- The global economic outlook remains reasonably positive with the global economy set to see continued growth and interest rates generally now on a downward trend.
- Even so, some risks remain – particularly over Trump’s tariff plans, which reinforce our belief that inflation will remain above the desired 2% level.
- Bond yields look attractive although capital values could remain quite volatile, primarily due to the uncertainties over US policy
- Equities have potential for further gains given the economic backdrop remains quite favourable and valuations outside the US remain cheap.
The year past
2024 saw global equities perform strongly for the second year running, returning 20% in both local currency and sterling terms after gains of 15-20% in 2023.
The strong performance was in good part a response to the global economy pulling off a softish landing – although a burst of recession worries mid-year did cause a short-lived correction of close to 10%. Global growth remained respectable while inflation pressures eased substantially, allowing interest rates to be reduced.
The gains were led by the US which returned 26% in sterling terms. The superior performance of the US economy was partly behind this but so too were the ‘Magnificent Seven’. Led by Nvidia, the AI chip manufacturer which close to tripled in price, these mega cap tech stocks rose as much as 60%, contributing close to two thirds of the gain in the US market.
The UK, Japan and Emerging markets all returned a more moderate 10% or so, while Europe drew up the rear with a gain of only 3%, held back by political problems, particularly in France. China had a rollercoaster year but ended up a sizeable 20% on the back of the authorities finally launching a major stimulus package.
Fixed income had a disappointing year. UK gilts lost 3% while US Treasuries were flat and UK corporate bonds returned 2%. Bonds started the year with yields at quite attractive levels but a scaling back of hopes for rate cuts put yields under some renewed upward pressure and led to capital losses.
Commodities saw gains of 5% or so. Here, gold was the stellar performer, increasing close to 30% on the back of large central bank purchases. Finally, on the currency front, the big move was a 7% rise in the dollar which benefited from the strength in the US economy. The pound ended the year down 2% against the dollar but up 5% against the euro.
The year ahead
The basic macro backdrop remains quite favourable for markets, with global growth expected to slow only a little and remain fairly respectable. Lacklustre growth in the UK and Europe should be offset by a continued firm performance from the US. Indeed, Friday’s US employment numbers surprised on the upside, confirming the current strength of that economy. As for China, growth should be supported by further stimulus measures.
Inflation, meanwhile, is expected to remain subdued in the US, Eurozone and UK. Still, it looks more likely to settle at closer to 3%, rather than the 2% level desired by central banks, due to upward pressure from deglobalisation, an ageing workforce and the tariff plans of President-elect Trump.
Still, inflation should remain low enough to allow interest rates to be cut somewhat further, if not by nearly as much as expected when the US Fed first started relaxing policy in September. Rates look likely to be lowered over the coming year by 0.25% – 0.5% in the US and UK and by rather more in the Eurozone where inflation pressures and the economy are rather weaker.
Continued economic growth – which should ensure further gains in corporate earnings – along with a reduction in interest rates represents quite a benign backdrop for equity markets. But there are a few caveats to this broadly positive picture worth mentioning.
First, there is the uncertainty surrounding Trump’s tariff plans. Most likely, his bark will prove worse than his bite. And although tariffs will be hiked, the increases will end up being significantly smaller than the alarmist numbers touted by Trump. If so, it should be possible to avoid a major trade war which would undoubtedly be damaging, hitting growth at the same time as boosting inflation.
Second, global equity valuations are on the high side following the strong market increases of the last couple of years. This both limits the scope for further gains and increases the risk of a significant sell-off on any negative surprise. That said, the overvaluation is confined to the US, with valuations in most other regions still on the low side.
Third, there is the risk posed by the increasing dominance of the Magnificent Seven, which now account for as much as 33% of the market capitalisation of the main US equity index and 21% of the entire global market. Investors are assuming these companies continue to deliver very strong earnings growth. But most of the earnings gains so far have come from the build-up of AI-related infrastructure and it remains unclear how quickly companies more generally will adopt AI and thus deliver the profits needed to justify the vast investments in this area.
Finally, as ever, there is geo-political risk. This is clearly higher than normal and currently centred on the Middle East and Ukraine. However, Taiwan continues to pose some medium-term risk. And if Trump were to be believed, so too now Greenland and even Canada! Even so, as has been the case this time with the conflict in the Middle East, much the best approach for investors is generally to ignore the geopolitical threats and just focus on the macro.
Despite the gains already seen and these various risks, which will very likely create some market volatility along the way, we believe now is not the time to be holed up in cash. Global equities still look set to beat cash by a comfortable margin over the coming year.
So where to invest in equities?
Trump’s victory does leave the US market looking rather better placed near term than before, because of his plans to cut taxes and deregulate the economy. Tariff increases are also likely to hit other economies harder than the US.
Against that, the high valuation and concentration of the market point to disappointing long-term US returns from here. They also pose some risks in the meantime as a lot of good news is priced in, leaving no room for disappointment.
By the same token, the lowly valuations of other markets mean it shouldn’t take much good news to lead to them outperforming – as seen with last autumn’s 30% bounce in China. Our favoured regions outside the US remain the UK and emerging markets.
The main attraction of the UK is its cheapness with a price-earnings ratio of only 11.2x. This is close to 20% below the long-term average and way below the US P/E ratio of 22.5x. Although the latest sell-off in gilts is unhelpful, it should not derail the ongoing if lacklustre UK economic recovery.
Certainly, it increases the pressure on public sector finances by raising interest costs and will make it harder to hit the fiscal rules in four years’ time. But while this may prompt further tightening of policy longer term (most likely via reduced spending rather than more tax increases), it should not prompt any near-term change, not least because Rachel Reeves has rationed herself to only one full fiscal event per year, in the autumn.
Emerging markets comprise a diverse bunch of countries, but relatively cheap valuations and/or strong growth prospects are the main attractions. We also prefer the cheaper areas within markets generally, notably small and mid-cap stocks in the UK and US.
As for fixed income, the latest rise in bond yields has led to renewed capital losses but left yields at quite attractive levels. UK gilts and US Treasuries both now yield around 4.8% while UK corporate bonds yield 5.9%. While this doesn’t instantly look super attractive with UK base rate still at 4.75%, the point is that rate cuts are likely to leave cash returning not much more than 4% or so in a year’s time.
Although fixed income should deliver significantly more than cash over the medium-term, capital values do look set to remain quite volatile. In the US, the uncertainty over Trump’s policies and the reaction of the Fed means the market’s views on the interest rate outlook will very likely continue to fluctuate significantly. The already large US budget deficit, which now looks set only to get larger still, could also yet put yields under some further upward pressure. That said, here and in the UK, the bulk of the rise in yields should now be behind us.
The latest sell-off in the UK gilt market has led to 10 and 30-year yields touching their highest level since 2008 and 1998 respectively, inevitably prompting some talk of another Liz Truss moment. In reality, this time is quite different in a number of respects. The recent rise in yields has been more gradual and driven much more by US than domestic developments, with the gap between UK and US yields little changed since the autumn. Also, while the pound has weakened to $1.22, this is a far cry from the sharp decline to $1.07 seen in September 2022.
All said and done, the backdrop for equities and fixed income looks reasonably positive. The various risks highlighted above are more likely to create volatility along the way – rather than a sustained sell-off. Even so, to minimise the dangers, a well-diversified portfolio looks more important than ever.
Rupert Thompson – Chief Economist