Our take on what’s in store for investors this year and three factors that could impact returns.
Interest rate cuts, lower levels of inflation and a new US President have dominated recent headlines. With most electorates showing their disdain for incumbent ruling parties this year, it may come as a relief to investors that in the year to the end of December, developed world equities (FTSE All-World Index) were up 19.3% for the year and 5.9% over the quarter.
For the US, “Trumponomics” is back, bigger than it was before. Well, that’s the rhetoric the market has followed in 2024 with the US stock market continuing to rally, and encouragingly outside of the traditional mega caps. It appears the US growth engine continues to roar, and when consumers feel positive, they will spend. The earnings growth for the US in 2025 is expected to be measured in double digits and when combined with the lower interest rates expected, it’s no surprise this market has enjoyed its own “Santa rally”.
So, where can we expect markets to head this year and what are the driving factors?
Well, we believe there are three factors that will influence asset class returns:
The headlines are clear on this. Expect government spending increases in the UK, US and China, and interest rate cuts across the developed world. This is a combination that should support equities but may lead to a volatile fixed income outlook.
Geopolitics doesn’t tend to move markets unless it impacts on a commodity of some form. In our case it’s dependent on two main men, Donald Trump and Xi Jinping. Donald wants the US growth engine to dominate, whilst Xi is trying to get his economy going. Both are in favour of capital expenditure and deregulation, though.
That leaves fundamentals, which have benefitted massively in the post-pandemic growth surge. Company profit margins have got to near all-time highs, unemployment remains closer to record lows than averages and wage inflation is supporting spending and debt repayments.
Whilst the headlines are favourable for the year ahead, we will delve into the dynamics across the major regions and cover our positioning.
Europe was the first to cut interest rates this year, and after four cuts in 2024 (from 4% to 3%), expectations are for a continuation of this trend in 2025. Most central banks would look at rate cuts and worry about currency weakness, yet this may support and offset any pressures from tariffs implemented by the US government, making exports more competitive for European manufacturers.
Europe is suffering from a manufacturing recession and political uncertainty. It can point to low unemployment and normalising inflation levels as the positive, but it needs fiscal stimulus and infrastructure investment to get it out of what appears to be a stagnant economic position.
Where the US has its technology, China is investing in future growth and easing regulation, and Japan has announced a new fiscal package, Europe remains stuck between a rock and a hard place, not wanting to reach into its savings (specifically Germany). The last two years of economic growth have no doubt been boosted by the Russia/Ukraine war, as its well-known government spending on arms flows into other sectors.
The war could be resolved in 2025 by the new US leader, and this spending will hopefully be redirected to longer term projects. The issues then lie with Germany and France. German elections are in February and the far right may have more influence in the country than many wish to admit. In France, the turnover in politics is high and little alignment on policy isn’t helping. The European Central bank will of course be watching wages and the state of the global economy as an indication of its policy, ignoring the shorter-term political noise/damage.
Whilst these are ifs, buts and maybes, a sign of pressure is already starting to show in the jobs data. At the beginning of December companies began cutting jobs at the fastest pace in four years. It wouldn’t surprise us to see a tick up in unemployment and a weakening of European growth from here, with hope resting on fiscal regime change.
Stagflation is the word we may hear more of in the coming months, and the European Central Bank will be hot on its heels to cut rates further, if need be, which could boost equity returns.
Whilst valuations could remain attractive and a stronger US and China would support business, we remain underweight European equities at present but cognisant of valuation opportunities, especially for small/mid-cap.
Trump has already started to play the tariff cards before he has even arrived at the Presidential table. His initial announcement has focused on levying trade measures against the emerging markets, Canada and South America. This, of course, brings worries from our perspective.
Anything being taxed on its way into the US will inflate prices. It’s quite clear that analysts are finding it difficult to judge what impact this may have. In the short term, one thing has been clear, inventory build is high. US companies are importing goods and raw materials ahead of these tariffs to keep cost pressures down and maintain margins which remain near record highs. This started as early as the second quarter of 2024 and has continued since. Retail sales in the country have remained strong in the fourth quarter and discounting has not ramped up as many expected – a real sign of the economic strength.
Momentum, momentum, momentum has been the fundamentalists nightmare for the last decade of returns in the US equity market and it could continue that way. Government spending and a resilient economic backdrop are significant positives. It’s difficult not to see the US market grinding higher if earnings expectations are met. This is a big “if” though.
Where can the upset come from? Well, either through higher rates for longer, which is likely to be the case if tariff implementation is fast-tracked, or through worries around government debt, which in turn push yields up and squeeze borrowing for business and the consumer.
