If you had told anyone following financial market trends on April 2 this year that by September just about any asset class under the sun would be basking in positive returns for the year, they would have called you crazy. But the doom and gloom of the “liberation day” tariff announcement quickly dissipated, and since then the markets have learned to take each and every curve ball thrown their way in stride, shrugging off any longer-term implications while reveling in the joys of a short-term sugar rush. Everything from gold to emerging market and European equities to our own S&P 500 is up double digits, and even the once-jittery bond market has settled into a comfortable place with prices up low to mid-single digits across a spectrum of credit risk. It’s a year for the Pollyannas of the world. And that sugar rush may have a ways to go before it ends.

Party Like It’s 2021

It wasn’t all that long ago that we had a similar dynamic. 2021 was the year of the “everything rally,” the year when the punters of the world united to pump up the prices of dubious stocks like GameStop while loading up on all things crypto and outbidding each other for “unique” digital images of primates in various postures of ennui. The fun back then ended, of course, when the Fed took away the punchbowl of zero-level interest rates and began its extensive monetary tightening program in early 2022.

Interest rates are still high relative to where they were in 2021, but that may be about to change in a way that gives this year’s everything-goes rally another burst of upward movement. The Federal Open Market Committee will meet next week, and investors are all but certain that, come 2:00 pm Eastern time next Wednesday, the Fed funds target rate will drop by 0.25 percent. The FOMC has three more meetings this year (including next week’s), and prediction markets have pegged a rate cut for each of those meetings, having the Fed funds rate end the year 0.75 percent lower than where it is today. Couple that with the frequent impulse for markets to rise during the holiday season, and it’s not hard to see why pundits from a number of corners are furiously raising their estimates for risk-asset performance between now and New Year’s Eve.

Reality Bites Back (Sometime, Probably)

A rationally-minded person might ask why all this good cheer is happening at a time when there doesn’t seem to be much in the way of good news out there. The labor market is in a clear slowdown phase, and this week we learned that the BLS jobs numbers reported for the twelve months between March 2024 and March 2025 were revised down by 911,000 – that’s roughly 75,000 fewer payroll gains over that period than previously reported. Also this week, we saw that inflation is not showing much sign of trending down. Year-on-year core inflation (measured by the Consumer Price Index) is up 3.1 percent. Grocery prices, which don’t show up in the core inflation number but which very much do show up in household budgets, rose by 0.6 percent in the month of August alone. The effect of tariffs as a sales tax on consumers is showing up in an ever-widening array of goods and services.

The stickiness of inflation complicates the Fed’s interest rate calculus, but the central bank has been clear in recent messaging that current concerns are tilted towards the jobs side of its dual mandate. So while the market is probably right that rate cuts are coming, they will be coming with plenty of attendant concerns about future developments. Several FOMC members have expressed confidence that inflation will level off and subside after one or two months of tariff-related increases, so job number one is making sure that employment conditions don’t venture far enough south to push the economy into recession territory. Maybe they’re right – and we can see a world in which markets continue to buy into this worldview for some time to come. But reality has a way of biting back, sooner or later. In our view, this is a time neither for overly defensive pessimism nor excessive optimism.

Bonds were all anyone in financial circles could talk about as the post-Labor Day market cranked into gear. The US 30-year Treasury bond was nudging five percent, while UK gilt yields soared past levels last seen in the late 1990s. Stagflation-induced bond weakness was topic number one as the customary Brady Bunch-like panels of talking heads gabbed on CNBC and Bloomberg News. What was the Fed going to do – even if it were to manage to remain independent – when its two tasks of maintaining stable prices and promoting maximum employment were in direct conflict with each other?

Labor Pains

With today’s jobs report from the Bureau of Labor Statistics, we probably have a solid answer to that last question, at least for the near term. The August employment numbers validated the sharp downward trend seen in the July report – yes, the one that came out just one month ago with numbers grim enough to put the agency’s head in the crosshairs of a displeased White House (sadly for the administration’s spinmeisters, there is no BLS head available for them to fire this month). In fact, the previous report looks even worse now, with a net negative revision to the June and July numbers. For the month of August, nonfarm payrolls grew by just 22,000 (versus economists’ forecasts of 77,000) and the unemployment rate crept up to 4.3 percent, its highest level since 2021.

