Q1 2025 Investment Update

 Overall, investors had a good year in 2024, with global stock markets benefiting from optimism over falling inflation, easing monetary policies, growth in Artificial Intelligence (AI), and the US election result. This helped drive good returns in equities led by the large US technology companies (the so called Magnificent 7) which have increasingly dominated market returns and make up over 30% of the S&P500 index. We have come to believe that this is the result of relentless flows into passive (or index tracking vehicles) which invest into stocks in proportion to their market capitalisation and by definition are not valuation sensitive investors. This has left pockets of markets expensive and increasingly dislocated from fundamental reality.

Global bond markets also delivered positive returns although this was largely driven by “carry” which is investment jargon for the interest earned rather than capital appreciation.

Economic growth forecasts for 2025 are positive. The spread of economic activity is not expected to be uniform: emerging Asian economies should continue to grow at a healthy rate close to 5% whilst economic growth in advanced economies is likely to average 2% in the coming year, led by the US but pegged back by lacklustre growth in the Eurozone. Similarly corporate earnings growth, led by the Magnificent 7 is expected to deliver another solid year. Any geopolitical concerns about Donald Trump were assuaged by the expectation that his bark was worse than his bite and the bluster was just a negotiating tactic. Consensus forecasts were expecting further gains in 2025 led by the US.

Likewise, the consensus view for bond markets was for a benign outcome in 2025. Expectations for further declines in the rate of inflation towards Central Bank targets (usually 2%) would lead to further interest rate cuts which are positive for bond markets.

It may be too early to say that the consensus narrative has changed but it has certainly been challenged by recent news:

The development of DeepSeek, an AI engine in China for a fraction of the cost of AI engines like ChatGPT and without the need for expensive high-powered chips from Nvidia brings into question the economic moat of technology superiority and whether or not the tens of billions of dollars spent on AI development by the tech companies will turn out to be a poor investment. These concerns could undermine the demanding valuations of the Magnificent 7 tech stocks.

When Trump did not immediately impose punitive tariffs on US trading partners on his first day in office, much of the investment world heaved a sigh of relief. However, as Trump’s recent announcement of tariffs on Canada, Mexico and China subsequently proved—this was no reason for exporters to the US to celebrate. And although there has been a stay of execution for Mexico and Canada it looks like China is less likely to accommodate Trump and has imposed retaliatory tariffs.

Economic developments in the US point to a bottoming of inflation above the Federal Reserve’s 2% target and this is before the impacts of any tariffs (which will push up the price of goods) and immigration (which will reduce the supply of workers) is taken into consideration. This has reduced expectation of interest rate cuts in the US.

We would not claim to have anticipated the development of DeepSeek. However, the increasing uncertain and unpredictable outlook driven by politics and the market perception that we will see fewer interest rate cuts in 2025 is not a surprise. We have been positioned somewhat defensively since September when we took profits in the Fidelity Global Index fund based largely on valuations.

Nevertheless, developments so far have not materially dented investors’ enthusiasm for equities. Encouragingly we are beginning to see signs of a rotation whereby previously unloved segments of the markets such as non-US regions (where the portfolios are overweight) or out of favour categories such as US small cap are beginning to outperform the Magnificent 7.