Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Global Markets, the Markets and Financing Division of State Street. I'm your host, Tim Graf, European Head of Macro Strategy.

Each week, we bring you the latest insights and thought leadership from our award-winning suite of research, as well as the current thinking from our strategists, our traders, our business leaders, and a wide array of external experts in the markets. If you listen to us and like what you're hearing, please do subscribe, leave us a good review, get in touch with us, it all helps us improve what we hope to bring to you.

And with that, here's what's on our minds this week.

TG: Happy New Year, everyone. Welcome back to another year of Street Signals.

Now, we saw phenomenal growth in the podcast in 2024, and we're ready to make this an even better year. And next week's episode, I think, will help take us a long way there. But you'll just have to wait a few more days to hear why.

For this week, I thought it would be good to kick off the new year with a quick catch up on what has changed since our last episode in mid-December, particularly if anything has changed in terms of the message offered by our proprietary indicators of investor behavior and inflation.

And I want to come at this from the perspective of the consensus views that formed for 2025. Three of these really stood out to me. First, there's the positive outlook for risky assets, especially US equities, and within that, especially US tech equities. Specifically, I want to look at whether there are already any challenges to what is a strong consensus view that this will be another very good year for the asset class.

Also, a positive US dollar outlook was another widely held consensus view, one which we also subscribe to on the strategy team. Finally, and related to this, is the view that with the incoming Trump administration policies and the exceptionalism of the US economy still in play as drivers, rates will be higher for longer in the US and maybe elsewhere, and that these factors will also keep the dollar well supported.

So far, this is all about the US. That makes sense. US equities are about 60% of global equity market cap at this point. US Treasuries are the largest sovereign bond market out there. The dollar still maintains its dominance over all other currencies. So we're going to spend a fair bit of time on all three.

But especially where FX markets are concerned, there's the rest of the world to think about as well. So we'll finish with what the picture looks like in Europe, in the UK, and in emerging markets, particularly China. That's the plan, so here's where we're at.

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TG: The median strategist forecast for the S&P 500 is for a further rise of 10% in 2025, excluding the returns from dividends. Double-digit return forecasts are pretty rare, especially following years that also saw double-digit returns. That has happened only one other time in the last 25 years. And actually, we've had two prior years of strong double-digit performance, with returns in each of 2023 and 2024 just shy of 25 percent. So, I think it makes sense to assess how crowded equities are and if anything has changed to challenge that consensus view.

The institutional investor allocation to equities is still very large, close to the highs and at levels we saw just before the global financial crisis in 2008. And this is dominated, of course, by an overweight in the US that is also still near multi-decade highs.

But some interesting changes have actually come since we put out our year-ahead views in early December. If you go to our public website, statestreet.com, you can find a presentation from my colleague Michael Metcalf that is an monthly update of our public three I's indicators, which broadly gauge aggregate investor sentiment.

The message this month is that in December, institutions did reduce risk into year-end, although they did so in an interesting way. They moved out of bonds into cash. So, actually, the relative equity bond weight that we track actually grew this month in favor of stocks.

However, at the same time, Michael also notes that the overweight to US stocks actually dropped. This position was at a 26-year high, and it is still the largest country-level overweight we have out there by some distance. But we did see some risk reduction in US equities as December wore on.

And the underweights on the other side of this in European, Japanese, and Chinese equities, these were also paired back. So we do get a sense that investors are pairing down some of their strongest consensus positions, which is a key insight, I think, given how strong the outlook for equity markets still is for this year.

And sector-level flows are even more interesting to me and fit this pattern of risk reduction that we've seen in recent weeks. Sector positioning, to start with, is still dominated by the usual suspects. IT, communication services, and to a lesser extent, global financials are the preferred overweighs to the expense of pretty much everything else.

But flows over the last month? They've gone into health care, consumer staples, and utilities, and out of consumer discretionary stocks, energy, IT, and financials. You don't really get a more defensive flow bias than that.

So let's sum it up for equities. There's definitely evidence that institutions are finding some initial disagreements with the broad 2025 consensus of another strong tech-led rally in stocks. Obviously, it is still very early days, but the consensus positions are still very large, and the current flows are not really backing them. We don't exactly have a benign policy backdrop to think about this year, given the political realities at play. More on that in a second.

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TG: We're less than two weeks away from Donald Trump assuming the office of the presidency for a second time. Where his first term policies felt scattershot and his administration saw significant turnover even before he took office, this time around, his messaging, his priorities, and his personnel look a lot more pointed and clarified. Tariffs are likely coming soon, to a degree we don't quite know yet. With a Republican congressional majority, fiscal policy is also poised to ease and deficits to grow. Immigration policy likely has a lot of high institutional barriers to change, but let's just assume for now it won't be deflationary at the margin.

So with that in mind, the broad consensus view is that US rates are likely to stay high from here, with the Fed also signaling in December that they're basically done easing policy, and the market is fully on board with that. There's only one Fed cut fully priced between now and July. So yeah, the easing cycle is done in the market's mind.

And all of this has helped support the dollar. As a test case, you only need to look at price action on the first really liquid trading day this year, this past Monday. Reports that there were potentially less onerous tariffs coming weakened the dollar by up to 1 percent against the major currencies. But Trump's denial of those reports later in the day reversed all of that, and we saw a return to dollar strength.

So where do things stand on US rates and the dollar in our behavioral metrics? Well, positioning in Treasuries is underweight on a duration-weighted basis. But looking across the curve, this is driven entirely by the very longest maturities. There is a sizable underweight already there in the 30-year sector, but really nowhere else. In fact, you look at the other points on the curve, institutions are heavily overweight the front end and also in the 10-year bucket.