The weak jobs report increases the likelihood of a Fed funds rate cut when the Federal Open Market Committee meets the week after next. Market observers see a 0.25 percent rate cut as a near-certainty, barring an unexpectedly red hot inflation print when the Consumer Price Index report comes out next Thursday. And that, in turn, has taken the edge off the bond market mini-freak out earlier this week. Yields have come down across the full spectrum of maturities, with the 2-year Treasury yield now below 3.5 percent, the 10-year at 4.08 percent and the 30-year long bond dropping down below 4.8 percent after that dalliance with five percent earlier in the week. Stock markets are getting an injection of rate cut-driven animal spirits as well, with the S&P 500 up half a percent just after today’s market open

Yes, But Stagflation

The short-term palliative of rate cuts may not last for long. We won’t have a full inflation picture until next week’s CPI and PPI reports come out, but last Friday’s Personal Consumption Expenditures report (the inflation number most closely watched by the Fed) showed core PCE ticking up to 2.9 percent, still far away from the Fed’s two percent target rate. As consumer-facing companies wrap up their second quarter earnings reports, more and more of them are affirming that the days of finagling supply chains and inventory levels are coming to an end. Consumers will be seeing more of the higher costs brought about by tariffs, and may finally understand that tariffs are, in effect, a sales tax.

So despite the late-week reprieve in yields, we will not be surprised to see the 30-year bond head back up towards five percent and perhaps wind up on the other side of that round number threshold. Of still greater concern is that this trend is happening at the same time that the US dollar is weakening against other currencies. One of the most dependable trends in financial markets over the years has been the positive correlation between the dollar and the long bond yield. The April 2 tariff announcement broke that trend, and it hasn’t recovered since.

Normally, rising yields on what is supposed to be the world’s safest asset makes that asset more attractive and thus boosts the value of the dollar as investors pile in. A weak dollar, on the other hand, suggests that the brand value of that “world’s safest asset” nomenclature is not what it used to be, and the potential for stagflation threatens to push yields even higher. A cut to the Fed funds rate – or even successive cuts as the more dovish FOMC members want to see – is not by itself going to offset the threats to long-term yields brought into the spotlight earlier this week. Caution remains the watchword when it comes to long duration exposures.

The gold bugs are one of the more colorful subcultures among the sprawling highways and byways of global financial markets. Mind you, investing in gold returns nothing to its buyers other than the hope that the price will go up as opposed to down. No dividends, no interest coupons to clip, no other sources of periodic cash flows delivered to your account. Just a promise based on the storied history of thousands of years as a sought-after decorative commodity and the lingering aura of the time, a century and more ago, when nearly all the principal national currencies of the world were bound together in the tough-love strictures of the international gold standard. The precious metal continues to fascinate and beguile, while those campy, over the top ads on late-night cable TV can elicit scorn or condescending amusement from smart money sophisticates. Or so it was, anyway, before the gold bugs saw the value of their holdings jump by more than 30 percent in this year alone. 80 percent over the past two years. Take that, smart money types!

The Stagflation Trade

While gold has been steadily rising over the course of the year, the US dollar has been falling. This is a trade we have seen before, back in the stagflation era of the 1970s. Higher potential inflation coupled with anemic growth lessens the attraction of dollar-denominated assets, while investors latch onto the scarcity characteristics of gold and other precious metals.

The stagflation trade has been running somewhat ahead of the data, though. A scan of the headline macro numbers early in the third quarter did not scream “stagflation.” Real GDP growth for the prior quarter was over three percent, with continued resilience from the all-important consumer spending component. Inflation was not trending notably higher, despite persistent concerns about the effect of the ever-changing tariff regime. Employment trends were steady from month to month. Private sector investment was growing on the back of the billions of dollars of capital expenditures going into AI infrastructure. And why invest in gold, anyway, when intermediate-term fixed income instruments continued to offer attractive real interest rates?

The numbers tell a somewhat different story today. Somewhat different, not radically different. The labor market is showing clear signs of weakness, based on below-forecast payroll growth numbers for July and sharp downward revisions for the prior two months. Inflation, while by no means out of control, has been creeping up slowly. Today’s Personal Consumption Expenditures report from the Bureau of Economic Analysis showed that core PCE (the metric preferred by the Fed in its inflation deliberations) rose by 0.3 percent in July for a 2.9 percent year-on-year gain – higher than the previous month and moving in the wrong direction away from the Fed’s two percent target rate. We won’t know the Q3 GDP numbers until mid-October, but the current consensus average from Blue Chip Economic Indicators has real growth for the quarter coming in below one percent.

