Entering 2025 with conviction and diversification

First and foremost, we would like to wish you a happy, healthy and prosperous 2025. We’re using the first weekly market update of 2025 to answer some questions we’ve received following the release of our 2025 Market Outlook.

Question #1: The US policy outlook looks uncertain: will fiscal stimulus primarily boost economic growth or just fuel inflation? Will US tariffs turn out to be manageable or disruptive for the rest of the world?
Overall, we think markets may have overreacted to the potential impact of tariffs on inflation and, more generally, the consequences of Trump’s impact on the economic outlook. Many feel that Trump’s arrival will mean more growth and inflation. To be fair, this could be true, but only to a certain extent. Trump will have to manage two central conundrums: growth and inflation.

He’ll have to reconcile his potentially inflationary agenda due to the tariffs and tax cuts with his campaign promises to fight inflation. It’s unclear whether the current 21% corporate tax rate will be rolled over in 2025. While this rate is currently fixed, other provisions of the Tax Cut and Jobs Act signed during Tump’s first mandate are set to expire at the end of the 2025 fiscal year (30 September 2025). Any change to the corporate tax rate would require legislative approval by Congress. For now, no new legislation has been enacted to modify the existing rate.

In addition, it’s also worth noting that higher tariffs, which have been in place since Trump 1.0, have not narrowed the trade deficit (exports net of imports). It’s widened even more. After all, a stronger US dollar allows US importers to import more, but it hurts US exporters. We think tariffs are a means to an end, not an end in itself. With Trump’s entourage seemingly more pro-business vs Trump 1.0, the new Trump administration policy tone could be more balanced, albeit still influenced by “America First”.

Trump faces similar challenges with growth. Fiscal stimulus, if not so big to trigger inflation and rate hikes, is positive for the economy. What about anti-immigration laws? Tightening immigration policies for skilled foreign workers, whom tech companies hire a lot, may lead to increased business offshoring, contradicting Trump’s goal of reshoring jobs to the US. 

From an investment perspective, we maintain an equity overweight, with a preference for US equities. Still-strong US growth (see below) supported by an AI investment cycle and the US Federal Reserve’s (Fed’s) rate cuts are positive catalysts. Meanwhile, risks of higher inflation made us swap shorter-dated inflation-protected bonds with longer-dated ones. Moreover, tariffs are likely to be negative for the rest of the world. We recently lowered our European equity exposure, and we don’t have tactical emerging market positions across equities and fixed income. 

Question #2: Government bond yields have been quite volatile over the past 12 months as investors adjusted their central bank rate expectations. What can we expect in 2025?
Market expectations of interest rates are notoriously volatile. The recent rise in US yields has had ripple effects on European markets, particularly in the UK, compounded by domestic factors. The recent sell-off in the gilt market underscores the fragile balance central banks face between combating inflation and maintaining financial stability, along with the need for the government to maintain fiscal discipline.

Rising yields weigh on bond prices, eroding portfolio values for those overexposed to interest-rate risk. However, the higher yields now on offer – even at shorter maturities – may prove attractive for income-focused investors. A disciplined approach to portfolio construction is essential, balancing the need for resilience against potential upside.

In the UK, the gilt market sell-off has reignited discussions around fiscal sustainability, amplifying pressure on the UK government to consider spending cuts to reassure markets. Elevated borrowing costs make servicing public debt increasingly expensive, narrowing fiscal space and limiting room for manoeuvre. As the dust settles, the sell-off may prove a reset, offering value to long-term investors while highlighting the ongoing tension between growth and inflation control.

In our discretionary portfolios, we prefer short-date gilts, which are less sensitive to the fiscal outlook and more dependent on the near-term central bank path. With the Bank of England likely to cut interest rates further, we think this position is likely to benefit.

The gilt market turbulence also has significant implications for sterling, which remains caught between competing forces. On one hand, elevated yields provide a degree of support, as higher rates make UK assets relatively more attractive to foreign investors. On the other, concerns over fiscal sustainability and a slowing economy weigh on sentiment, limiting upside potential.

Sterling’s path will likely hinge on the Bank of England’s policy decisions and the market’s perception of the government’s commitment to fiscal discipline. If economic growth falters or inflation remains stubbornly high, sterling could face renewed pressure, particularly against the dollar. For now, the currency reflects the broader uncertainty gripping UK financial markets, with volatility expected to persist.

Over the course of this year, we think most central banks across the globe will continue cutting interest rates, in some cases (such as the US) not right away but after a pause of a few months, as inflation gets close to target. This means that rate cuts are likely to remain a tailwind for bonds, taking a 1-year view, also supporting performance if the economy were to underperform market expectations. That said, central banks will only reduce rates to more ‘normal’ levels of around 4% for the US and the UK and 2% for the eurozone, rather than the lows we saw following the global financial crisis.

Question #3: The share of the US equity market represented by its largest companies is at a record high. Is this degree of market concentration a risk for US equities?
We’ve so often heard that the US market is overvalued. Now we hear it’s concentrated. On the former, while currency values tend to mean revert over (a long) time, there’s less evidence for equities. Valuation is not a timing tool, and elevated valuation is not necessarily a bad thing. The rise in valuations significantly contributed to the good performance of the equity market in 2024, accounting for more than half the return of the S&P 500 equity index and nearly half the return of the MSCI All-Country Index. Market concentration risk refers to the danger of relying too much on a few companies, industries and/or sectors when investing. While we run a diversified approach, concentration risk could be present in some of the assets we own. 

For instance, we still like large caps and tech companies due to the ongoing AI investment cycle. However, they dominate the US equity market. Looking at the numbers, the combined market capitalization of the biggest seven US public companies (the Magnificent 7) accounts for more than a third of the total S&P 500 market capitalisation. Relative to peers, the Magnificent 7 added USD 10.5 trillion in market value in 2024; that’s the size of the French, German and UK stock markets combined.

But concentration is not just a US risk. The largest 10% of companies in the S&P 500 or the Nasdaq 100 index account for around 60% of both indices. However, the largest 10% of companies in the pan-European STOXX 600 index account for 58% of the index and 45% for the UK FTSE 100 index and the Japanese Nikkei index. In addition, in 2024 these top US companies delivered strong earnings of around 15% on average, which mitigates this concentration risk. 

So, how do we tackle this risk? We’ve diversified our exposure away from tech and large caps by adding the S&P equal weight index to our portfolios. Trump’s policies point to a broadening of growth across other sectors. Less regulation would benefit financials. Tax incentives, tariffs on offshoring, and the special economic zone would each support industrials. There’s a valuation argument, too, as this part of the market has more average valuations. 

Watching inflation this week
The focus is on US and UK inflation data (Wednesday). US consumer prices are expected to have moved up in December, just below 3%. It’s mainly due to a rise in energy and possibly also services prices. Core inflation (without energy and food prices) is expected to remain a bit higher at 3.3%. 

In the eurozone, apart from hard industrial and retail figures in November, Germany’s first GDP estimate for 2024 (Wednesday) will likely show a marginal shrinking of the region’s biggest economy for a second consecutive year (the consensus is -0.1%). This would support the case for further ECB cuts. Moving East, China’s GDP for the last quarter of 2024 (Friday) should have risen closer to Beijing’s 5% target, supported by the late-2024 stimulus measures. 

Lastly, the US Q4 earnings season will start, with JP Morgan and UnitedHealth among the first to report in the second half of the week.