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2024 was a positive year for balanced portfolios. However, beneath the headline numbers, there was a remarkable and historically unusual diversity of individual market returns. The USA and the dollar led the way, receiving a late boost from the landslide election of Donald Trump as President. In turn, the rest of the world, fearing economy-slowing tariffs, pulled back. This single event has added some unwelcome uncertainty to what are still the very early days of the new global growth cycle. What will his policies mean for inflation? The all-powerful US Federal Reserve Bank seemed to articulate these fears in their December policy shift back to inflation from employment. Expectations for US and thus global interest rates have once again flipped back to maybe only one more cut in 2025. That view would leave “US Real Interest Rates,” i.e., interest rates less inflation, at a 20-year high and at a level normally consistent with the end of a cycle rather than the beginning. This seems to represent the “noise” associated with the forthcoming Trump Presidency rather than economic reality.
The UK economy appears to have been “talked” into a slowdown. The political pessimism many months before the now infamous Budget created an atmosphere of “impending doom” that has impacted UK economic growth, which has flatlined since the General Election. Increased public spending, funded by extra borrowing and an employment tax, has further impacted the UK economy. Market interest rates have risen, and growth has deteriorated. The Bank of England, for many months the most optimistic of the global Central Banks, had to turn into Scrooge ahead of Christmas and left the Base Rate unchanged. Rachel Reeves has so far not delivered on her promised growth agenda; 2025 is her opportunity to do so. UK equities remain extremely cheap, as corporate buyers and Private Equity investors know. As in the US, Real Interest Rates remain at a high level.
It is the Inflation and Interest rate equation that, as ever, drives portfolio returns. They are still on their cyclical journey down, this never happens in a straight line. “Double Dip Recession” is the usual fear 12 to 18 months into a new cycle, and we are in month 14. Markets have to attempt to price in Trump’s future actions, but they can’t, he is unpredictable and what he says often doesn’t match what actually happens! So, 2025 has all the fundamentals in place for good levels of global economic growth, i.e., low inflation, interest rates that are still too high and crucially recovering earning growth as well. However, the day-to-day performance will be dominated by the announcements from the White House.
Portfolio Roadmap
This chart shows a typical balanced portfolio (bonds, equities, and property) built using Investment Association Unit Trust Sector Averages. It is not a client portfolio but reflects general trends and turning points. Several key points can be read from this chart. The events of the last three years are not abnormal. Nothing in the pattern or long-term trend suggests that the concept of long-term, properly diversified, balanced portfolios should be questioned. Ignoring the COVID-19 period of 2020, performance patterns align with long-term trends and historic volatility levels. As highlighted in previous newsletters, certain timeframes recur in bond and equity market histories. This chart shows the current movement from the top to the bottom tramline is remarkably similar to the Credit Crunch period of 2008/09. Back then, markets turned as the Fed released cash into the global economy through quantitative easing. It is now forecasting to do the same through interest rate cuts. Markets are not entirely predictable, but we’ve seen these portfolio performance patterns many times before. It appears the long-term uptrend has reasserted itself.
Interest Rates and Inflation
These charts showing U.S. and U.K. interest rates and inflation since the invasion of Ukraine tell the key story of 2025. Inflation has fallen back to “normal” levels, yet so far interest rates have barely changed. Historically, there is a fixed gap between the level of inflation and the level of official interest rates (e.g. Base rate) and market yield on a government’s debt (e.g. Gilts). Economically, the return from the lowest-risk investment (cash/government bonds) should ideally be just above the rate of inflation. Historically, it has been around 0.5%, currently c1.5%. If inflation stabilizes at 2.75% to 3.0%, then interest rates and bond yields should be around 3.25% to 3.5%.
Ten-year gilts, after the Budget, are yielding 4.6%, at least 1.0% too high. The U.S. 10-year Treasury bond also fell after Trump’s victory and yield a not dissimilar 4.5%. Bond markets are thus being very pessimistic on inflation, they appear to be saying it is going to 4%. Why? This is partly because government bonds are in a market, if more are issued than the market can bear, prices have to fall and yields thus mathematically have to rise. In the UK, gilts have fallen because the government is borrowing more to pay for day-to-day services and not for investment. In the US, it is the opposite, taxes are going to be cut, so the Federal government will need to borrow to pay for day-to-day services, or merely stop providing them, as seems to be the plan. There is also the fear that both new governments have policies that are fundamentally inflationary.
