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Q1 2025 Outlook

 

2024 proved to be another volatile year for investors. It was a year of policy speculation, both in terms of the path forward for interest rates and politically, with key elections over the year driving sentiment from week to week. As anticipated, developed central banks started normalising policy during the year, however surprisingly resilient growth in the US and sticky inflation meant markets pared back expectations for how quickly interest rates would decline over the year, resulting in mixed performances across key asset classes.

Performance also varied between regions, with US economic performance decoupling from other major regions over the year. In the US, economic exceptionalism continued to drive valuations higher, with strong returns from the dominant US tech sector leading momentum despite signs of weakness appearing elsewhere in the US economy. In Europe, economic momentum declined over the year due to challenges within the manufacturing sector and political turmoil, with challenges for growth in a period where tech was a key driver of performance. In Asia, weaker Chinese activity and a strong dollar weighed on the region throughout the first half of the year, before policy changes injected a much-needed sense of optimism to the growth outlook in September.

In the UK, markets started the year strongly, with UK assets outperforming their European counterparts as the economy recovered from 2023’s lows. In October, the new government’s Autumn budget put a halt to this outperformance, denting investment sentiment and shrinking growth expectations, leading to an increase in UK bond yields as investors assessed the potential inflationary impact of the measures. Following this, UK assets saw a re-rating of risk, with markets moving to price in only one interest rate cut in 2025, despite continued signs of weakening economic activity.

Looking at performance over the year, after performing strongly earlier in the year despite their low equity content due to a conviction-led approach and an overweight position in UK government bonds as yields declined, the Volatility Managed portfolios lost momentum in October following the UK budget, with the conviction-led holdings declining on the back of the surprise expansionary nature of the measures. Despite this setback, we chose to maintain the overweight position on the basis that markets had overreacted and priced in too much bad news in our view, therefore any temporary underperformance would be reversed, and the yields on offer are attractive.

In comparison, the Long Hold portfolios performed strongly during this period due to their higher equity content, with Donald Trump’s victory in the US election, combined with Chinese policy announcements delivering a fresh boost to risk assets to finish the year positively. It is worth noting that due to the long-hold nature of these portfolios, they tend to focus on the medium to long term outlook, and where the outlook remains positive, they will ride market momentum, without the need to manage risk or protect capital given the short-term risk outlook – a key difference against the Volatility Managed portfolios.

Looking forward, our short-term outlook remains positive for the Volatility Managed (VM) portfolios and we are expecting some volatility in the Long Hold (LH) portfolios but expect both over the coming 12 to 18 months to provide strong returns, with one being risk adjusted and the ether open to full market volatility, on which we are expecting a roller coaster.

Within the VM portfolios we are mindful that with deteriorating economic data, geopolitical tensions and protectionist US policy on the horizon, we are likely to see some volatility in markets in the coming 3-6 months. Over this time horizon with our overweight position on UK government debt and underweight equity we feel we are perfectly positioned, as long as Trump does not cause inflation by imposing unexpectedly high tariffs.

As we look ahead, after carefully analysing the risk outlook, here are our key themes to watch in Q1 2025.

An Improvement in UK Bond Market Conditions 

Despite recent shifts in the political landscape weighing on bond yields in the near term and contributing to market volatility, our expectation in the next 3-6 months is for bond yields to decline meaningfully as growth stagnates in key economies. If we look back at historical levels, the 20-year gilt yield is now the same as it was in July 1998 (nearly 27 years ago) when interest rates were 7.5% (the peak). They then fell to a low of 5% in June 1999 and over this period, we saw 20-year gilt yields fall to 4.25%. We believe we are witnessing a very similar situation now. The recent jump higher in yields is down to the Autumn budget and Trump tariff risks spooking the market, both of which we feel are now overdone.

As real risks become pronounced in Q1 2025, we expect investors to look towards US and UK government debt as an attractively positioned asset class, bringing down yields again. As a result, we feel that these assets are particularly well positioned to perform strongly in the first 3-6 months of 2025. At a certain point, we will dispose of our position and reinvest into equities, but for now, we need to see how Q1 develops, and the level of tariffs Trump intends to introduce before we make that decision. The below chart highlights the recent return to levels not seen since 1998 in the UK 20 Year gilts, which we see as irrational given market fundamentals.

 

Chart 1: UK 20 Year Gilt Yield 1998-Now

 

Our forecast is that the 20 year gilt yield could move anywhere between 4.25% and where it is now in the coming 3 months if data continues to weaken in the UK. We monitor the data constantly and will be waiting for an opportunity to close our position within the Volatility Managed (VM) portfolios and realise a nice profit.

Continued US Dollar Strength

Further supporting this view for yields to fall is the recent weakness in Sterling against the US Dollar, which in our view confirms the market’s view that there is underlying weakness in the UK economy (and the contrasting strength of the US). We believe that interest rates in the UK will fall by more than in the US, and by more than what bond markets are currently pricing. As such, we expect the dollar to remain strong in Q1.

Muted Equity Performance

Equity market performance in 2025 will undoubtably be influenced by how and when President-Elect Donald Trump introduces his proposed trading tariffs. This remains somewhat uncertain at present, and we therefore expect equities to remain muted in Q1 2025. However, we do expect equities to have another positive year in 2025 as interest rates continue to decline and more clarity is gained on future fiscal policies. At present, we feel the return potential of bonds is greater than equities, hence we continue to maintain our overweight positioning to these assets in the Volatility Managed portfolios, however we are expecting to shift this positioning back later in the year as equities once again become more favourable.

Geopolitical Tensions

With ongoing conflicts in Ukraine and the Middle East, geopolitical tensions will undoubtably continue to play a role in influencing investor sentiment, although it should be noted that a significant escalation in either region that could cause negative impacts to inflation is not our base case expectation. We will be watching developments closely for any signs that could shift this narrative and impact our outlook.

Conviction

We understand that the recent movements can be concerning as bond and equity market momentum shows signs of short-term weakness, however when we look past the short-term “noise” we are currently observing in markets surrounding political factors and interest rate speculation, research continues to point to a significant shift lower in yields, and a positive medium-term outlook for the global economy. With key events such as the US Election now out of the way, we believe that domestic investors will shift to focus on the fundamentals of the UK economy, with growth in the UK now showing signs of stagnation while interest rates remain in restrictive territory, signalling a need for the Bank of England to take action to support growth in the early part of 2025.

Given our strong conviction surrounding further rate cuts in the UK and Europe as economic growth in both regions continues to underwhelm, we believe that equities which carry a sizeable exposure to their respective domestic economies remain well positioned to deliver strong returns in a declining interest rate environment over the year. With a focus on those assets which we feel will outperform in an environment of falling interest rates, we believe that the current portfolio asset allocation of both the VM and LH portfolios can deliver strong returns in 2025.

Contact Us

OCM Asset Management HQ
St Clair House, Old Bedford Road, Northampton, NN4 7AA
T: 01604 621 467
E: dfmsales@ocmassetmanagement.co.uk