By Matt Wirz and Vicky Ge Huang

Some on Wall Street are worried that inflation and interest rates could rebound.

Stock indexes are setting new records, bitcoin hit $100,000 and the Federal Reserve just cut rates for the third time in less than six months. Still, some investors are switching to defensive strategies as they enter 2025 because they think the fight to stabilize prices isn't over.

There was persistently hot economic data even before Donald Trump won the election on a platform of trade tariffs and immigration crackdowns, both historically inflationary policies. Bond yields also rose sharply in the last quarter of the year, stoking fears that rates and inflation would jump in tandem, sparking a repeat of the 2022 market selloff.

Here is a look at what some money managers are doing to protect their portfolios:

Greg Lippmann

You know him as the trader played by Ryan Gosling in "The Big Short" who made a fortune betting against subprime mortgage bonds. Nowadays Greg Lippmann runs his own $11 billion hedge-fund firm called LibreMax Capital. It made money in 2022 -- a down year for most investors -- thanks to another unconventional bet, this time on interest rates.

Lippmann doubted consensus views that postpandemic inflation was transitory. He purchased derivatives that gained when rates rose, outweighing, or hedging, losses from the asset-backed bonds LibreMax primarily invests in.

The firm profited from the hedges in 2023 and 2024 too, and still holds about 50% more interest-rate swaps than it normally owns, a person familiar with the matter said.

"There is complacency out there that rates are going to go down and there's an unappreciated risk of the 10-year suddenly spiraling to 5% or 5.5% in a matter of weeks," Lippmann said.

Chances of a rate surge are less than 50% but will increase if Trump boosts spending and lowers taxes, pushing the already worrying deficit higher, Lippmann said. The danger is that the Fed's already waning influence over the U.S. economy and, by extension, bond yields, keeps weakening.

Typically economic activity slows when the Fed raises the interest rate it charges banks to borrow, making bank loans more expensive for their customers. But more than 70% of all U.S. consumer debt consists of mortgages, over 90% of which are fixed rate, Lippmann said. That means interest rates will need to stay higher for longer to damp spending.

"The Fed raised rates faster and higher than anyone thought and yet we're not in a recession," Lippmann said.

Mina Pacheco Nazemi

Ask Mina Pacheco Nazemi what worries her going into 2025 and it is a no-brainer: inflation. Pacheco Nazemi heads up diversified alternative equity at Barings where she advises pensions, endowments and other investors on private-equity strategies. Right now she is steering them toward funds that specialize in real assets that she says should hold their value if costs escalate again.

Handicapping what the Trump administration will do in January is speculation at best, but taken at face value, his campaign promises would push prices up, she said.

Tariffs -- like the levies Trump pledged on Chinese, Mexican and Canadian goods -- will increase costs for U.S. manufacturers and retailers that they will pass on to consumers. Deporting undocumented immigrants will shrink the supply of labor in industries like home-building, hotels, food processing and restaurants. Fewer workers usually means higher wages.

Pacheco Nazemi is urging clients to put cash in a Barings fund that takes stakes in new-economy infrastructure projects like data centers and renewable power, like industrial batteries and geothermal energy.

"Regardless of what ends up happening, we believe there's going to continue to be a demand for power and bandwidth, whether it's from AI or our kids playing more videogames or more people working from home," Pacheco Nazemi said.

There is one potential check on inflationary policy: popular opinion, Pacheco Nazemi said. Rising costs are already forcing more Americans to spend most of their income on staples such as rent, food, vehicles and internet access.

"What is the administration going to do if the public realizes, 'Oh wait, inflation isn't going down, it's actually going up?' " Pacheco Nazemi said.

Tim Schmidt

Tim Schmidt is chief investment officer for Prudential Financial, the Newark, New Jersey-based insurer with $1.5 trillion of assets under management. A lifelong insurance executive, Schmidt expects the Fed to tame inflation, but only after a difficult battle that threatens to catch corporate America in the crossfire.