Add into that mix the fact that our online inflation metrics for the US provided to us from price stats do show some unseasonably strong inflation in December. To be fair, this happened in quite a few developed economies. In fact, the strength of online inflation in the Eurozone was even greater relative to seasonal norms. And we now know from the CPI estimates that were released for December earlier this week, that didn't materialize in the overall broader data to as great of an extent.

But the fact remains that after two years of largely normal inflation data from what we can discern online, the US price formation pattern has recently been a little bit stronger. So you take that alongside the fact that investors aren't positioned for higher rates. The possibility that the Fed might have to reverse the policy rate cuts of recent months is definitely not positioned for. That isn't the base case at this point. But it is an instance where the consensus, which is that US rates are likely biased upwards this year, is not fully positioned.

And finally, duration-weighted treasury flows are also negative, as they have been for the last six months. So there is plenty of potential for a push to higher rates, especially in the shorter and medium-term maturities.

In the dollar, there's already a very large overweight. This is in line with the consensus. It is paired most notably against the euro and emerging market currencies. And there doesn't really seem to be any interest in cutting that back yet. We did see dollar buying stop in December. There were even a couple of days of small selling. But it never turned into aggressive selling or an unwind of that position. It was just flat.

And now, actually the last few days, we see dollar buying coming back. So when it comes to consensus views, this is one that actually still does have pretty good flow backing, even if the position still is very crowded.

You add in the notion that US fundamentals still look relatively robust, monetary conditions are no longer going to be so easy, and political factors are, if anything, dollar supportive for the time being, this is one consensus view that institutions are finding it very hard to fall out of love with.

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TG: We've alluded to what's going on in other markets in the discussions of the US dollar, US rates, and US equities, but let's finish with a more specific look at what investors have been doing in other markets. In equities, the selling of the US that we capture is offset by inflows into two main regional areas. Developed European markets sees some of the buying, but actually the most noteworthy to me is probably the strong buying we see in Chinese shares.

EM equity positions have been depressed for years, and that is almost entirely a function of a complete lack of interest in Chinese equities, which are the largest market cap weight. It's still a pretty big underweight, but it is at least starting to close and flows into China remain positive over the last month. The stimulus measures that have been detailed over recent weeks and months may not yet be boosting consumer confidence, consumer demand, or sparking further loan demand. In fact, the inflation gauges we have for China via price stats suggest we only see modest reflationary pressures. But sentiment from investors does seem to be improving around Chinese assets.

EM currency positions are also a big underweight, and these have been slower to close, particularly with flows coming back into the dollar in recent days. The renminbi is one where institutions look very much at pains to buy. Even if asset sentiment has improved, currency flows are very weak, and the long-held underweight that investors have held in the renminbi doesn't look like it's going to unwind anytime soon.

There are two big other blocks of underweights out there in EM FX. The first is in European currencies, particularly the Czech crown, the Hungarian forint, and the Polish zloty. These exporters to core Europe, I think institutions are staying away from, just seeing the overall European economic outlook as still pretty bleak. There's no sign of flows coming back into those currencies.

We also see big underweights in some of last year's carry trades in EM, the Turkish lira, and the Indian rupee most notably. So far, we do see some equity market demand for Turkey, but no interest in reengaging in either currency and chasing carry in EM.

I also mentioned that Europe was seeing some of the equity flows coming out of the US. But when it comes to bond markets, that is definitely not the case. In fact, the selling of European government bonds is even stronger now than what we see in US treasuries. And this isn't just a France thing, though there's plenty of investor selling there, to be sure. It's actually more broad-based than that. And the overweight positions we capture in BTPs and in German sovereign debt look at risk just given how weak flows in those two markets especially are.

And that's also the case in the UK, where gilt flows are similarly under pressure at the moment, as they really have been for most of the time since Rachel Reeves' budget measures were announced a couple of months ago. And here again, there's room to sell. Gilt holdings are not particularly crowded on the underweight side.

The one place in fixed income where you don't really see a lot of potential for further selling might be in emerging markets where aggregate duration-weighted holdings are already underweight to a pretty strong degree. And in fact, EM inflation pressures that we capture through price stats, they don't look particularly strong. So if there are bond markets to look at on the long side, it's probably here. But just looking at flows, it's definitely not in developed markets.

And I think that is a really good thought to finish on and bring us full circle. As I mentioned at the beginning, at the very highest level, money is being reallocated within equities. We see a small reduction of the overweight in the US and the underweights elsewhere. We see a modest sector rotation away from growth into more defensive sectors. That challenges the consensus for the year, I think, and it puts some helpful context around the choppy days we've seen to start 2025.

The dollar is also a consensus risk, but this is one that institutions look pretty comfortable with. And they're already positioned for dollar strength, but unlike in equities, we don't actually see that much near-term reduction in holdings.

But it's rate markets that I think are the most interesting thing here. Because they affect the other two quite dramatically. And there's a prevailing view that rates will stay high or even push higher in the new year. And that isn't really positioned for yet. But flows are starting to move in that direction pretty strongly. And there's ample duration to sell, not least given budget deficits globally are not coming in. And in some cases, the US most notably, they have the potential to grow.

Everything falls out from there. Higher rates in the US will likely support the consensus dollar view a while longer. And keep it from slipping too much. But the implications for risky assets are another matter entirely. I think we might have a similar setup to 2022 in play when sharp rises in rates derailed the post-COVID recovery in risky assets and safe assets.

So far, the equity market has proven very resilient to the sharp rate repricing of the last four months. The biggest companies are also the best companies. So they have weathered the storm very well. But we know now that if the 2025 view on equities is to be challenged, there could be a lot more selling of both stocks and bonds to come.

But that's another story for another day, and we'll keep our eye on these themes throughout the year. Next week, we're back to our normal interview format with a really special conversation to kick things off. We'll see you then.