Diversification Alternatives

What concerns us most, when we look at the above chart, is the trend of the dollar. Our portfolios, rationally, have a high concentration of dollar-denominated equity and fixed income assets. Now, there is always room for a certain amount of exposure to alternative assets, including commodities such as precious metals, as conditions warrant. But the majority of our holdings are always going to be in the equity and fixed income categories, so that is where the main action is going to be as we model out scenarios that include the possibility for an extended period of stagflation. As we see the global economy evolving to a more multipolar and less US-dominated future, the logical strategy would seem to call for more diversification among assets denominated in other major currencies. This is a theme we will be coming back to on a regular basis in the coming months. We will not be surprised to see that dollar index trend lower as we head into 2026.

Stop us if you’ve heard this one before. The whole investor world is piling into stocks with a hot AI story to tell, driving prices into the stratosphere. Then, out of nowhere, something comes along – a research piece, an offhand comment by someone at the center of the AI universe – that pours cold water over the bullish vibes. Suddenly, everyone is talking up “rotation” and “equal-weighted index” and running as fast as their little legs will take them away from all things AI.

The Rotations That Weren’t

Well, we have arrived at the midsummer-2025 version of this dance, thanks to the combined jab-cross effect of a recent study conducted by a team of researchers at the Massachusetts Institute of Technology and some out-loud musings by Sam Altman, the head of OpenAI. We’ll get to the gist of what these deliveries had to say in a moment; first, though, let’s do a quick review of bygone Cassandras signaling the apparent end of the AI narrative.

Just about one year ago it was a research piece by Goldman Sachs that dared to ask the question: what is all this $1 trillion in AI capital expenditure actually going to do? The point being made was that all that money going into sprawling data centers and voracious large language modules had yet to prove the existence of profitable use cases to justify the outlays. AI stocks pulled back sharply, CNBC pundits announced the dawn of the rotation into value stocks, and then…the rotation fizzled, nobody came up with a more compelling narrative for the market, and everyone went back to buying AI names.

The next head-fake came at the beginning of this year in the form of DeepSeek, the Chinese AI platform that appeared to have nearly the same whiz-bang capacity as their American competitors, but at a fraction of the cost. Once again, investors ran for the hills, pundits wrote the obituaries, and then the rotation faded away. Eventually, the market talked itself into the idea that, actually, DeepSeek was more of a validator for the AI story than a detractor.

MIT and Altman Deliver a One-Two

Now we come to the present moment, on the heels of yet another long run of outperformance by the so-called Magnificent Seven and their assorted hangers-on in the AI space. This week a group of researchers affiliated with the Massachusetts Institute of Technology published a study with the conclusion that 95 percent of organizations are getting “zero return” from their generative AI investments. In other words, the MIT study seemed to validate what that Goldman Sachs research article was saying a year ago – that all the jaw-dropping sums being poured into AI were failing to demonstrate how the technology was going to make money for its users.

With the MIT study fresh off the press, investors then went back and looked at some comments made late last week by Sam Altman of OpenAI (the enterprise that gave ChatGPT to the world). Altman remarked that a bubble in AI may well be at hand and that investors had the potential to lose a lot of money before the technology lived up to its full potential (which Altman, naturally, believes is eventually going to be world-changing). Rotate into value, call the pundits, rinse and repeat.

The Innovation – Adoption Gap

One fact which has almost always been true about new technologies is that there is a window of time – sometimes a very long window – between the original innovation and its widespread adoption. The light bulb, to cite one example, was invented in 1879. Forty years later, only half of all American households were connected to the electric grid. Another example: computers didn’t start landing on the desks of office workers in any meaningful number until the early-mid 1980s. The productivity gains from automating business processes didn’t show up in macroeconomic data until the early 2000s.

It is likely that a similar innovation – adoption gap will exist between the introduction of generative AI, which happened only two and a half years ago, and its ability to demonstrate a profitable impact on enterprise functions. So-called AI agentics – the ability to leverage personnel and related expenses with scalable AI operations – are already out there, but have yet to approach any kind of critical mass.

In the meantime, though, we see no signs of any kind of let-up in the flow of investment dollars into AI infrastructure. The companies that are making these investments and own the intellectual property behind them are going to continue to have a compelling story to tell. For that reason, we imagine that the current AI freak-out is going to end the way the previous ones have. Rinse and repeat.

