This year has been a better year for investment markets compared to the previous couple with less volatility and returns coming from a broader set of assets.  We think that this sort of market might continue for another couple of years with three key points to be aware of:

1. Equity market returns should broaden
2. Bond markets could produce equity-like returns
3. Bouts of short-term high levels of volatility will become more frequent

Equity market returns should broaden

The last few years have been dominated from a return perspective by the so-called ‘Magnificent Seven’ – Apple, Alphabet (Google), Microsoft, Tesla, Nvidia, Meta and Amazon, the largest seven listed companies in the US.  Share prices rise for two reasons – the first is that profits rise, the second is that investors are willing to pay more for future profits.  The reason why these seven firms have performed so well is a mixture of both, that profits have risen strongly on a consistent basis and that investors are willing to pay more for future profits.  At the same time, investors have been willing to pay less for other firms (in the US and elsewhere), so we’ve ended up in a situation where equity market returns outside of these seven firms have significantly underperformed.  We expect this to change in 2025.

Profit growth for medium and smaller firms is expected to exceed that of larger firms and that coupled with lower starting valuations could lead to a shift away from those seven large firms to other parts of the equity market.  The last time that profit growth was higher for small and medium compared to large sized firms led to significant outperformance.  Whilst we continue to have large-cap exposure, we recently increased our holdings in global small and medium sized companies.  Some of the best performing assets in the portfolio this year have been those that underperformed in the last couple of years, and we expect this sort of rotation to continue.

Bond markets could produce equity-like returns

Whilst you should expect equity markets to provide higher returns than bonds, the difference over the last three, five and ten years has been stark, mainly due to interest rates being at near zero then rising significantly.  The difference in expected total return for equity and bond markets for the next few years is quite similar, which is why we have been increasing exposure to bond markets.  A quick example would be Pimco Income fund, which is held in all portfolios and invests in bonds globally, with a skew towards the US.  It currently offers a gross yield to maturity of 7.33% and this figure has a high correlation with future five-year returns.  We don’t need interest rates to fall to generate that return, however if they did, returns would be higher over the short-term than expected.  It isn’t solely bond markets that should perform well, it is also interest rate sensitive assets, such as infrastructure and property.  All of these asset classes have struggled in recent years; however they are now offering high real returns (after inflation) and means that investors don’t have to take as much risk as they have done to achieve inflation-beating returns.

Bouts of short-term high levels of volatility will become more frequent

As mentioned earlier, this year has been quite calm from a market volatility perspective.  However, it didn’t feel calm in the first week in August, when the main US equity index, the S&P 500 (the largest 500 companies listed in New York) fell by 6.1% in three days and the main Japanese index, the Topix, fell by 18.5% over two days.  The structure of markets has changed over the last ten years, with much higher levels of investment in passive investment products (also called trackers), especially in equity markets.  In 2014, there was roughly $10 trillion invested into active investment products compared to $4 trillion in passive products.  Today, there is roughly $13 trillion into each (source: Morningstar).

These products are called passive as they buy (or sell) companies based on their current size, instead of whether the companies are attractive investments or not, for example Apple currently makes up about 7% of the S&P 500 index, so the tracker will buy 7% of Apple irrespective of the outlook.  They only buy when investors add more money to the product.  The problem comes about when investors sell.  The passive product automatically sells everything, and like when buying, will do this irrespective of the price.  This creates sale demands for all stocks at the same time with one-way trades.  This is different from an actively managed product, where the fund manager will decide what to sell to create liquidity and could still even buy companies.

Therefore, with more going into passive products, buys and sells will be increasingly on or off, which has the potential to create a vacuum if there aren’t enough buyers to take up the sale orders (and the other way around).  Therefore, at these times, markets would fall by more than they would otherwise have historically.  There are other issues too, including the changing role of banks in providing liquidity and the role of high-frequency and automated strategies.  The vacuum that this could cause isn’t anything to do with whether Apple is a good or bad investment or it is expensive or cheap.  This means that when investment flows are positive, there is a risk that Apple’s share price rises by more than expected because of the one-way nature of passive buys at any price and the share price will fall by more than expected if investment flows into passive products turn negative.

We have seen an increase in hedge fund strategies looking to take advantage of the arbitrage opportunities that automated passive product flows create.  When we see bouts of volatility, it makes investors nervous, especially if there are large sudden drops in asset prices.  Our role is to try and take advantage of these times and reassure clients that volatility is a normal feature of markets, even if they become more frequent and unpredictable.

We expect 2025 to be a good year for investment markets as interest rates fall to ‘neutral’ levels of around 3-4% in the US and UK, which will support interest rate sensitive asset prices and earnings growth will support a broadening of returns from equity markets.

Have a great Christmas everyone and enjoy the journey!