The latter of these is more probable and the consequences will be on short term yields. The chart below represents the changing yield curve in the US over the last 12 months. Notable has been its recent flattening to a slight steepening. It has come out of the inversion (10-year yield now above the 2-year). Historically a move out of an inversion is a sign there will be a recession at some point in the following 18-months. If this is the case then it’s likely we see the middle of the curve coming down, the short and long end remaining elevated.
Treasury yield curve
Source: Bloomberg data, as at 20.12.2024. Past performance is not a reliable indicator of future returns.
The portfolios have more exposure to the 5–7-year part of bond curves at present, as we increase government debt and reduce corporate bonds. With investment grade corporate bond spreads remaining close to historic lows, we are not being paid much to hold corporate bonds presently.
For the Federal Reserve it is highly likely that following December’s rate announcement we see a pause into the first quarter. No doubt the words “data dependent” will be used by central bankers as they assess inflation expectations present and future. The market is only pricing two rate cuts before year end, and we think this is a reasonable estimate at present. Retail sales for November increased 0.7% during the month and were well ahead of the 0.5% increase expected, with seven of the thirteen categories posting increases. It is data like this which will hold rates higher for much longer but also supports the earnings outlook.
It all looks rather positive even with higher rates for longer, so is there risk to holding US equities? Yes, if you are concerned about concentration risk and valuation. The top ten companies in the S&P 500 Index account for 34.8% and with the Nasdaq seeing over half its market capitalisation in its top 10, it remains a big red flashing light. Valuations in the main market continue to push highs last seen in 2022. It’s difficult to allocate to some of these names when you are paying up 60-years’ worth of earnings today.
For us, diversification in the US is the order of the day, with our MPS models investing in an equally weighted S&P 500 Index which could continue to benefit from positive sentiment and consumer spending. Markets always look to price in future scenarios, and we are cognisant we need exposure, but not too much due to the risks highlighted. It remains our largest equity position.
In the UK, its reliance on US consumption benefitted returns, as the FTSE 100 Index rallied 9.7% during the year, with the FTSE 250 Index not far behind it up just over 8,1%. Financials, a significant part of the FTSE 100 Index, have been one of the best performing sectors this year globally, as yields remained higher than expected across the developed markets. Bank earnings benefitted from lower-than-expected non-performing loans and delinquencies.
The UK economic landscape appears a little more mixed given the close links to Europe and worries of US tariffs. The UK economic data during the month of November showed slowing manufacturing but a resilient services sector. GDP also shrank by -0.1% consecutively over the months of September and October. The Autumn Budget appears to have taken some wind out of the sails of corporate outlooks due to increased employee related costs.
Of course, whilst hiring has slowed the UK consumer remains in a positive position. Savings rates are high, debt levels (specifically personal loans) have climbed but remain lower than 2019 (pre-covid). Inflation pressures are of course a worry with Government spending putting pressure on debt in the short term.
Gilt yield curve
Source: Bloomberg data, as at 20.12.24. Past performance is not a reliable indicator of future returns.
Interestingly the yield curve, as shown above, is already ahead of where we would expect the US to get to with inversion in the short end and a steepening middle to long end. It’s difficult to see demand driven inflation being the reason for rates to remain elevated, unlike in the US. It is more likely supply side issues are playing a role. Margin protection will come into focus and businesses that have been afraid to cut jobs due to significantly higher costs to rehire may consider this avenue as a last resort. If, however, US global growth ticks on and China’s stimulus reboots demand for commodities, there is no reason to think that the UK market, with significantly cheaper valuations, won’t benefit. The team is marginally overweight against our own Strategic Asset Allocation with a focus on mid/large-cap at present.
A region that maintains a lower correlation to other markets is Japan. Whilst it has lost some momentum following the summer, the Nikkei 225 is up 10.5% in sterling terms and 21% in local currency to year end. Incredibly, in local currency it is up over 45.4% in three years, which is above that of the S&P 500 Index. Yen weakness has offset this significantly in sterling terms.
Unlike the west, Japan is moving into a period of tighter monetary policy whilst maintaining an easier fiscal regime to stimulate growth. The Bank of Japan governor Kazuo Ueda has focused on the need for rate hikes in 2025 as the country faces a labour shortage and wage pressures. The 2025 Spring negotiation in October has called for pay rises of over 5% year-on-year, which has added to the inflationary pressures. It’s a difficult position to be in as Japan will recall the 1990s when it raised interest rates and slowed growth, only this time easier fiscal regime is welcomed and inflation could be an issue, a good one!
