Investment Strategy Focus February 2025

Summary

1. “Tariff Man” strikes again: President Trump has targeted Mexico, Canada, and China with wide-ranging tariffs, prompting retaliatory tariffs from Canada and China. Suspension of Mexican and Canadian tariffs post concessions suggests that these tariffs may not be permanent. If  ultimately maintained, expect a -0.4% drag on the US economy and +0.8% on core inflation. 
2. Can inflation ease further? Despite tariffs, inflation rates can ease further as i) oil & gas prices, ii) housing costs, and iii) wage growth should all moderate in the months ahead. Further rate cuts should benefit manufacturing activity, bank lending, and construction sectors. 
3. A buying opportunity in US inflation-protected bonds: US 10-year real bond yields above 2% have historically resulted in 12-month returns close to 10% on average. With real yields now at 2.1%, we like US Treasury Inflation-Protected bonds. We also favour longer-duration US and UK sovereign bonds given higher term premia. 
4. Deepseek disruption? Is the launch of this low-cost Chinese AI large language model the “Ryanair” disruptor to US mega-cap tech oligopolies? This accelerates the “commoditisation of AI” and may trigger sector rotation away from Technology. Favour equal-weight S&P 500, Financials & Industrial sectors. 
5. A constructive 2025 outlook for private assets: certain private credit strategies offer attractive yield pick-up opportunities in a world of tight credit spreads. European commercial real estate offers high prospective returns from a nascent recovery in property values, rental growth and higher rental yields as interest rates fall.

Consider US TIPs, longer duration US and UK government bonds

UK, UK longer duration bonds offer higher yields 

Since September last year, the benchmark 10-year bond yield for US Treasuries and UK Gilts has jumped from 3.6% to 4.5% in the US, and from 3.7% to 4.6% in the UK. We see this surge in yields as an excellent opportunity for conservative investors to buy US and UK sovereign bonds, with the expectation that inflation can ease in both countries in the near future and thus that central banks will lower benchmark interest rates further. 

Highest term premium in over 10 years

One measure of the better value today in longer-duration US and UK bonds is a higher 10-year term premium. As a reminder, the term premium is the amount by which the yield on a long-term bond is higher than on a short-term bond, reflecting the amount that investors expect to be compensated for holding longer-duration bonds.

In the case of 10-year US Treasuries, this term premium has increased to +0.5% from below zero as recently as early October. Indeed, this term premium  now stands at its highest level in nearly 10 years, well above the 20-year average term premium of 0.4%.

Not only do we like longer-term US and UK government bonds as these elevated yields, but we also like US and UK investment-grade corporate bonds for similar reasons, in spite of their relatively low credit spreads. In absolute yield terms, BBB-rated US corporate bonds offer a 5.5% yield, while UK investment-grade corporate bonds yield 5.4%.

US inflation-protected bonds are attractive now

In the wake of the surge in US bond yields since September, with a 1% increase in the 10-year Treasury benchmark to late January, the 10-year Treasury Inflation Protected real bond yield today sits above the key 2% level at 2.1%.

From a historical perspective, this real yield has rarely exceeded 2% for long in the past 25 years. Prior to 2024-25, the last occasion was in 2009. Subsequent 12-month returns in inflation-protected bonds has averaged 10% when the starting 10-year real yield was 2% or higher.

Recall that the total return from bonds is typically best predicted by the yield level at entry – i.e. the higher the starting yield, the higher the expected returns over the medium term. Today’s starting US TIPS yield is the highest seen in over 10 years.

Moreover, even when inflation and interest rates were low prior to 2020, US inflation-protected bonds significantly outperformed the Bloomberg US Treasury bond index. The US inflation-protected bond index has returned 4.3% on an annual average basis from 2002 to 2024, 0.9% per year better than the 3.4% achieved by the overall US Treasury bond index.

Key messages

In fixed income, we turn Positive on US and UK government bonds, recommending a benchmark duration (of 6 years in the US). We also like US inflation-protected bonds, given the attractive real yields on offer today.