Well, it’s that time of the year again (seriously, how did it get to be the second half of August already?). The world’s great and good central bankers will meet, as they always do, amid the soaring peaks of the Grand Tetons that ring the posh ski resort town of Jackson Hole, Wyoming for their annual confab, ending with a much-anticipated valedictory by Fed chair Jerome Powell. The weather forecast for next week looks appropriately delightful for the bankers, with highs in the mid-80s and lows in the 40s and 50s. The intellectual atmospherics may be rather more unsettled, though. The global economy is in a very different place this year than it has been in years past. Forging a sound monetary policy, never easy in the most forgiving circumstances, is of several magnitudes more difficult when the policymakers don’t always even know the right questions to ask, let alone what the right answers might be

The Specter of Stagflation

The frothy performance of the stock market in recent weeks may have created the impression that all that worry earlier in the year about the likelihood of stagflation – the unappetizing combination of tepid growth and high inflation last endured in the 1970s – had gone away. No, it hasn’t. Two recent pieces of data illustrate why. Two weeks ago, complacency about the state of the labor market took a hit when the Friday jobs report from the Bureau of Labor Statistics revealed a sharp downturn in nonfarm payroll gains, not just for the most current month but for the prior two as well. Amid other recent signs of a slowdown in consumer spending, the continued strength of the labor market had been one of the key positive indicators. Now that is in question.

This week, from that same BLS, came two inflation reports suggesting that the long-expected effect of tariffs on prices may finally be showing up in the numbers. The Consumer Price Index, which came out on Tuesday, showed an uptick in core inflation (excluding the volatile food and energy categories) to a year-on-year rate of 3.1 percent, with notable price gains in categories with direct exposure to tariffs. Then, on Thursday, the Producer Price Index (which measures price changes among wholesalers) came in at a much hotter than expected 3.7 percent, which included a month-to-month gain in July of 0.9 percent (economists had expected the monthly gain to be just 0.2 percent).

For the Fed, with its dual mandate of stable prices and full employment, this presents a dilemma. Members of the Federal Open Market Committee have been signaling in recent days a predisposition towards a rate cut when the Committee meets next on September 16-17. Financial markets are betting heavily on a 0.25 percent cut in the Fed funds rate when that meeting concludes, which is one of the go-to explanations for the stock market’s recent giddiness. But there is a potential downside to moving ahead with successive rate cuts if inflation takes another turn upwards. The PPI can be a leading indicator for what may happen downstream (i.e., at the consumer level) in future months. There will be three more inflation reports for the FOMC to consider at the September meeting – the July Personal Consumption Expenditures index that comes out next week, and the August CPI and PPI reports next month.

Data, What Data?

Of course, we assume that there actually will be monthly inflation and jobs reports for the FOMC to consider. Going forward, though, that assumption is not as rock-solid as it has been. The CPI/PPI inflation reports and the jobs report are all under the purview of the Bureau of Labor Statistics, and that institution has found itself in the cross-hairs of political interests, with which it is entirely unfamiliar. Following that dour jobs report two weeks ago, the administration promptly announced the firing of the BLS commissioner (who, it should be noted, has absolutely no role in the actual work of conducting the work that lead to the production of the numbers in the report) and proposed replacing her with someone whose candidacy has elicited widespread criticism across the spectrum of economic experts on the right and the left. Among the potential “reforms” to the BLS on the table, apparently, are simply doing away with the monthly reports until such time as current practices and procedures have been reviewed and revamped to something more of the administration’s liking.

We bring this up not to make a political point (which is not the purview of this commentary) but to highlight one of the new realities facing the central bankers as they get together in Wyoming next week. The bankers don’t have access to a crystal ball, and they rely on the very same data that you and I rely on to make assessments about economic conditions – including, importantly, the reports produced by the BLS, the Bureau of Economic Analysis (where the PCE inflation report and the GDP numbers, among other data points, reside) and others. Independent, statistically robust and reliable information is key to the formation of monetary policy. It shouldn’t have to be something that weighs on the minds of Powell and his colleagues next week – but it will no doubt be a topic of discussion as they countenance the many challenges arrayed in front of them.

The US stock market’s performance since the dark days of April has truly been something to behold. On April 8 the S&P 500 had fallen by 18.9 percent from its previous record high, set on February 19. On April 9, of course, the Trump administration punted its “Liberation Day” tariff plans three months down the road, and the markets took off. By the time that three-month pause came due, on August 1, the blue chip index had risen almost 28 percent from the April 8 low. Good times, if they can be maintained.

