All-Time Why’s

Little Regard for Risk

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Soundbite: Bulls are not questioning this rally. This raises a lot of questions from our vantage point. Our Value-at-Risk tail loss measures have dropped an enormous amount (over 30%) since the April equity market lows. This is a realized volatility calculation across all the stocks in the Pave universe. Other popular indicators, such as the 12-month forward earnings yield minus the 10-year Treasury yield, hover around zero, and high yield credit spreads are tighter than at any time since the April 2 Liberation Day chaos. Bottom Line: Investors have priced out any risk cushion in stocks, meaning there is little margin for error for any negative event unfolding this year. If credit spreads widen, get defensive.

Make no mistake, the absence of an adequate equity risk premium is a red flag. Currently, investors are not worried about any downside risk and are fully focused on growth prospects. Because stocks are priced for perfection, we are hyper-focused on high yield spreads to start widening as a signal to start trimming exposures. This would be a signal that fixed income investors are getting pessimistic and demanding higher yields for riskier companies.

High yield credit spreads are now a full 1½ percentage points lower (tighter) than their April peak at the height of tariff hysteria. Now trading only 300 basis points above Treasuries, they are just 40 basis points away from the major tights struck on Trump’s November presidential win. In the bigger picture, the fact that stocks are at new highs, but credit spreads have not moved below those November lows, is itself a warning.

Given the absence of investor demand for downside protection and a vacuum in defensive positioning, July may be the month to start looking at those areas for potential bargains. The relative value of defensive sectors, Consumer Staples, Utilities and Healthcare versus the major indices is now lower than at the top of the 2000 NASDAQ bubble.

Taking our cues from other market tops, extreme complacency does not need to reverse tomorrow; it is better to wait for the bond market to start pushing up default risk levels. That will be seen in the movement of high yield spreads—track them more closely than usual.

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Second Half Outlook: Look Out?

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Soundbite: We are in the latter stages of the business cycle marked by low unemployment rates and peaking profit margins. The longer end of the bond market shows no concern over the prospect of higher Treasury supply, despite a budget deficit that is certain to expand further. We have favored a barbell strategy combining low volatility/high quality stocks with the magnificent 7 that now appears to be a consensus view. Because a top in optimism could be measured in days or weeks, not months, we are hyper-focused on potential downside triggers. This comes in the form of a contraction in the labor supply, the fact that any  tariffs not passed through will compress margins, the August Quarterly Refunding Announcement, European yields overshooting to the downside, and a host of other factors.

If you had fallen asleep from February until now, you would not think anything had happened in the U.S. stock market. That type of sharp selloff, followed by an equally dramatic rebound, can be indicative of a top, but it is not reason enough to sell everything.

However, the problems that seem to have evaporated with the dramatic equity turnaround have not gone away:

· Immigration flows will contract and be stagflationary.

· A wider deficit leading to higher treasury yields on supply concerns will result in a further widening of the deficit from a compounding interest rate expense is still a plausible scenario.

· Bank unrealized bond losses are still massive, remaining vulnerable to rising interest rates.

· The final form of tariffs is still unknown, and a New York Fed survey shows that tariffs increased firms’ costs by 20% for manufacturers and 15% for service companies. Fully passing through those costs increases the likelihood  of stagflation, and fully absorbing the tariff increases will cause margin compression.

· The August Quarterly Refunding Announcement will continue to kick the can down the road by adding more to the short-end supply against the recommendations of the Treasury Borrowing Advisory Committee.

We believe that the equity market is vulnerable to fixed income markets. Investors could be disappointed, expecting three Fed rate cuts this year and that European bonds will continue being the go-to hedge against U.S. equity downside. Europe is seen as an attractive destination, but its bond market cannot absorb massive flows out of Treasuries. We mentioned last week that Switzerland already has a negative two-year rate. If sharply declining yields occur throughout the Eurozone, investors who are now over 30% overweight their European benchmark (and over 30% underweight the U.S., according to Bank of America) are vulnerable to left-tail losses.

Everyone is looking at the disruption going on as the start of a new era of growth, but the fact is that we have the overhang of being in the latter stages of the business cycle, and profit margins are perfectly mean reverting. As we approach the peak, this seeming virtuous cycle turns vicious, so complacency is not our recommendation for H2 2025.

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Nothing Artificial About Job Cuts

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Soundbite: Forecasting the size and timing of the labor displacement caused by Artificial Intelligence was always going to be a problem. Goldman expects AI to automate one out of every four U.S. jobs and will purge 300 million jobs worldwide by 2030. McKinsey is less dramatic, but still expects 12 million American workers will need to switch jobs over those 5 years (about 8% of the workforce). These are seismic, structural shifts. We can hope that AI is merely a productivity enhancing tool, but it appears to be more of a replacement mechanism.

If consumers begin to fear a labor market that falls off a cliff, we should see consumer confidence shift lower and personal savings rates gap higher. The problem is that the economic impact can happen over time, but in the interim, the ground can shift quickly as the AI rollout occurs. For example, white-collar jobs were originally thought to be insulated, especially customer-facing roles; now that expectation has reversed.

The real source of anxiety appears to be the uncertainty surrounding the speed at which the AI implementation can occur. The recent news is unsettling, with the latest Challenger Report showing tech layoffs are up 35% from last year. Some reports show Microsoft has announced over 17,000 job cuts in the last 60 days, representing 8% of its workforce.

This is the type of problem that is similar to the immigration overhang and a 6% budget deficit forecast—clearly negative for investors, but because there is no instantaneous hit for earnings, stocks have room to frustrate the bears. However, this does not make the negatives any less authentic.

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What to Look for This Week

(All times D.S.T.)

1. Data Dump on Thursday July 3 at 8:30 a.m. June Nonfarm Payrolls including Average Hourly Earnings which has been steady at 3.9% all year, are released. Private Payrolls have been +140,000 for April and May, but are expected to fall toward +100,000 for June. We will be looking at changes in the labor pool in the Household Survey data. At the same time as payroll data, Initial and Continuing Claims are released. With that much data there is a chance for conflicting results, but if they all show weakness, it may get investors hopeful for a July FOMC rate cut.

2. Tuesday, July 1 at 10:00 a.m. May Job Openings and Labor Turnover Survey. For April, the Hires Rate rose but the Quits rate fell. For a clear signal of labor strength to support what Chairman Powell is saying about the strong employment situation, both should be rising if workers are feeling rising confidence in the job market. The latest Conference Board Survey showed that workers believed that Jobs Easy to Get vs. Jobs Harder to Get continued lower, reflecting just the opposite—the job market is getting more difficult to find employment.

Earlier Tuesday at 3:55 a.m. German June Unemployment is released. It is of note since it has been steadily rising for exactly three years and has been sitting at 6.3% in March, April and May, right against the 6.4% limit during the 2020 pandemic

3. Thursday, July 3 at 10:00 a.m. June ISM Services is released. May dropped just below 50 into contraction territory, but the real disappointment was the New Orders subcomponent, which fell from 52.3 in April to a weak 46.4 reading. The Prices subcomponent will be important to watch, especially if payrolls are weak, because last month spiked up from 60.9 in April to 68.7 in May, the highest level since November 2022.

FOMC Voters Speaking: Monday, June 30 at 1:00 p.m., Chicago Fed President Goolsbee speaks. Chair Powell speaks on July 1 at the 9:30 U.S. equity market open along with remarks from ECB President Lagarde, BOE Governor Bailey, and BOJ Governor Ueda. The blackout period for the July 29-30 FOMC meeting starts in mid-July, but with no other speakers next week, they are taking an early 4th vacation.

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