Back
Summary
- A strong global economy was the foundation for positive equity returns in 2024 and – absent the usual surprises and shocks – there is no reason to think this will not continue into 2025.
- US technology companies were (again) the dominant investment theme for The seven US technology giants (including Microsoft, Nvidia and Tesla) grew their earnings by around 80% in 2023 and 2024 combined. During that same period the earnings for the other 493 companies in the S&P 500 fell.
- Outside of equities, government deficits are currently running at 7.0% in the US and 4.7% in the UK even as the economy is growing and unemployment is near historic lows. This pro-cyclical policy is pushing interest rates higher as governments need to attract investors to fund their borrowing by paying more.
- With this framing there are two clear risks in First, technology company earnings disappoint today’s lofty expectations and equity valuations re-rate lower. Second, higher interest rates (and the higher cost of capital they mean for businesses) finally start to bite and push equity markets down again.
- Our focus in the second half of 2024 was therefore on some alternative investments that are not exposed to these sorts of risks including gold, insurance linked securities and absolute return
- That said, our base case is that the economy remains strong and risk assets continue to perform. A strong economy is normally good for equities but puts pressure on bond markets. That was the story for 2024 and there is no reason to think it will not continue into 2025.
A look back on the key themes of 2024
Before looking forward to 2025, I thought it would be helpful to look back on 2024. It was another strong year for equities but returns were more mixed for fixed income and many alternative assets. This, I think, is fine. Fixed income and alternatives are supposed to be diversifiers. If they are more pedestrian when equities are on a bull run they can still deliver value if (and this is obviously a big if) they play their role when the equity bull market ends. Equities generally struggle in recessions, and we still believe an allocation to fixed income investments should deliver if the economy starts to slow again.
But that said, as government debt levels continue to climb higher there is still a risk that government debt markets become the problem rather than having their usual safe haven status. One important difference between today and 10 years ago is that at least today you are being compensated to take that risk. Even low risk bonds have yields that are comfortably above today’s inflation rates. This means you can beat inflation today without having to reach for high levels of risk.
My four themes for investment markets in 2024 were:
1. US Technology was (again) the number one investment theme
I was tempted to write here about US exceptionalism in general. But, in fact, I think this is really a technology and software story. Outside of China, the leading technology companies are nearly all based in the US and these are the companies that have delivered the lion’s share of growth in earnings to investors. You can of course still make money outside of technology, but it’s much harder. The seven US technology giants grew their earnings by around 80% in 2023 and 2024 combined compared with earnings for the other 493 companies in the S&P 500 index which fell.
Charts 1 and 2 show that even with this lack of earnings growth, US valuations for non-technology stocks have expanded over the last couple of years. I often hear people say that US technology stocks are expensive so you should look at the cheaper parts of the US market. That has been the wrong call for the last couple of years. We will need to see some earnings growth finally come through for non-technology companies in 2025 for it to be right for this year.
Similarly, it is common to look despairingly at UK and European equity market performance when compared to the US. But the real difference to me is technology vs everything else rather than the US vs Europe. UK and European equity markets have similarly pedestrian earnings growth when compared to US technology. But they trade at much lower valuations than their US counterparts, even after you take out the technology sector. It may be that when the US technology juggernaut slows down the real opportunity might be over here in Europe rather than over there.
2. Government policy was the number one reason for higher interest rates
If there was one thing I underestimated in my outlook piece last year it was the role of government policy in keeping interest rates high. I had thought that interest rates would follow inflation lower in 2024. Instead, we have inflation at 2.6% today and the UK bank base rate is still at 4.75%. That inflation rate, though above the bank’s 2% target, is still below the 3.0% level UK inflation hit in 2017 and well below the 5.3% we saw 2011 when interest rates stayed anchored at 0.5%. What has changed? The first and most important point is that – even when economic growth is strong and unemployment is low – the government deficit is still running at 7.0% of GDP in the US and 4.7%
3. The economy remained strong
I have written before that many investment outlook pieces could be re-written pretty quickly as: the economy normally grows a little each year and stocks normally go up (for 4 years out of 5 anyway). That would be an acceptable one sentence summary of 2024 for me. And there is some reason for optimism that the current economic expansion may have some more room to run. Chart 3 compares the growth we have seen since Covid (which is now 4 years in the past) to the two expansions before that (which both lasted around 10 years). And it is worth remembering that on nearly all metrics the private sector looks to be in good health. Wages are back above inflation again (see Chart 4) and savings rates are high (see Chart 5). I will focus some more on what could go wrong in this note, but it is worth remembering that this is a pretty good starting point. And, outside of recessions, annual investment returns are normally (but not always of course) positive.