What About the Denominator?

But with that stellar price performance comes the usual scrutiny about valuations. This time, the scrutiny is particularly warranted, because valuations by some measures are probing fresh new nosebleed territory. Consider one measure, price to sales (P/S). We tend to like sales as a denominator for valuation ratios versus the more widely used price to earnings (P/E), for the simple reason that there is less room for distortion and accounting chicanery at the top line of the income statement versus the bottom line. So let’s look at the forward (next twelve months) price to sales ratio for the S&P 500, going back a quarter century, all the way back to the peak of dotcom mania at the end of 1999.

On average, investors on August 1 were willing to pay $3.08 on average for every dollar of a company’s revenue, slightly more than the $3.06 they were happy to fork over in early 2000, when the stock market crested ahead of its long, three-year slide during which the S&P 500 lost 49 percent from peak to trough.

Now, before anyone asks, we’re not here to say that history is about to repeat itself. Markets, and history generally, don’t work that way. Still, that is a milestone worth thinking about. The forward P/E ratio, which is what we are looking at here, represents the consensus forecasts of securities research analysts who cover these companies. The forward outlook today is better than it was three months ago; based on the current consensus among analysts covered by FactSet, a market research and analytics company, the outlook for second quarter sales is almost a full percentage point higher than it was four months ago. But those estimates can always change – and as we noted in our commentary last week, the economic picture for the remainder of the year continues to present more questions than answers.

Then there is the Shiller CAPE – the Cyclically Adjusted P/E ratio developed by Yale economist Robert Shiller that presents average real earnings over a ten-year period to smooth out the fluctuations and vagaries of shorter term figures.

The current CAPE ratio of 37.8 is not as high as it was in 2000, when it neared 45. But it is still higher than at any other time since 1881, including the three major earlier secular bull markets that peaked in 1901, 1929 and 1966 respectively.

The Staying Power of Irrational Exuberance

As the time-tested saying goes, the market can stay irrational longer than you can stay solvent. Neither the CAPE nor, for that matter, any other valuation metric has ever been a reliable gauge for timing when to get out of the market and when to double down. The same is true today. The fact that prices are by some measures (e.g., sales) higher than they were at the peak of dot-com mania does not mean that they are due for a crash tomorrow.

In fact, the main driver of US stock price performance for the past couple months is largely the same one that has been driving price performance since the beginning of 2023: the AI narrative. The top two companies in the S&P 500 by market capitalization, Nvidia and Microsoft, make up fifteen percent of the total market cap for the index. The top eight companies, which include the aforementioned two plus Apple, Amazon, Meta Platforms, Broadcom, Alphabet and Tesla, account for 34 percent of total market cap, and all of them in one way or another represent a facet of the AI story. Debates about the practical role of artificial intelligence in the economy versus the theories and the hype abound, but so far the story has weathered a considerable amount of scrutiny without experiencing anything close to a knockout punch.

What investors can do, and what we have been sharing as strategic thinking with our clients this year, is to diversify exposure to US large cap equities away from levels that may have been prudent two years ago but are (in our opinion) less certain today. Non-US asset classes, both equities and fixed income, deserve closer consideration. So, to, do certain nontraditional asset classes. Trying to time the inflection points is a fool’s errand. Patient and careful diversification, we believe, is a better approach for the long term.

This week has been witness to a veritable inundation of data, including headline macroeconomic reports on jobs, inflation and GDP, another pause decision on interest rates by the Fed, and a bevy of corporate earnings reports of which the top-line message seems to be that nothing is going to stand in the way of the AI narrative and its attendant tsunami of capital spending. Financial markets have powered through this onslaught of numbers with their usual nonchalance – the S&P 500 and Nasdaq stock indexes adding to their record high count, and interest rates mostly staying put around recent averages. Retail investors have poured record amounts of money into equities; among other things, reviving the silliness of the meme stock frenzy that raged through the surreal summer months of 2021.

We’ll have more to say about the stock market and its potentially concerning frothiness in next week’s commentary. Today, though, we try to wade through and make sense of this week’s sea of data. That will be easier said than done.

The Growth Question

Let’s start with the GDP numbers. On Wednesday, we learned that real GDP growth for the second quarter was up by 3.0 percent on an annualized basis, a nice pickup from the slightly negative first quarter and comfortably ahead of economists’ expectations. Upon closer scrutiny, however, the second quarter numbers were distorted by a near mirror image of the factors skewing the first quarter results, all having to do with imports and exports.

