At last, key U.S. economic data return

A powerful common driver
Variance in S&P 500 returns explained by a dominant underlying factor

For a few years, we have laid out how the economic transformation of mega forces challenged traditional methods of portfolio diversification. In this environment, efforts to diversify away from the U.S. or the AI mega force amount to larger active calls than before. Our analysis shows that after accounting for factors that typically explain equity returns, a growing share of U.S. stock returns are tied to a single, common driver. See the chart. We think investors should focus less on spreading risk indiscriminately and more on owning it deliberately – in short, a more active approach. We also think portfolios need a clear plan B and readiness to pivot quickly. Another illustration of the diversification mirage? Spiking developed market bond yields in recent weeks. This underscores our view that traditional diversifiers like long-term bonds do not offer the portfolio ballast they once did.

The surge in long-term bond yields is partly due to heightened market concerns about loose fiscal policy and deteriorating fiscal outlooks. Japanese 30-year bond yields hit record-highs earlier this month and are up more than 100 basis points this year. The latest move up was triggered by a Japanese government fiscal spending package, as well as the Bank of Japan signaling a potential rate hike this week. Central banks in Australia and Canada have also shifted their tone on rates – either flagging an end to cuts or the potential for a hike.

Global monetary policy disconnect

We think the U.S. disconnect with other central banks is a risk heading into next year. The U.S. has stronger growth and inflation but is taking a more dovish stance, while these economies face weaker data with more hawkish central banks. We already see the Fed erring on the side of being too easy even with the divisions among Fed policymakers. Long-term Treasury yields can rise further if investors demand more premium for the risk of holding them, so we prefer short-term Treasuries in this environment. Any rebound in hiring or a rise in business confidence could reignite inflation pressures and bring back policy tensions with debt sustainability. This puts a spotlight on this week’s U.S. data, especially when the release of economic data starts to normalize in January. We think the delayed October payrolls data this week could show a contraction, reflecting deferred government layoffs. These figures could also be noisy due to the difficulties of collecting data during the government shutdown as Fed Chair Jerome Powell noted last week.

We are in a more challenging environment for diversification, favoring a dynamic approach. We think this environment calls for seeking truly idiosyncratic return sources - such as in private markets and hedge funds - as a distinct allocation for earning alpha in portfolios.

Our bottom line

We see the diversification mirage theme from our full-year outlook unfolding now. This environment calls for a dynamic approach with a plan B. We stay pro-risk on the AI theme and prefer unique exposures for portfolio ballast.

This is our final edition for 2025. Happy holidays to all, and the Weekly commentary will return on Monday, Jan. 5.

Market backdrop

Tech stocks slid on a sharp drop in AI names Broadcom and Oracle over larger capital spending plans and thinner profit margins. The Nasdaq shed about 2% on the week, while the S&P 500 lost nearly 1% but was not far from all-time highs. The Fed penciled in another cut in 2026, reinforcing our view that it will err on the side of keeping policy too easy next year. U.S. 10-year Treasury yields rose to three-month highs near 4.20%, while long-term yields surged elsewhere.

2025 winds down with a busy week of central bank meetings. We see the potential for a Bank of Japan rate hike; expect the Bank of England to cut; and think the European Central Bank will hold rates steady, even as it turns more hawkish. We look to global inflation data to shed light on central banks’ positioning going into 2026 and eye U.S. payrolls to see if the softer labor market that has allowed the Fed to cut persisted during the data blackout.

Read our past weekly commentaries here.