Still in the later stages of a bull market in stocks

Growth, liquidity and buoyant sentiment in charge

The bull market in stocks that started back in October 2022 remains the primary market trend, supported by a combination of:

a. Positive economic and earnings growth, led by the US with Q4 2024 GDP growth of 2.3% annualised and 11% Q4 annualised earnings growth for the S&P 500;

b. Buoyant global liquidity, fuelled by rebounding money supply growth in the US and China, lower central bank interest rates and high Chinese, Japanese and European household savings rates looking for higher returns in stocks, corporate bonds and money market funds;

c. Risk-on sentiment in global financial markets as measured by bullish investor surveys, historically tight corporate credit spreads and robust ETF flows.

d. A continued reduction in supply of shares in US, European and Japanese stock markets. Share buybacks continuing to vastly outweigh new supply in the form of initial public offerings or secondary share issuance.

But keep an eye on long-term interest rates

The high valuations of US mega-cap tech stocks render the US stock market vulnerable to a correction, should long-term interest (US 10-year bond yields) rise to and beyond 5%. These long-term rates, in turn, depend on a combination of long-term inflation expectations and confidence in the sustainability of sovereign debt in the face of rising interest costs. Current US 10-year yields below 4.6% do not point to an imminent risk to US stock valuations but should be monitored closely.

Sector rotation away from Tech

We saw a sell-off in the mega-cap tech and semiconductor sectors for several days following the surprising 23 January announcement of the impressive results from the low-cost Chinese Deepseek R1 large-language model. But this merely accelerated a sector rotation away from technology, which had begun at the start of this year.  To 30 January, the Nasdaq 100 only gained 1.9%, while the S&P 500 ex tech index advanced 5.8%, the Euro STOXX 50 +7.9% and the German DAX +9.1%.

The bigger story here is the commoditisation of AI – that more and cheaper AI models and algorithms provide a more cost-effective route for companies to embed AI-enabled processes into their businesses.

The Jevons Paradox and AI

According to the Jevons Paradox, as technological improvements increase the efficiency of resource use, the overall consumption of the resource tends to increase (not decrease) as demand increases sharply. Cheaper leading-edge AI models should accelerate their adoption in the wider economy, driving productivity gains across sectors and driving even faster growth in electricity demand. The big winners from this next stage in the AI development cycle will not necessarily be the Magnificent 7, but rather companies that can drive significant AI-related productivity benefits in the financial, health care and software sectors. AI commoditisation should also spur the development of a new wave of businesses and industries, as seen with the widespread adoption of mobile internet and smartphones.

Trump announces new import tariffs

US tariffs – More and faster but for how long?

The announcement of higher US trade tariffs confirms our key assumption that Donald Trump’s campaign promises should be taken literally and seriously. In fact, the announced increase in tariffs were even larger and came faster than we had penciled in. We had anticipated that the tariffs would be increased at a preannounced path to raise the pressure gradually.

The announcement of a 10% tariff on China and a 25% tariff on all imports from Canada and Mexico (except for Canadian oil and energy products, for which a 10% levy would apply), starting 4 February suggests a much more immediate and marked increase in the effective US tariff rate than we had been assuming.

A key question is now whether the US President has announced such high tariffs to put the maximum pressure for upcoming negotiations or whether he intends to really keep this level of tariffs to redirect supply chains and use the revenues to help reduce budget deficits.

On 2-3 February, President Trump subsequently paused the anticipated tariffs on both Mexico and Canada for 1 month. This follows an agreement by Mexican President Claudia Sheinbaum to place 10,000 Mexican soldiers on the US-Mexico border to stop the flow of fentanyl and illegal immigrants into the US. Canadian Prime Minister Justin Trudeau has made a similar commitment. This pause allows time for further negotiations. Discussions with the Chinese premier are also very likely. A deal and lowering or cancelling of tariffs is still quite likely, in our view.

Is Europe next in line to be hit by tariffs?

We also expect tariffs against Europe to follow soon. The current announcements have already hurt some large European enterprises especially in the auto sector. Indeed, German carmakers have shifted production of cars and car parts to Mexico over the past few years. A negotiation leading to lower tariffs against much more oil and gas as well defence goods purchases could be a compromise.

Trump’s dilemma and why we think tariffs will not stay as high

The price to pay to keep tariffs at such high levels would be very high. Indeed, economic literature and evidence from history suggest that such high tariffs generate higher inflation and dampen economic growth, especially considering that the risk of a “tit-for-tat” escalatory trade war is very high. High tariffs act as a consumption tax and have a direct effect on inflation and can destabilize inflation expectations. For businesses and consumers, elevated tariffs would likely leave a lasting impact on investment and consumption. Further, the central bank could face a critical stagflation dilemma between weaker economic activity and rising inflation. The costs for Trump and the Republican party could thus be very high as they would risk losing their thin majority on the House of Representatives at the 2026 mid-term elections. This political consideration adds to the argument for a moderation or cancelling of these tariffs in time.