The GDP math for imports and exports is relatively straightforward: exports add to GDP and imports subtract from it. In the first quarter, businesses rushed to import the goods they needed before the anticipated tariffs kicked in. Imports grew at a stunning 37.9 percent for the quarter and were the primary reason for the overall Q1 contraction in GDP of minus 0.5 percent.

In the second quarter, the trend went the other way. Imports fell by 30.3 percent. Meanwhile consumer spending, which is the single largest contributor to GDP, grew by 1.4 percent, an improvement over first quarter growth of 0.5 percent. Government spending also increased slightly after falling in the first quarter. All told, the changes were enough to deliver that headline growth rate of 3.0 percent.

But the underlying trends show some cause for concern. The GDP report contains an addendum figure called, unglamorously, “final sales to private domestic purchasers.” Economists refer to this number as “core GDP” – a measure that strips out much of the noise affecting the top line. For the second quarter, core GDP by this figure was 1.2 percent – well below the average of 3.0 percent last year and the lowest since the last quarter of 2022. A slowdown trend by businesses and households alike is becoming visible.

The Fed’s Mandate-balancing Act

The GDP numbers came out Wednesday morning, as did an employment survey by ADP showing another relatively healthy month for the job market (note: we are writing this commentary before the Friday BLS jobs report that will have been published by the time you receive this). These were the final two pieces of data for the Fed to chew over before concluding its Federal Open Market Committee meeting the same afternoon. As expected, the Committee decided to hold the target Fed funds rate at the current range of 4.25 – 4.50 percent, though with two notable dissents from FOMC members Michell Bowman and Christopher Waller, both of whom were appointed during the first Trump administration and who in recent weeks have been outspoken proponents of cutting rates sooner rather than later.

The Fed’s dual mandate is to maintain stable prices while seeking full employment in the economy. The unemployment rate has trended in a relatively tight range on either side of four percent for more than a year, a level commensurate with what most economists would consider to be full employment. Inflation, while not yet having risen by as much as some were forecasting on account of tariff increases, has meanwhile remained stuck at levels meaningfully elevated over the Fed’s 2.0 percent target. The core Personal Consumption Expenditure index, the Fed’s preferred gauge of inflation, was 2.8 percent year-on-year as of the most recent report issued this morning.

The decision to hold rates rather than cut now is, we believe, a correct assessment based on what the data are telling us today. If the employment numbers do change in a meaningfully negative way in the coming months (which was the essence of the arguments put forth by the FOMC dissenters on Wednesday), then a reassessment may be appropriate, come September, when the Committee next meets.

What does all this mean for the market? The other big news segment this week, corporate earnings with a focus on earnings from tech companies, has given a renewed upward push to valuations that have already reached the stratosphere. We’ll share our thoughts on this development in next week’s commentary. We have a lot of data to work with, but still more questions than answers.

There has been a decided thaw in the economic cold war between the US and China. Just last week, megatech chipmaker Nvidia, the first company to reach a $4 trillion market capitalization, got a boost to its already copious fortunes when the government lifted restrictions on its ability to sell its H20 chips to China. Those restrictions had previously forced the company into a $4.5 billion writedown from first quarter results.

More broadly, the lifting of export restrictions for Nvidia reflects a growing sense among investors that the bellicose rhetoric of several months ago is turning into a softer cadence of looking for dealmaking opportunities. That, in turn, is bringing back into play the question of China as an investable opportunity. Front and center in this debate is one of the year’s best-performing stock markets to date: Hong Kong.

The Window on China

Hong Kong’s role as a window on China – a proxy for those unwilling or unable to venture into the mainland itself – goes way, way back. Back to the days when multinational entrepots like Jardine Matheson and Swire’s – the historical inspirations for James Clavell’s saga “Tai Pan” – mediated between the pecuniary interests of foreign investors and the ever-changing faces of Chinese power from emperors to nationalists, red book-waving communists and Deng Xiaoping-era reformists.

That storied history has taken a hit in recent years as the heavy political hand of Beijing weighed on the freewheeling ways of the Cantonese-speaking island. But there are definite signs of a resurgence, not least of all in the form of the Hang Seng stock index thus far in 2025.