No doubt the central bank will welcome inflation for the first time in 30 years, as long as it is demand driven. The fiscal outlook has been slightly hindered by the November election result, which saw a minority ruling coalition put in place. However, the good news has been the announcement of fuel subsidies, cash benefits for low-income households and domestic semiconductor and AI technology investment.
Whilst Government bond yield have moved up on demand and inflation expectations, we are wary of the risks to JGBs yields if the government does turn off the taps. It shouldn’t be ignored the risk also lies in market dynamics more than pure economics. In August, the reversal of the Yen-carry trade (selling of dollars to buy Yen), led to a significant pull back in equity markets.
Even with this, the inflation dynamics are a positive for now and an opportunity for businesses in Japan to increase margins. We have been mindful to take some profits here while remaining constructive on the long-term governance shifts that will improve shareholder returns in this market. Therefore, we maintain our Strategic Asset Allocation (SAA) with a marginal overweight for the year ahead with a close eye on monetary and fiscal dynamics.
China has been the main surprise this year. Having been unloved for much of this year, and the last three years, this sleeping dragon was stirred by a more constructive and market friendly stance taken by their central bank and ruling party. So far this year we have seen the introduction of market reforms, interest rate cuts and the bazooka of a long-awaited government stimulus package. It’s no surprise this has all coincided with the period in which the US starts cutting its own interest rates, enabling currency protection.
China continues to face several structural issues on the back of a slow housing market and a lack of consumer confidence. Although things are slowly improving, businesses will be wondering about the major unknown – upcoming tariffs.
The US and China both have tariffs rates close to equal at present, with China holding average tariffs around 23% against the US, and the US reciprocating with 18% at present (according to the Peterson Institute of International economics). For China, the US makes up only 15% of its exports, enabling it to offset falling US demand for its goods with sales elsewhere. If the US targets other countries, China may benefit from greater demand elsewhere as they switch away from US goods.
On the other hand, China has a significant oversupply of goods on the back of subsidies to Chinese companies, the EV market is a prime example. The US may continue to buy the goods, as even with the tariff the goods could remain cheaper than elsewhere and continue to be deflationary. What is likely, however, is that the Yuan weakens if the US economic growth engine continues, and interest rates remain high.
We cannot ignore the headline risk, however, with the market remaining significantly cheaper than others. With expansive policy moves, it would not surprise us to see some momentum coming through in 2025. We are therefore holding an overweight to emerging markets against our Strategic Asset Allocation.
The hardy backdrop has clearly fed through to fixed income markets. Corporate bonds love a steady environment with very few shocks and consequently rallied in 2024. Longer dated bonds have been more restricted by their greater duration, given the stickier backdrop to inflation. With an expectation of greater issuance to meet rising fiscal pledges, these have continued to remain volatile without much return for the year.
For us it’s a question of how long higher rates can remain before we see corporate bond spread widening. The healthy economics we have mentioned clearly mean default risk is low as reflected in current spreads, but there remains a significant amount of debt refinancing into 2025 at rates significantly higher than the last decade. We are left to question the risk/return dynamic in this environment. High risk credits may yet still perform if the US and Chinese policies drive consumption, but such credits will be at risk if the economic backdrop is not as strong.
Our expectation is that the higher for longer narrative is likely to play out in the US but not in the UK or Europe to the same extent. For this reason, we have been improving credit quality through Investment Grade Corporates and increasing our duration with more Government bonds, to provide a more cautious element to our exposure.
Premier Miton’s Chief Investment Officer Neil Birrell wrote in his recent 2025 outlook of three opportunities in the next year; magnificence, AI transformation and currency divergence.
The magnificence focused on the shrinking Magnificent 7, which we believe is likely. It’s very rare that from one decade to another the biggest companies in the world stay the same.
The power of AI, whatever and however it may be defined is clearly something that can change business efficiency, operations and margin potential. Whilst it seems we are at the start of another technology revolution, the benefits currently remain difficult to measure.
Finally, currency divergence – this is of importance. The dollar has been a major currency for stability, yet it’s difficult to know whether countries will want this stability in a world where the US is trying to suck competition from the system.
What we do know is that for the first time in many, the year ahead will lead to divergence across regions, sectors, central banks and political agendas. The previous momentum trades will be challenged and while this presents some risks, it will also provide opportunities. We therefore expect a broadening of market returns that for the last decade have been dominated by the US.
RISKS
The value of stock market investments will fluctuate, which will cause the prices of the funds held in a portfolio to fall as well as rise and investors may not get back the original amount invested.
Forecasts are not reliable indicators of future returns.
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