These are just fears at present, 2025 will need inflation numbers to resume their downtrend. Also, we should expect a critical event around March when there is a hump in U.S. commercial real estate loans needing to be rolled over. These are all at pre-Ukraine interest rates and thus have a high probability of default. Trump will want interest rates lower by then.
Earnings Growth
For 2025 markets should begin to move away from the big US Technology shares. Thanks to Artificial Intelligence they have been the only sector to offer high levels of corporate profit growth. Others from a wide range of sectors are still stuck in recession-like low levels of profitability and displaying limited growth. Based on history that should change in 2025.
With the economic cycle turning positive then so should corporate earnings growth and across a wide range of industries.
This is reflected in the estimates for recovery across Europe and the UK. At this stage of the cycle such forecasts are often highly subjective and are usually beaten. Whilst the US numbers look good it does mask a likely shift from Technology where growth is slowing to the rest of the US market where growth is starting to accelerate.
UK Equities
UK shares are “off the scale” in terms of undervaluation. Corporate buyers know this and almost daily a major UK business is snapped up by mainly Private Equity buyers. Rachel Reeves has suggested a minimum UK holding for UK pension funds, currently c4%. There are investment industry rumors pointing to an initial 10%, this would create forced buyers. The FT Mid 250 is where the growth is, however, this was impacted by the Budget. Labour intensive sectors such as housebuilding and hospitality were hit hard. Nevertheless, there is opportunity, especially as sentiment is so negative and valuations are low. Potential buyers just need some positive news flow. The UK needs interest rates to be cut, which is dependent on inflation. Additionally, watch for a revised EU trade deal.
European Equities
European equities fared reasonably well in 2024 but with huge variances. Car makers struggled as did Luxury Goods. Germany remains in recession and suffers from a lack political leadership, as does France. France is in breach of EU financial stability rules at a time when the government is gridlocked. Trump tariffs pose a greater economic risk to Europe than to China, though, European companies do have the option of shifting production to the US e.g. BMW’s largest factory is already in the USA. As with FTSE100 the performance of European equities has been as much to do with the lack of big tech companies rather than the underlying economic issues. The European growth cycle often trails the US by 12 months. The European Central Bank (ECB) can and likely will cut European rates further.
US Equities
US equities appeared to be the “only game in town” during 2024, but it was actually all about “big tech.” The other 493 constituents of the S&P 500 mirrored the rest of the world and just went sideways. Post-Trump’s victory, however, the performance tables have seen US small caps and banks move to the top, a significant change in tone. The likes of Apple and Amazon were deservedly at the top of the tables as they delivered the highest earnings growth. For 2025, their growth is expected to slow while “the rest” accelerate. Historically, value shares and small caps are the outperformers and they are at record-breaking discounts to the leading seven tech companies.
China, Far East and Emerging Markets
China remains an investment conundrum. Post-pandemic, it appeared that the Communist Party might be pushing back against capitalism. With high youth unemployment and an ongoing property crisis, they have to do something. Stimulus finally began in 2024, in an uncharacteristically piecemeal fashion. Normally, China implements large, headline-grabbing packages, this time, it is a drip feed of easing and reforms, which is no bad thing. The Trump tariffs are holding back the indices, but analysis shows they would only have a limited impact on Chinese GDP. There remains significant upside potential for Chinese equities; however, buyers will wait for what Trump says and does.
Investment Markets in 2025
Investment markets are not predictable, however, they do tend to follow repeatable patterns. After a classic drawdown period when inflation took off post the Russian invasion of Ukraine, they have now entered the growth phase of the cycle. Typically, this should last around five years. But as the old adage states, “Bull markets climb walls of fear and worry.” The most difficult phase of the cycle is the one we are currently in. Typically, we get fears of a “double dip” recession as central banks tend to be slow to cut interest rates. The first year of a new US Presidency is always an uncertain one and with Donald Trump it is likely to be even more uncertain than usual. Europe is in a political mess; it looks as if Rachel Reeves has killed off a promising economic recovery in the UK and China is waiting to see exactly what Trump says and does before committing to much-needed monetary stimulation. All of this, though, is just noise. Markets are driven by interest rates and inflation, both of which are trending down, which is positive. At some stage, earnings growth will take over, and markets will return to concentrating on value. Based on history, profit growth and valuation should soon take over as the dominant drivers for market returns. 2025 will be a complex year for geopolitics and politicians can temporarily derail markets. Nevertheless, all three key drivers of equity markets have turned positive and that is a good thing.