Insurers are relatively insulated from interest-rate moves. They sell life insurance policies and annuities, then invest the money they collect in long-term bonds. Rising rates may temporarily push bond prices down, but that isn't a problem as long as the bonds pay out on time.

What worries Schmidt about prolonged high rates and inflation is their impact on the companies Prudential lends to.

"We're going to be more defensive in our overall corporate investments, especially in lower quality credits that tend to finance themselves with floating-rate debt," Schmidt said. "Syndicated bank loans, direct lending and private equity, those are the sectors that tend to be more exposed to floating rates."

Direct lending is part of the private-credit craze that has swept Wall Street and much of the interest expense on that debt "floats" in tandem with benchmark rates, increasing the risk of default.

Default rates on private debt were 4.7% in October, according to Fitch Ratings. That is more than twice the 1.6% default rate on junk bonds, which have fixed interest rates.

Prudential will buy private debt, Schmidt said, but primarily fixed-rate private bonds arranged by banks for mostly investment-grade companies.

Will Smith

Will Smith is director of high-yield credit at AllianceBernstein, where he manages the mutual-fund company's $31 billion holdings of below investment-grade corporate bonds. His market has had a good year, outperforming most other types of bonds, but that performance comes at a cost.

High-yield bond prices have run up so much that they are more susceptible now to fallout if interest rates jump again in 2025. Junk bonds gained 8.7% in 2024 through November. That is double the return for U.S. credit broadly and slightly more than the 7.86% of emerging-markets bonds, according to research by Barclays.

As Trump's victory and expectation of Fed rate cuts drove bullish sentiment, investors bought riskier corporate debt, echoing the ebullience lifting stocks. Now high-yield bonds look expensive relative to safer kinds of debt because when bond prices go up, their yields go down.

The difference, or spread, between the yield of double-B rated bonds and Treasury-bond yields fell to about 1.58 percentage points in November, the lowest level since at least 2019, according to Barclays. That makes high yield more sensitive than usual to moves in benchmark interest rates.

"There seems to be more ways to lose than win if spreads are this tight, " Smith said. AllianceBernstein started to reduce high-yield bond risk in the portfolio about six months ago and redoubled those efforts in September he said.

Smith increased purchases of corporate bonds in Europe, the Middle East and other emerging markets, where economic growth and inflation risk are lower than in the U.S. About 11% of his portfolio is now invested in emerging-markets corporate debt, up from a median exposure of 5.5%. He has also bought more short-term bonds.

Sonal Desai

Sonal Desai, chief investment officer of fixed income at Franklin Templeton, oversees more than $200 billion in assets and doesn't expect inflation to return to the Federal Reserve's 2% target even at the end of 2025.

Fiscal deficits are already alarmingly high, with deficit spending reaching $1.83 trillion in fiscal year 2024. Absent significant reductions in expenditures, the country's debt will expand further. President-elect Trump's proposed tax cuts, tariff increases, military expansion and mass deportations would widen budget deficits by an estimated $7.5 trillion over the next decade, keeping inflation high over the long term.

Meanwhile, investors have dialed back rate-cut expectations. The Federal Reserve signaled greater doubt over how much it would continue to cut after agreeing to a reduction at its December meeting. If economic strength holds up and rate-cut expectations scale back, yields on the 10-year Treasury note could grind higher to 5% in 2025, she said.

Plus, monetary policy may not be as tight as previously thought. Desai believes the Fed's "neutral" rate, one that neither spurs nor slows growth, is closer to 4% rather than the 2.5% to 3% anticipated by most economists.

After a stellar year of bond returns, Desai said she doesn't see fixed-income securities providing stocklike returns in 2025 but investors should stay invested rather than being in cash.

"This is not a great time to be positioned in cash," she said. "Rates are going to be cut so you can start getting invested within the fixed income space. At this point, I don't see fixed income providing massive capital gains, but I do see it providing income."

Write to Matt Wirz at matthieu.wirz@wsj.com and Vicky Ge Huang at vicky.huang@wsj.com

(END) Dow Jones Newswires

January 01, 2025 05:30 ET (10:30 GMT)

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