% move on April 9th.

Phil: Up.

Brent: Up. Right. So you've had an incredible drop followed up by one of the best days that we've seen in 30 years. So, again, time in the market, not timing the market is what accretes to long-term value over time.

Phil: Yeah. If you missed April 9th, the 9.5% rally, that's a good year of return that you missed. And it really is a great reminder that it's very difficult, if not impossible, to time markets.

Brent: So, Amy, I can see we have an awful lot of questions in the queue. Why don't we turn it over to Q&A?

Amy: Well, thank you both for taking a deep dive into markets and the economy. If you found this information helpful, I just want to take a quick second to remind you that we do have a subscription where you can get all of this information sent directly to your inbox, multiple publications throughout the month, and we're also available on podcasts wherever you like to get your streaming.

Okay. Let's jump into questions. We did have several come in this month. Brent, one that recurred throughout the month is around tariffs, and we talked about how that's impacting inflation. But how are you thinking about that for the broader economy and market?

Brent: Yeah. It's very complicated. You've got multiple factors, right? So you have the exporter. You have the importer that's involved in that. You have the company, and then you ultimately have the consumer. So a lot of variables. At the end of the day, right, someone has to absorb the $400 billion in tariffs that have to ultimately be paid. We have seen exporters' prices come down a little bit, right? We have seen—

Phil: The foreign exporter.

Brent: The foreign exporter relative to us.

Phil: They're negotiating.

Brent: Negotiating with each other. It also is very complicated because it depends on pricing ability and pricing pressure that a big corporation could put on that exporter of the goods that they're importing.

Very complicated dynamics, but by and large, we do ultimately believe that that $400 billion has to be absorbed. So the potential for that to either reduce demand to increase the ultimate cost and prices is certainly there. But, again, I think it's going to be very idiosyncratic, company by company, and whether or not it materially hits consumers as it relates to forward aggregate prices, it's too soon.

And we certainly covered a slide in this presentation, which talks about the increase in prices that we have seen on the goods side. Doesn't affect services as much, but on the goods side. So it's a very complicated, variable equation that is ultimately going to have to be figured out. It's probably too soon to actually get to a conclusion.

Phil: And look, we've seen in survey data for certain types of companies, goods-heavy companies, we are seeing margin pressure.

Brent: Yeah, right?

Phil: But when you think about the largest companies in the S&P 500, many of them have very little tariff exposure, if any, or they have incredible pricing power. So there is a split here when you think about small businesses versus large businesses. That's something we've talked about that a small business—do they have pricing power? And do they have negotiating power with their trade partner. They may not have the same power that a massive corporation does.

So it is not all equal, but the truth is when you look at inflation data, the worst case just has not played out. And there's a few reasons. One, we mentioned that we spend more on services than goods. Two, there's negotiations happening across the border with trade partners. If you think about a large corporation that could pressure an exporter from a foreign country that helps.

And then additionally, and then something we have cited throughout the year is that US corporations are pretty dynamic. We were reminded of this during the pandemic, especially the largest corporations, have a lot of levers they can pull in terms of if you have a production facility in Asia and one in—not in the US, but North America—maybe you can shift production. So a lot of that is slow moving, but the impact is there. It's just nowhere near the impact that you might have thought on April 2nd on Liberation Day.

Brent: Yeah. I think it is interesting. I know we certainly talked about it in the corporate earnings and profitability. If you look at next-12 months operating margins sitting at 17.9%, right? The expectations that are actually coming from either analyst expectations or from the company's earnings calls themselves, it hasn't yet been a big factor to date. And, again, complex situation here. And, again, we'll have to see how this ultimately plays out, but someone will ultimately have to pay this.

Amy: And one thing that's been dominating the headlines is around Fed independence, and I think we would be remiss to not talk about that a little bit.

Phil: Yeah. We touched on, Brent touched on this. I mean, look, our view and where we come from, and I really think what the market is pricing that, yes, there's a lot of political pressure on the Fed right now, but the Fed will be independent.

To be clear, we and markets like an independent Fed. There's many examples of other countries where we don't have an independent Fed and it gets pretty ugly, particularly on the inflation front, financing deficits with inflation, et cetera. That can be a real problem. So we want an independent Fed. But when you look at the rates markets, for example, what we are not seeing is pricing that that is going to end.

We think that the Fed takes their mandate very seriously and will focus on price stability and full employment, even as you move into next year.

Amy: Brent, how should people be thinking about—obviously markets have continued to be at all-time highs—how should people be thinking about diversification in their portfolios?

Brent: Yeah. I think it's super important. I think the first thing is to make sure that you have a thoughtful financial plan, so you actually know what you're investing for, right?

So by doing that comprehensive plan, whether you're a family, whether you're a business and thinking about what your spend rate needs to be, you need to make sure you understand that first.

And then I think, for me, over the next 5 to 10 years, balance and diversification, I believe, will matter way more over the next 5 to 10 years than maybe what we've experienced over the last decade or so where we had, you know, unprecedented monetary and fiscal policy stimulus and interest rates at zero for upwards of 7 to 8 years, right? So we've had a lot of extremes that have affected market prices.

So we believe that given valuations and where things are, having diversification thoughtfully between stocks and bonds is going to matter. Having diversification inside of your equity portfolio is going to matter. And for a long time, you could flip a nickel at the S&P 500 and look like a rock star for decades. We believe that going forward over the next decade, diversification is going to matter, not just within US or international, but within the United States. Mid cap, small cap, core value is going to matter. Developed and emerging markets, having diversified exposures, ultimately, we believe will lead to better outcomes in the future.

Phil: And this year has been a reminder of that.

Brent: Yeah.

Phil: Right? We have seen diversification pay even as large-cap US was selling off. We saw things like international outperform and have outperformed year to date. Doesn't mean it's always going to work. But over the long term, it's something that we think is important not to mention fixed income, which we touched on in detail. There is just yield there. And if there's yield in fixed income, it's a more viable asset class than it was, say, leading up to the pandemic and immediately after the pandemic.

Amy: And just to be clear, our analysts aren't in the back flipping nickels and making decisions off that.

Brent: No, no, it's a much—it's a very rigorous approach that we take to building portfolios.

I mean, we develop our forward-looking capital market assumptions every single quarter for a 3-year forward look ahead, and we are dynamically making sure what you need to own, when, and how much every single quarter—doesn't mean that we trade every quarter or make changes—but we're constantly evaluating what should be in your portfolio over the next market cycle to make sure that our clients are positioned thoughtfully ahead of what might come.

Amy: Thanks for clearing that up.

Brent: Yeah.

Amy: Thank you both for answering questions. And to our listeners, thank you for trusting us to bring you this information. It's something that we never take for granted, and we will be back with you next month.

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Authors

Brent Ciliano CFA | SVP, Chief Investment Officer

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Brent.Ciliano@FirstCitizens.com | 919-716-2650

Phillip Neuhart | SVP, Director of Market & Economic Research

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Phillip.Neuhart@FirstCitizens.com | 919-716-2403

Blake Taylor | VP, Market & Economic Research Analyst

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Blake.Taylor@FirstCitizens.com | 919-716-7964

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