Connecting to the Mainland

What’s behind the strong performance of Hong Kong this year, and why is it outpacing mainland Chinese equity indexes, represented in the above chart by the Shenzhen A Share index (green line)? To answer this, it is worth noting that Hong Kong serves as an opportunity for investors in mainland China – both institutions and individuals – to invest in Chinese companies while avoiding the tightly-controlled domestic financial system. They can do this via a mechanism called Stock Connect. Many of the most sought-after Chinese equity names – the likes of tech giants Alibaba and Baidu – are available in Hong Kong via Stock Connect but are not quoted on mainland exchanges.

This year, over $104 billion has been invested into Hong Kong from mainland sources, more than the amount invested over the entire year last year. Perhaps unsurprisingly, this has been happening as new listings by Chinese companies in Hong Kong are also at a record: 208 companies in the first six months of 2025, making Hong Kong the largest IPO market in the world so far this year, with $13.9 billion in deal flow compared to $9.2 billion on Nasdaq, $7.8 billion on the NYSE and less than half a billion in London.

Absent at the Feast

What is missing from this picture – or at least, what is not dominating the picture so far – is meaningful investment flows from origins other than China. This goes back to that question we introduced earlier: is China investable? There have been plenty of reasons for international investors to answer that question in the negative. The Chinese economy has been in the doldrums for years now, with the chronic sickness of its all-important property market and lackluster consumer spending that keeps the economy teetering on the brink of deflation.

But there are longer-term strategic reasons to question this hitherto conventional wisdom. China has a long term strategy predicated on achieving superiority in the so-called industries of tomorrow: artificial intelligence, clean energy and biotechnology, among others. China’s carmaking industry is now world class, particularly in the electric vehicle segment where it is the number one global producer. The fortunes of leading carmaker BYD are rising as those of Tesla are falling. The export-driven economy has managed to withstand the pain inflicted by the trade war – which, as noted above, appears to be softening.

Exposure to Hong Kong equities is not particularly difficult for international investors. Exchange-traded funds like the iShares MSCI Hong Kong ETF – or the MSCI Pacific ex-Japan variant if one wants some added diversification into other regional markets (Singapore, Australia and New Zealand alongside Hong Kong) – are liquid and cost-efficient. The risks are still there, of course. But as a long-term strategy, the China case study is not without merit. Hong Kong, in its time-honored role as a window on China – is a potentially attractive way to gain a foothold.

The Federal Open Market Committee meets again on July 29-30, and the consensus expectation is that the Committee will once again hold the target Fed funds rate at the current range of 4.0 – 4.25 percent. Unlike recent decisions, though, this one may not be unanimous. A small subset of the FOMC’s twelve voting members has been quite vocal in recent weeks about the desirability of a July rate cut. Perhaps unsurprisingly, this strain of Fedspeak has played out in the context of the increasingly strident rhetoric from the White House urging (inadvisably and inappropriately) for interest rates to be slashed. To appreciate why a pause is the right move for the moment, let’s consider a forty year history of FOMC interest rate decisions and the economic conditions in which those decisions were made.

Jobs and Prices

The Fed has two jobs, made explicit in its dual mandate: stable prices and full employment. When a hot economy threatens to unleash higher inflation, it’s time to raise interest rates and cool things off. Conversely, when the unemployment rate starts to trend sharply upwards, then a policy of rate cuts is appropriate as a way to stimulate the economy and generate job growth. Simple, right? Not really. The Fed is not in possession of a crystal ball any more than you or we are. The FOMC has to work with whatever data it has to figure out how dire the situation is and when the right time is to execute the decision. As the chart below shows, however, the Committee has done a pretty good job of this over the past forty years, with each of the four major rate cut cycles coinciding with an economic recession.

Those rate cut decisions, in 1990, 2000, 2007 and 2019 respectively, look even more prescient when considered in conjunction with the employment circumstances of the time. The unemployment rate rose to a maximum level of 7.7 percent, 6.1 percent, 9.9 percent and 14.8 percent over the course of those recessions. The Fed fulfilled its mandate by following policies aimed at bringing unemployment back down (which, in each case, it did).

When the Fed Stayed Put

And then there was the case when the Fed paused. This followed the rate hikes of 1994 (which caught financial markets by surprise), when the Fed took preemptive measures to head off what it feared could be a return of higher inflation. By April of 1995 the Fed funds rate was at 6.0 percent. There was a slight uptick in unemployment a couple months later and the Fed brought rates slightly lower, similar to what the Committee did last September in easing back from the maximum range this cycle of 5.25 – 5.5 percent.

