The Stock Market is Entering the ‘Danger Zone.’ How Strategists Recommend Piloting Around It

The stock market has stumbled into 2025 after closing out 2024 on a weak note. The S&P 500 has dropped for five consecutive sessions, shedding 2.8% during this period. According to HSBC Global Research, the markets have now entered a "danger zone," echoing the lyrics of Kenny Loggins.

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Max Kettner, HSBC's chief multi-asset strategist, and his team attribute the market's precarious state to rising 10-year Treasury yields, which are nearing a seven-month high at 4.56%. This uptick in yields has pushed risk assets into a vulnerable position. Several factors have contributed to this environment, including the Federal Reserve's hawkish stance in December, improved economic data, persistent inflation, and concerns about increased U.S. Treasury issuance post-election.

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HSBC notes that risk assets performed relatively well since the summer's economic slowdown, even managing to overlook some potential negatives associated with the incoming administration. However, rising bond yields have recently put pressure on equities. Historically, higher yields tend to hurt stocks by increasing borrowing costs and offering an alternative to equities for investors seeking returns.

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In HSBC's view, the greatest near-term risk remains higher bond yields, rather than political developments. The firm emphasizes that upcoming catalysts for the market are not tied to the presidential inauguration on January 20. Instead, key events include the December inflation report and the Treasury’s quarterly refunding announcement, scheduled for February 3 and February 5, respectively.

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The next few weeks are expected to remain volatile. Persistent inflation and fears of increased bond supply could lead to further selling of longer-duration bonds, putting additional pressure on risk assets. HSBC advises against closing their underweight position in U.S. Treasuries (USTs) or buying the dip in equities or credit just yet. The bank believes sentiment and positioning indicators need to provide at least a weak buy signal before investors should consider entering these markets.

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However, HSBC sees a silver lining. The analysts anticipate that the volatility of the coming weeks may create a buying opportunity for U.S. Treasuries and risk assets. They argue that fears surrounding a significant increase in long-term Treasury supply might be exaggerated. Additionally, high inflation expectations are already priced into the market.

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Another encouraging sign, according to HSBC, is that the extraordinarily high "supercore" inflation readings from the first quarter of 2024 may not be repeated to the same extent this year. This aligns with the bank's economists' forecast of three Federal Reserve rate cuts in 2025.

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When it comes to equities, HSBC highlights the deterioration in market breadth—a metric that tracks the number of stocks participating in market moves—as a potential contrarian signal. Based on this measure, they suggest that the ongoing market correction might be nearing its end.

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So, how should investors position themselves in this environment, which HSBC believes could ultimately be a "Goldilocks" scenario for the market? The firm suggests that a dovish Federal Reserve could weaken the dollar, lower bond yields, and support assets like emerging-market debt. In equities, sectors that have sold off sharply, such as homebuilders, could offer opportunities. HSBC also sees potential in U.S. banks, which have corrected lower with the broader market despite favorable conditions like higher yields, deregulation, and optimism about increased mergers and acquisitions.

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Technology stocks could also present buying opportunities if they experience further dips. Stabilization in U.S. Treasury yields and the dollar would likely be positive for emerging-market equities, which have seen substantial foreign investor outflows recently.

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As markets opened on the first trading day of 2025, U.S. indices showed signs of recovery. The S&P 500, Dow Jones Industrial Average, and Nasdaq Composite were all trading higher. Treasury yields dipped slightly, the dollar retreated from a two-year high, oil prices rose, and gold hovered around $2,650 per ounce. Despite these gains, investors remain cautious, with the focus firmly on inflation data and Treasury issuance in the weeks ahead.

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In summary, while the markets have entered a challenging phase, HSBC maintains that the current environment could lay the groundwork for a more constructive outlook later in the year. Investors should keep an eye on key catalysts and consider strategic positioning to take advantage of potential opportunities as they arise.

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