“Throughout 2024, positive nominal growth and interest rate cuts supported equity markets, even amid extreme valuations in the United States. As 2025 gets underway, I expect corporate earnings to hold up, and for nowinflation is still moving in the right direction. However, there are two risks that raise some concern.” He underlines it Johanna Kyrklund, Group Chief Investment Officer, Schroders.
Bond yields rising
Firstly – explains the expert in a comment – the increase in bond yields will it put the shares at risk? Since 2020 there has been talk of a change in the market regime. The 2010s were characterized by tight fiscal policy and zero interest rates. It was an era that we might describe as “Adam Smith on steroids,” as the theory predicted that individuals and businesses acting in their self-interest would create positive outcomes for the economy. It was the invisible hand that operated on a global scale.
However, “this led to excessive income inequality and a feeling that the “average person” in the West was not getting enough from the system. This, in turn, has led to support for populist policies and a new consensus centered on more generous fiscal policy, protectionism and higher interest rates.”
More generous fiscal policy implies greater debt.
Right now, “the UK is under scrutiny with a significant rise in Gilt yields after the October 2024 budget. This volatility highlights how fiscal policy is a much more important driver for markets than it was a decade ago. However, even if today iThe UK is under pressure, This is not a problem that affects just one country.
In many regions, demographic aging e the need to spend in new areas, including defense, will lead to higher levels of debt. These will become the ultimate speed limit for market returns”
“This is because the ultimate limit to populist policies will be their consequences on inflation and debt levels and the bondholders’ willingness to accept them. Government spending has helped support economies, but could spell some trouble for stocks going forward, with excesses in the system that would normally be addressed in a downturn.”
Stock valuations “can be supported if bond yields do not rise too much. With the 10-year US Treasury yield now hovering around 4.8%, we are starting to enter a more dangerous zone for stock valuations than bonds. Rising bond yields can draw money away from the stock market and increase financing costs for companies.”
From a tactical point of view, “I find it interesting that, after a couple of years in which a downturn or recession was predicted in thethe United Statesmost market commentators, including us, now have positive forecasts for the US economy. This could mean that, from a contrarian perspective, the path of bond yields could be calmer in the near term, especially as US interest rate cuts are all but priced in for 2025. However, high bond yields are a risk to keep an eye on during the year”.
Index concentration
The second challenge – explains the expert – is represented by the level of concentration of the weighted indices by market capitalization. We believe that the strong earnings growth seen by large-cap technology stocks this cycle is very different from the speculative bubble of 1999/2000. Back then the valuations were impossible to justify. This time, many of the big US tech companies are making enough profits to support their valuations. However, a misstep by one of these companies would put overall market returns at risk, given their dominant position in major indexes.
In fact, “the level of concentration of the indices far exceeds that of the late 1990s. From a portfolio perspective, such high exposure to a small number of stocks is not prudent. Furthermore, the dynamic of each of the “Magnificent 7” is different. Treating them as a block underestimates the different business drivers of individual companies. Given the concentrated nature of the market, now is not the time to make inadvertent bets.”
US risks shared with other markets
Market concentrationit is equally high in Europe and JapanAnd. Investors who rely on past winners to drive performance are already starting to lose steam. Since the summer of 2024, we have seen a much more interesting path for markets, with different sectors performing differently at different times”
“At a time when major stock indices are not offering the diversification they once did and changing political consensus is altering correlations between various asset classesinvestors will need to work harder to build resilient portfolios“, concludes the expert.