Broad-based commodity strength building

Reversal in US yields arrests USD advance

Since September when Donald Trump began to poll ahead of Kamala Harris, the US dollar has followed bond yields higher in the expectation of i) higher import tariffs, ii) stronger economic growth, and iii) fewer (if any) Federal Reserve rate cuts.

This was reflected in the widening gap in 2-year bond yields between the US and Europe (using Germany as a benchmark), with this yield spread increasing from 1.4% to over  2.3% at peak in November. Since then, US inflation prints have proved relatively benign.

With this EU-US yield spread subsequently declining to 1.95%, one would normally expect the US dollar to weaken against the euro, given the tight relationship between the two in 2024. While we maintain our long-term target of USD 1.02 per 1 euro, there is a good chance that the US dollar will ease against major currencies in the near term after a powerful rally.

The imposition of sweeping tariffs against the US’s 3 major trading partners has initially reinforced the US dollar, but the subsequent 1-month suspension of announced tariffs on all Mexican and Canadian imports suggests a pause in the US dollar’s momentum, better news for commodity prices.

A following wind for commodities

Despite the recent strength of the greenback, broad commodity indices have rallied in recent months, hitting their highest levels since the end of 2022 led by agricultural commodities, such as coffee and cocoa, with help from precious metals and natural gas.

Believing in a volatile commodity supercycle

We maintain our belief that commodities have entered a supercycle since 2022 on the basis of restricted supply across a swathe of raw materials, albeit one that is volatile due to fluctuating geopolitical currents.

Industrial metals are laggards for the moment but could benefit from an expected upturn in global manufacturing activity and the announcement of further Chinese economic stimulus measures, broadening the commodities rally.

Key messages

For a broad exposure to commodities in a diversified portfolio, consider enhanced roll commodities strategies that outperform standard commodity indices over time.

Macro: Could inflation turn out lower than expected?

Inflation has settled in the “2s”

US and eurozone inflation rates have returned to the “acceptable” region of 2%-3% (2.7% for eurozone core CPI year-on-year and 2.8% y/y for the US core Personal Consumption Expenditure - PCE),. As a result, central banks continue to reduce their benchmark interest rates. Moreover, China remains on the brink of deflation, with inflation at merely 0.1% y/y.

In the US, consumer inflation expectations for the year ahead have steadied at 3%, close to the pre-2020 average, while the consensus of economists expects eurozone inflation to average just 1.9% this year.

Further downside inflation surprise to come?

While the conventional wisdom in financial markets expected President Trump’s policies around tariffs and immigration to be inflationary in nature, there are good reasons to suggest that US inflation can in fact trend lower over the next few months.

Firstly, US services inflation should trend lower as wage growth eases, with the JOLTS quits rate falling to 1.9% and pointing to even lower wage pressures ahead. The poor current reading in the present situation component of the University of Michigan’s consumer confidence survey also predicts lower wage growth over the next 12 months.

Secondly, real-time measures of US rental inflation points to a lower shelter CPI to come – the cost of shelter remains by far the largest component of core inflation, running at 4.6% y/y as of December.

Energy prices to ease post winter seasonality

Thirdly, energy costs should ease. Seasonally high natural gas prices should ease as we exit peak heating demand from March onwards, which will also ease electricity prices.

We also look for lower crude oil and oil product prices ahead off the back of increased OPEC+ and non-OPEC production this year (4 million barrels/day more in 2025 versus 2024), which should drive the Brent crude oil benchmark towards our forecast USD 60-70/barrel range from the current USD 77 level.

In conclusion, we expect inflation to remain low enough for central banks in the US, Europe and China to continue to lower their reference interest rates. 

Private markets: a potential return to form as interest rates fall

Below-average private equity returns in 2023-24

Asset classes that benefit from financial leverage such as private equity and private real estate delivered below-average returns for the 12 months to end-June 2024, as high interest rates took their toll on asset values.