4. China proved to be the biggest surprise
If developed markets were relatively stable and strong, the biggest surprise of the year came out of China. China is struggling with the sort of property boom and bust that caused a lost decade (or two) for Japan in the 1990s. It is also facing increasingly hostile US foreign policy and the re-election of Donald Trump. Its measures have been focused on supporting property and (just as importantly for investors like us) equity markets. The truth is that China’s problems are large and structural and what has been announced so far is not nearly enough to get the job done. But it is clear that the authorities realise the extent of their problems and are finally trying to do something to address them.
We added some China exposure as these reforms started to be announced. Outside of the US, the success or otherwise of the China reform program looks to be one of the key risk/upside surprises for 2025.
Outlook for 2025
Your base case should be (and ours is) that with the economy strong and the private sector in good health this is a pretty good starting point for any year (and is certainly better than much of 2022). What could de-rail this? I think there are three risks on the horizon:
- The equity market has been driven by the incredible performance of a few large US technology companies (called the Magnificent 7 in the market jargon). These need to keep delivering on what looks to be elevated investor expectations at this This would, I think, be a short sharp correction as investor expectations reset rather than anything more serious. While never enjoyable at the time, 10% to 20% falls in equity markets are actually fairly normal and the price you pay for longer term equity returns (nothing good in investment comes for free). After a strong couple of years, a reset of investor optimism feels on the cards for 2025.
- The second risk looks more structural. As interest rates rise, government deficits are going to become increasingly expensive to run (see Chart 6 for the US for example). This will force governments to have to balance the budget again and (with more of the budget being taken up by interest payments) spending cuts will be back on the agenda. You would then be in a scenario where governments are a drag on the economy even while interest rates stay For me, this all needs to happen before the next recession comes along. Government finances are pretty weak today. In a recession, governments need to be part of the solution than part of the problem. I hope we see some progress along these lines in 2025.
3. Finally, as discussed above, the most important unknown for 2025 looks to be how far the China reform package goes and how effective it proves to be. Many emerging markets are tied closely to the Chinese luxury There are plenty of European companies (particularly in the goods sector) that rely on China for their growth. Good news (or otherwise) out of China will be important for 2025. The one positive here is that valuations remain low and sentiment remains pretty negative. The bar for the Chinese authorities to clear does not look that high.
Given the risks above, we are increasing our allocation to alternative assets where appropriate in our portfolios. This is funded by reducing our overweight allocation to fixed income (and so our exposure to rising government debt levels). We added gold to our portfolios in 2024 which is continuing to benefit from a desire from many global central banks to diversify away from the US dollar.
We also continue to like securities which have returns linked to insurance markets. Whilst if you are in the insurance business you do have to pay out claims (and so take some losses) premium levels remain attractive and the returns we have made over the last couple of years are comfortably above our internal targets. They therefore remain an attractive diversifier for us. Diversification is also behind why we are looking at absolute return style investments again. We started to add some into our portfolios in 2024 and that will remain an area of focus for 2025.
It is worth finishing with the big picture. Consumer and corporate balance sheets look to be in good financial health going into 2025 which should help support the global economy. And cash and fixed income yields remain comfortably above today’s inflation rates. Investment is never (and it is not supposed to be) easy but today’s starting point is probably better than many we have seen over last 20 years.
That said, I am sure that 2025 will have its fair share of shocks and surprises. It is always worth guarding against over-confidence. To this end I am ending with a chart that I showed in one of my weekly notes this year that showed that over a quarter of Britons thought they could qualify for the Olympics in 4 years’ time if they just put their mind to it. I just hope my outlook for next year is more grounded in reality than some of the replies to this YouGov survey seem to be.
Chris Brown, CIO
cbrown@ipscap.com
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