And then – nothing, for two years. In the mid-1990s unemployment continued falling, and growth perked up without an undue amount of attendant inflation. Given the data at hand, the Fed didn’t need to act again until September 1998, when the Russian debt crisis and the ensuing collapse of the Long Term Credit Management hedge fund brought fears of a systemic financial market crash (those fears proved short-lived, and the Fed resumed raising rates in 1999).

And now back to the upcoming July 30 FOMC decision. The unemployment rate is currently 4.1 percent, and it has been close to this level for several months, along with a fairly stable level of gains in nonfarm payrolls. Meanwhile, the core Consumer Price Index rate is 2.9 percent, still meaningfully above the 2.0 percent target rate. In the CPI report that came out this past Tuesday, it was possible to see incipient indications of the tariff effect on certain categories of goods such as apparel and home furnishings. The full inflationary effect of tariffs remains an unknown variable.

In terms of that dual mandate of prices and jobs, then, the data available today continue to support a strategy of “better safe than sorry.” Hold for now, and see what the price and jobs data say as the calendar heads into the next FOMC meeting in September. And please, Fed members, stay away from the toxic politics of it all.

For as long as we have been working in the financial industry, which comprises more decades than we care to let on, people have been worrying about debt and deficits. Throughout this time, though, investors the world over, institutional and individual alike, have been reliable buyers of US government debt. Deficit hawks, fretting over irresponsible Washington spending, turned out to be Cassandras endlessly predicting a financial apocalypse that never happened.

But the debt continued to grow, and so did the size of the deficit. In the 1980s the federal deficit was typically somewhere around one to two percent of GDP; today it is above six percent. In 1985, while we were all bopping out to “Wake Me Up Before You Go-Go” and knocking back Crystal Lite in our leg warmers, the total public debt was about 40 percent of GDP; today, that ratio is near a peacetime high of 120 percent. The conditions have changed, and those beaten-down deficit hawks may be on the cusp of having their told-you-so moment.

A Tale of R and g

In the world of finance, an upper cap R is the symbol for the rate of return, expressed as a yield on an investment, while g (lower cap) signifies the projected long-term growth rate. At the macroeconomic level of national output, these two terms come together in a relationship between the economic rate of growth and the cost of borrowing to obtain that growth, both adjusted for inflation. Long-term solvency is achieved by the rate of growth being higher than the rate of borrowing.

With that in mind, consider the chart below, showing the past three years of real year-on-year US GDP growth versus the yield on 10-year inflation-protected US Treasuries (TIPS).

As the chart shows, the relationship between borrowing costs and growth is extremely close, with inflation-adjusted Treasury yields slightly outpacing real growth rates. In a couple weeks we will get the first reading for third quarter GDP growth, and the current consensus among economists is for growth to be right around the same two percent (year-on-year) level as it was for the second quarter. We show this in the chart with the crimson dotted line.

The Specter of Stagflation

Why is this important? Well, it’s the same as any situation involving debt and income. If you take out a personal loan, your own household finances will be fine as long as (a) you don’t borrow an ungodly sum, and (b) your household income grows at a faster rate than what you pay in interest and principal on the loan every month. If that equation changes – if you lose your job, or your salary flatlines, or you have a variable rate of interest on the loan that suddenly shoots up – then your financial situation is precarious.

Which brings us to the question on everyone’s mind in 2025: what is going to happen to the US economy? If interest rates subside a bit and growth picks up, then the debt situation becomes more manageable. Unfortunately, that does not appear to be the likeliest scenario. The bill that made its way through Congress last week stands to add a substantial amount of debt to the national balance sheet, with an estimated $3.3 trillion addition to the deficit over the next ten years.

Meanwhile, even after backing away from the most outlandish tariffs announced back in April, the average global tariff on goods coming into the US stands at 15 percent, the highest since the Smoot-Hawley tariff era of the 1930s (never a good decade to which to be making economic comparisons). The potential for structurally higher inflation and lower growth – stagflation, in other words – is real, and the probability of this scenario coming to pass is growing by the day.

There are policy prescriptions that could make the stagflation outcome less likely, but we see no evidence of them emerging from the current batch of individuals making economic policy. As for investment portfolios, there is no perfect strategy against stagflation. But it raises the importance, in our view, of a careful and deliberate diversification, across geographies and asset classes for both equities and fixed income. The chips will fall in different ways in different places in the coming months and years. Disciplined asset allocation is about to get a lot trickier, and a lot more important.