Private real estate has suffered a revaluation of net asset values on the back of higher financing costs since the middle of 2022. Real estate returns are only now returning to positive territory as  property values start to stabilise, thanks to the lagged effect of falling short- and long-term interest rates.

Contrast this with the strong performance from private credit and hedge funds which have benefited from a combination of high interest rates and strong macro trends, while listed stocks and gold performed best of all.

Private equity funds have seen a fall in exits

The more challenging environment for private equity valuations due to higher interest rates, and the relative dearth of exits via initial public offerings (IPOs) has led to holding periods for private equity investments lengthening in many cases. But with the continued strength of the global stock market, we would expect an acceleration in IPOs in 2025 which will enable private equity funds to exit investments and return more cash to investors, potentially boosting fund returns. We forecast a long-term expected annual return of 9.5% for the private equity asset class.

Private credit continues to offer attractive spreads

Private credit continues to offer attractive uplifts in yields over listed corporate and government bonds, with private credit yields on average close to 10% in aggregate. Contrast this with the current 7.3% yield on US high yield credit, and 5.4% on US investment grade credit, while euro-denominated credit offers lower yields still. The private credit market continues to see impressive growth, with global assets under management totalling USD 1.5 trillion as of the end of Q1 2024, according to fund management group Apollo. This is the private asset class likely to grow the fastest over the next few years, fuelled by the need for company financial officers to diversify their debt funding away from just banks, and by the potential for trillions of dollars of loans to be transferred from bank balance sheets to long-term investors, such as pension funds, insurance companies and wealth management.

Higher volatility to favour market-neutral hedge fund strategies

Since his 20 January Presidential inauguration, Donald Trump has announced a myriad of new US policy objectives relating to tariffs, tax, deregulation, immigration and foreign policy. This should lead to higher market volatility, favouring lower volatility market-neutral hedge fund strategies such as equity and credit long/short funds, which have already enjoyed a strong 2024. According to Bloomberg, both equity and credit long/short hedge funds enjoyed double-digit performance in aggregate over the 12 months to end-November 2024.

Real Estate recovery starts; no stopping Gold momentum

Private real estate to benefit from better sentiment

Since September 2022, global commercial property values have seen cumulative price declines of between 12% and 18% in Australia, Europe,  the UK and US markets. According to BNP Paribas Real Estate, we are now seeing a slow improvement in sentiment towards the asset class, helped by the interest rate easing cycle and the adjustment higher in rental yields that has resulted from the fall in prices.

There are already the first signs of improvements in valuation across several real estate sectors, notably in residential, hotels, industrial and logistics. Rental yields on prime European commercial real estate is averaging as high as 5% in logistics, while BNP Paribas Real Estate forecast average annualised total returns over 2024-28 in the 7% - 9% range for the major European sectors, led by prime offices and logistics.

Global residential real estate is benefiting from the lower interest rate environment in many geographies, with positive yearly price gains in the UK, Sweden, Germany, Australia, and the US. In addition, rental growth remains positive due to the strength of demand and the shortage of available rental properties in many key cities, with average European rental values up 7.1%  year-on-year to Q2 2024. Even lower short-term interest rates over 2025 should support momentum in the more variable interest-rate sensitive markets such as the UK, Spain and Sweden.

Infrastructure: a way to benefit from structural growth trends

Strong investment trends in Artificial Intelligence, data centres and the resultant demand for electricity all underline the opportunity for investment in the related infrastructure, be it via electricity generation and transmission, data centres or associated digital infrastructure.

The infrastructure asset class remains the dominant investment in real assets by most long-term institutional investors, allowing the likes of pension funds to hedge long-term liabilities with long-term assets that also provide a degree of inflation hedging via growing income streams.

Historical returns from private infrastructure funds have been impressive, at an annual average of 9.3% from 2008 to mid-2024 according to Apollo.

Precious metals: gold and silver maintain momentum

Outside of US stocks, gold and silver have been two of the best-performing major assets over 2024, with both metals posting US dollar returns in excess of 20%. This momentum was driven by a combination of central bank buying, Asian retail investor demand, growing supply-demand deficits on growing industrial demand in the case of silver, and concerns over the sustainability of high G7 government debt burdens. We see these precious metals drivers continuing in 2025, with the potential for double-digit percentage gains in both metals by end-year.

Global Chief Investment Officer