For investors seeking stability and income, the expected moderation in inflation could create opportunities for fixed income investments, while US equities are likely to perform well under a Trump administration and small cap stocks could continue to catch up to larger companies, according to Schroders portfolio managers.
"Investors should be prepared for a landscape where bonds may not only serve as a safe haven, but also as a source of income amidst fluctuating equity markets," said Kellie Wood, head of fixed income, Australia, at Schroders.
“As we shift to a new investment regime involving higher inflation and greater macroeconomic volatility, fixed income’s defensiveness is likely to be useful in different ways compared to past decades. The key roles of fixed income will be to generate income, and to provide shelter in a weakening global economy.”
According to Ms Wood, higher bond yields should improve fixed income returns compared to equities, which, along with higher cyclical risk in equities given relatively high valuations, could result in a flatter efficient frontier.
“60/40 portfolios are arguably challenged by the possible correlation shift. This argues for a strong role for fixed income as an income generator.”
She said the key shift for investors in fixed income allocations is likely to involve lower duration bonds, absolute return strategies and high income products investing in diversified credit.
“We retain a mildly positive view on global duration. While the macro backdrop has become less favourable, it is also true that bond valuations have improved significantly over the fourth quarter, as markets now price a less aggressive profile for interest rate cuts from the US Federal Reserve, which has pushed up Treasury yields.”
Schroders is most cautious on the US, retaining a preference for European and Australian bonds, where the macroeconomic environment is more conducive for interest rates to decline and bond prices to rise.
“We continue to hold inflation protection via inflation-linked bonds in both the US and Australia. These positions offer some protection for a more permanent move to a higher for longer environment where inflation could remain stuck above central bank targets as growth stays elevated,” Ms Wood said.
In terms of interest rate cuts, Ms Wood points to sticky inflation: “This sets up the Reserve Bank to undertake later and shallower rate cuts than our peers, underpinning sustained yield support for Australian fixed income assets over the near and medium term given attractive valuations and a supportive cycle,” she said.
Meanwhile, an incoming Trump administration could lead to a period of strong economic growth in the US, potentially outpacing inflation, according to Sebastian Mullins, head of multi-asset and fixed income at Schroders.
“The US economy has surprised expectations in 2024, and the incoming Trump administration’s policies may be about to put the US Federal Reserve in a very tight spot. Investors will need to question whether his pro-growth policies will be enough to offset the inflationary forces of his protectionist agenda,” Mr Mullins said.
“We believe 2025 will be another year of US exceptionalism. Growth is likely to remain strong as other economies stumble out of their doldrums. We are cautious that inflation is likely to rise and will create volatility, arguing for more active asset allocation and stock selection as markets decipher the winners and losers of these new policies,” he said.
Mr Mullins is also optimistic about US equities due to the expected policies of the new Trump administration, which could lead to even higher nominal GDP growth in 2025. However, Mr Mullins is also cautions that inflation could re-emerge and create volatility in the market. He suggests that active asset allocation and stock selection will be crucial to navigate this environment.
“Investors would be wise to be more active in their asset allocation and more prudent in their stock selection. From a more strategic standpoint, this will result in pro-cyclical or unstable correlations between bonds and equities, which reduces fixed income’s diversification benefits through time.
The key role of fixed income will be to provide high quality income, and to provide shelter in a weakening global economy. In the most basic sense, the efficient frontier is likely to bear flatten, as the returns of bonds is higher but the diversification benefit reduces,” Mr Mullins said.
Mr Mullins predicts a continuation of the US rotation trade in 2025, with more cyclical companies catching up with the ‘Magnificent Seven’. He suggests investing in the Equal Weight S&P 500 as a way to play this theme, as it has a higher weighting in sectors like industrials and financials and less in technology and communications.
“US small companies likely have further room to run, but we prefer to play this theme with the Equal Weight S&P 500, which has a higher weight to sectors like industrials and financials and less in the technology and communication sectors. This is not to say we’re against the ‘Magnificent Seven’, they are phenomenal companies with margins almost double the S&P 500, but we argue for careful stock selection through active management in this space,” he said.
