INSIGHTS

On November 10, 2025

AAM Viewpoints — The Great Paradox

The financial markets posted strong gains in October despite a crosscurrent of potential economic headwinds. However, a paradox has emerged where investors have apparently overlooked short-term concerns in favor of long-term growth opportunities. Meanwhile, sentiment among U.S. consumers is currently at one of the lowest levels in 73 years, reflecting a notably downbeat mood while U.S. equity markets continue to reach record highs. Despite the federal government being shut down since October 1 — detracting billions from GDP — stock prices surged to unprecedented levels. At the same time, the Federal Reserve (Fed) cut rates again in October by 25 basis points (bps) as the U.S. economy continues to expand, a notable divergence from the typical pattern of rate reductions aimed at averting a possible recession.

The markets were rattled late in the month as Fed language showed less inclination to reduce rates further at the December meeting, with Fed Chair Powell noting rising tension between Fed governors who are focused on employment and those more sensitive to price stability. All the while, GDP has remained robust, growing at an annualized rate of approximately 2%, despite earlier forecasts predicting that President Trump’s tariffs would trigger an economic downturn. The paradox remains as investors pile into the best performers, squeezing valuations higher, while middle- and lower-income consumers continue to struggle; a theme that is likely to continue into 2026.

TRENDING TOPICS

The backbone of the U.S. economy is the consumer. Although recent consumer sentiment gauges have shown a downward trend, consumer credit write-offs at banks have not ticked notably higher. Surprisingly, monthly delinquency rates are lower than the same time last year, and many banks have released reserves for potential losses.

One explanation for this phenomenon is the theory known as the “K-shaped economy” in which 10% of consumers account for approximately half of all spending. This figure is up from 30% in the early 1990s. Moreover, banks and credit card issuers have been strengthening their underwriting criteria in response to current economic conditions.

There has been a longstanding debate among economists and Wall Street over the existence of a natural rate of interest, which requires the supply and demand for money to be in balance. For many years, the Fed has had a 2% inflation target but has consistently failed to achieve this equilibrium. According to Tom Orlik, Jamie Rush, and Stephanie Flanders of Bloomberg, in their book “The Price of Money: A Guide to the Past, Present, and Future of the Natural Rate of Interest,” there are five Ds of the current economic evolution: demographics, deglobalization, defense, data centers, and deficits. While tariffs remain dynamic, the price effect may be more of a rolling process than a sudden spike as U.S. companies have passed about 70% of tariff-related increases to importers and foreign producers, rather than consumers.

Exhibit 1 shows returns for various indices for October and year-to-date.

Source: Shenkman Capital Management

ECONOMIC UPDATE

The U.S. federal government shutdown is leaving the investment community in the dark on a multitude of important and closely monitored economic measures. The longer the stalemate persists, the greater the likelihood of surprise becomes, especially given the tectonic shift in U.S. tariff policy and its subsequent ramifications.

The releases currently on hold include: five weeks of initial jobless claims (and counting), nonfarm payrolls, retail sales, housing starts/building permits, leading indicators, durable goods orders, new home sales, two months of construction spending, personal consumption expenditure (PCE), and Q3 advance GDP. An unexpected shift in any one of these key measures has the potential to move markets, highlighting the disruptive nature of the shutdown.

One area of the economy garnering significant focus is the financial health of the U.S. consumer. Since the April “Liberation Day” tariff announcement, the Consumer Price Index (CPI) has risen each month, climbing from 2.3% in April to 3.0% at the end of September. While U.S. firms have thus far spread much of the tariff-induced increases to importers and foreign producers, costs are still hitting Main Street wallets.

Uncertainty seemed to carry over to small businesses in September as the National Federation of Independent Business (NFIB) Small Business Optimism Index declined to a three-month low. Just 25% of small businesses expect better business conditions over the next six months, down from 34% in August. Additionally, 31% of those surveyed said they plan to raise prices in the next three months.

Meanwhile, the Chicago Fed’s National Financial Conditions Index, which tracks the overall conditions of the financial industry, showed financial conditions being the most accommodative since early 2022 — yet another paradox.

HIGH YIELD UPDATE

October proved volatile for the markets, which extended to high yield bonds as trade turmoil resurfaced before a resolution was reached concurrent to a Fed rate cut late in the month. The ICE BofA U.S. High Yield Index (H0A0) returned 0.20% for the month, bringing year-to-date gain to 7.27%.

Returns by rating showed a clear risk-off tone as BBs rose 0.46%, outpacing Bs and CCCs, which returned -0.06% and -0.42%, respectively, according to the H0A0 index. Year-to-date dispersion by rating tier remained low, with BB, B, and CCC rated bonds returning 7.74%, 6.67%, and 6.60%, respectively.

Leveraged loans rose 0.22% in October, according to the Morningstar LSTA US Leveraged Loan Index, bringing the year-to-date return to 4.86%. Despite declining rates and modest outflows, the asset class has been buoyed by robust CLO (collateralized loan obligation) origination and better-than-anticipated corporate earnings.

High yield bond capital markets activity declined by 68% from the prior month to the second-lowest monthly volume this year, according to JPMorgan, though year-to-date volume remains 7% ahead. Leveraged loan issuance also subsided by 34% m/m, and year-to-date issuance now modestly trails last year’s record run rate.

Exhibit 2 shows new issuance for October and year-to-date.

CLO volume increased 24% in October from the prior month to the strongest monthly volume of the year as $55.9 billion ($18.4 net) came to market in 120 deals, according to JPMorgan.

Default activity subsided in October versus the prior month as three companies defaulted affecting $2.1 billion in bonds and $1 billion in leveraged loans, according to JPMorgan. On a year-to-date basis, 26 companies have defaulted, impacting $7.1 billion in bonds and $16.7 billion in loans. Concurrently, 25 companies have completed Liability Management Exercises (LME) transactions involving $5.7 billion in bonds and $18.4 billion in loans. The par-weighted US high-yield bond and loan default rates ended the month at 0.64% and 1.37%, respectively (+15bp and -16bps month-over-month).

MARKET OUTLOOK

The “October surprise” did not materialize this year. Investors seem to have de-emphasized the risk of high equity valuations and some idiosyncratic events in the credit markets. Since the federal government shut down, the Fed and investors have been seemingly unfazed by the lack of economic data from government agencies. Despite the data blackout, the Fed announced a 25bp rate cut in October. However, Fed Chair Powell’s pronouncement that a December rate cut was “not a foregone conclusion” caused Treasury rates to edge higher. Lower rates have become a focal point in addressing the mounting U.S. debt burden as each quarter point of rate decline amounts to savings of approximately $88 billion in interest payments.

The Fed also announced that it will start shrinking its balance sheet by rolling off its mortgage-backed security (MBS) holdings to allow for the purchase of U.S. Treasuries, which would provide liquidity to the system by printing more money.

The markets have been discounting significant negative headlines, begging the question of the potential for a market correction. If the data blackout ends and new releases surprise to the upside or downside, the markets could have an outsized reaction.

In the end, a “Santa Claus Rally” or “January Effect” may be supplanted by a market hangover amid potential profit taking following the jubilation from an unexpectedly strong 2025.

CRN: 2025-11007-12995 R

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