Commentary for December 2024
Market Overview
While December started with a bang it ended with a whimper. The traditional Santa rally ended early as investors took profits following what has been an excellent year. Major developed markets in the US, Europe and Japan declined by 1.0%, while the UK closed 1.3% lower. Elsewhere, China rebounded 4.2%, which drove gains of 1.5% for Asia and emerging markets as a whole. Global bonds drifted a further 1% lower, with UK gilts down by 2.3%. While the rise in government bond yields caused a headache for governments around the world, it was further good news for the gold price, which moved up a further 3.2% to close the year over 30% higher. The move signals how uneasy markets are becoming over the level of government budget deficits and long-term debt. The US dollar index also rose to hit a 2-year high.
In sector terms, the month saw renewed leadership from large-caps, growth and technology stocks, with a sharper sell-off in small-caps and domestically orientated value sectors. This represented a partial unwinding of the ‘Trump trade’, which saw these areas surge in the weeks following his re-election.
The main catalyst for market weakness occurred on December 18. The US Federal Reserve cut rates by a further 0.25% as expected but went on to spook markets with a more ‘hawkish’ accompanying statement that reduced the number of expected rate cuts in 2025. The perceived change in the US Fed’s policy led to a jump in bond yields. Compounding the change in sentiment was stronger-than-expected economic data, which raised fears that inflationary pressures might spoil the party.
The US economy remains in good health. Recent indicators suggest that growth is expanding at a solid pace: GDP rose 2.8% in Q3, the same rate as Q2. The Atlanta Fed’s estimate for the Q4 economic growth rate is currently 3.2%. Nonfarm payroll employment numbers were strong, with a further 250,000 jobs added in November. The inflation numbers came in as expected, which is to say that inflation remains sticky at best and rising at worst. Headline consumer prices edged up to 2.7% from 2.6%. As a result, forecasts for interest rates in 2025 have been dialled back to just two rate cuts of 0.25% each, down from four. The resulting move in US bond yields has left them some 100 basis points higher over the past three months.
In the UK, November’s GDP figures disappointed expectations, although the economy did at least manage to return to a marginal growth rate of 0.1% – the first time it has expanded in three months. This is not an ideal start for a new government championing a pro-growth agenda. Moreover, inflation rose by 2.6% on an annual basis in November. This was up from 2.3% in October and 1.7% in September, with higher energy costs largely to blame. However, on a monthly basis, prices rose just 0.1%, implying a slowdown from the previous month’s rise of 0.6%.
Chancellor Rachel Reeves has come under fire due to turmoil in the gilt market. The cost of government borrowing has surged as a result of fresh inflationary concerns, with 10-year gilt years reaching 4.85% at their peak. The bond selloff is unnerving for many reasons, but perhaps most because of the burden rising yields place on the cost of both issuing and servicing government debt. This puts the Chancellor in a tight spot. Her Autumn Budget – barely two months old – risks unravelling in the event of a breach of the government’s own fiscal rules. Many critics are blaming the rise in yields on policies announced in the Autumn Budget, although it’s fair to say that the move has also been driven by external factors, as higher bond yields in the US have set the tone worldwide. In the face of this uncertainty, the Bank of England chose to keep interest rates on hold at 4.75%. It did, however, suggest that there was room for further cuts through 2025 if required. Indeed, a number of economists are predicting that interest rates in the UK will fall more quickly than current market predictions of two cuts of 0.25%.
Elsewhere, the European Central Bank cut rates by 0.25% for a third consecutive meeting and made it clear that more were to follow. Eurozone economic growth is also struggling but inflation is less of an issue for the region.
Looking Forward
Trump 2.0 has certainly unleashed animal spirits. There is a sense of optimism that Corporate America will lift markets higher, especially with the new President’s business-friendly reflationary policy mix. Expectations on Wall Street are high for continued economic growth and earnings. The greatest perceived risk is one of economic overheating, which might be exacerbated by the incoming administration’s expansionist approach.
Another key issue for the US is that valuations are at historically very elevated levels, which suggests that much of the anticipated future growth is already priced in. High valuations historically correlate with lower future returns, suggesting that investors should temper expectations of significant gains in the coming decade.
Diversification into cheaper markets is an effective way of managing portfolios from both a risk and return perspective. We believe performance will broaden out in 2025, as the combination of stronger growth and lower rates provide a catalyst for rotation. US equities could lag other areas of the globe where prospects are improving, and relative values compared to the US have rarely been so compelling. Perhaps the greatest opportunity is in global small caps, which are trading at a multi decade discount relative to their larger counterparts.
Our Strategy
The outlook remains positive for markets in 2025, with attractive opportunities in regions outside of the US, particularly in small caps and value stocks.
UK equities offer exposure to many high-quality companies trading at valuations significantly below global peers. They also offer a compelling income stream. Sector exposures in the UK are very different to other global markets, bringing important additional benefits in terms of diversification. The UK has minimal exposure to technology, but greater exposure to cash generative financials, energy and basic materials, along with high quality consumer staples. This should prove beneficial if expectations for a sector rotation in 2025 prove correct.
The US monetary policy outlook is likely to be most supportive for emerging markets, where equities look set to benefit from stronger domestic growth. The region has delivered positive performance after the end of a US rate hike cycle in four of the past five cycles. Action by the US Fed also provides greater flexibility for this region to initiate its own policy easing cycle without the fear of negative repercussions for its currencies. Chinese policy is unambiguous in trying to engineer an equity market recovery. Stocks are set to receive a significant policy boost as the authorities are throwing the kitchen sink at the economy. Whether or not these measures will translate into overall growth and fix the deeper structural issues within the economy remains to be seen, but it’s hard to be bearish when both of the world’s biggest economies are loosening monetary and fiscal policy simultaneously. A stronger China would further increase the attraction of emerging markets in general and help unlock some of the value that’s been accumulating over the past decade or so.
While equities remain our preferred asset class, the prospect of lower rates means that bonds should outperform cash. From an income perspective, yields are now attractive in both absolute and real terms (relative to the level of inflation). Bonds also provide diversification in the case of slower growth but will not protect portfolios from the possibility that inflation remains higher for longer (with the exception of index-linked bonds), which remains our central view.
Alternative assets such as infrastructure, renewables, gold and commodity stocks offer a valuable additional source of diversification and allow us to hedge against inflation and other potential risks and capitalise on wider opportunities outside of traditional bonds and equities. Stimulus by China could exert further upward pressure on commodity prices. We continue to view gold as essential portfolio insurance. The combination of higher geopolitical risk, lower interest rates and strong central bank demand has created a highly favourable environment for the yellow metal. Our exposure to both physical bullion and gold mining shares across standard portfolios has been a major contributor to outperformance versus benchmarks.
Elsewhere, the infrastructure and renewables sectors look set to benefit from some weighty commitments outlined by the government in its new policy agenda. These include £35bn in roads and updating the digital grid, £20bn in green transport and a further £12bn in energy transition and renewables investment such as hydrogen, offshore wind and solar energy projects.
Overall, we continue to manage investments in a manner that allows us to capture the upside in financial markets while also effectively controlling risk to dampen volatility and smooth the path of returns.
