
View From The Top: Not out of the woods
View from the very top: We see good reasons for improved investment returns over the remainder of the year. However, the path forward will not be linear and tail risks remain. Markets are effective as both discounting and restraining mechanisms. Investors have already begun to look beyond a likely near-term economic slowdown. The more extreme policies proposed by the Trump administration have also been moderated and will likely continue to be so. However, persistent macro and policy risks continue to keep many investors cautious and markets reactive. There may be no permanent trade peace during this administration, while a reckoning over burgeoning budget deficits awaits. Such dynamics reinforce the case for truly diversified allocation strategies. With over $7tr sitting in money market funds, now is a good time to be both an opportunist and a contrarian.
Asset Allocation:
- Equities: The MSCI World Index is just 1.3% below its all-time high. This performance elides both the major drawdown witnessed earlier in the year and the massive dispersions that have occurred. Value has outperformed growth and almost every other region has beaten the US. Investors who have diversified across equity strategies have clearly benefited. Equities have been helped recently not just by macro developments but also by the most recent earnings season being better than feared. Although the earnings revision ratio (of upgrades relative to downgrades) has deteriorated since the start of April, for us this implies that risks are now better priced than previously. Project forward and we continue to advocate diversification across style and region. Active managers should truly benefit in this environment.
- Fixed Income/Credit: Debt has arguably experienced a secular bear market for the last five years with yields on 10-year US Treasurys at 4.4% vs 0.7% in May 2020. Higher bond yields since the start of April reflect both growing concerns about the sustainability of the US fiscal position as well as improved relative flows into equities at the expense of fixed income. More elevated yields are not just a US phenomenon either, evidenced by trends in the UK and Japan. We do not expect a change in these dynamics any time soon and recent moves reinforce the limits of traditional 60:40 allocation models. Our approach within the space is one of caution (especially around duration) favouring strategies that can play across the credit spectrum.
- Currencies: A negative Dollar stance has become the consensus view reinforced by the Dollar’s 8.5% % year-to-date decline. The Euro, by contrast, is experiencing its best year since 2017 while safe-haven currencies such as the Yen and Swiss Franc are appreciating too. We believe that currencies will mean revert over time. More crucially, it is hard to see what might replace the Dollar as the world’s reserve currency.
- Gold: A structural bull market in gold does not preclude near-term setbacks. For us, gold remains a strategic asset, serving as a portfolio diversifier and hedge against both geopolitical uncertainty and economic instability. Appetite from Central Banks remains robust.
- Alternative Assets: We believe this asset class can provide another useful form of diversification. Many alternative assets offer collateral-based cashflows. At the same time, they benefit from an illiquidity premium too. We advocate being highly selective across this broad and diverse area, favouring differentiated and uncorrelated strategies.
2025 has certainly not been dull. Rather, it has felt more like a rollercoaster so far. Investors have had to endure marked gyrations in both directions whether they like it or not. Equities are now higher than at the start of the year and bond yields lower (using the MSCI World Index and the US 10-year Treasury yield as proxies) but to assume that we are out of the woods would be naïve. Although we see good reasons for higher returns in the second half of 2025, the path forward will not be linear and tail risks remain.
Such a view is informed by simple pragmatism. Intra-year drawdowns in equity markets are a normal occurrence and happen almost annually. We may well have had ours already. The MSCI World Index fell almost 17% from mid-February to early-April. The move could indeed have been seen as inevitable after two prior years of double-digit gains. Readers clearly know the main reason for the move: Trump-inspired policy uncertainty.
The good news is that event-driven, as opposed to structural downturns tend to be shorter, with faster recoveries. Think of tariffs as a supply-side shock that serves to dampen demand. We are now past peak tariff uncertainty. As such, investors may already have priced a stagflationary pause into their expectations. Put another way, the economy typically follows capital markets with a lag. Think of markets, therefore, as being an effective discounting mechanism.
They are also an effective restraining mechanism. There have been signs everywhere in the past month – in bond markets, credit rating agency actions and FX markets – that US policymakers have less room to manoeuvre than they previously may have thought. There does appear to be a growing (grudging) recognition that at least some members of the Trump administration are becoming cognisant of the damage that incoherent policy actions can inflict on both the economy and financial markets. Awareness of the pending 2026 mid-term elections may also allow for a de-escalation stance to endure.
Fear, however, sells. This explains why $7tr is currently sitting in money market funds, per Bloomberg. It also underscores why the ‘end of American exceptionalism’ narrative has become so popular, even though it would be very difficult for investors to find comparable pools of liquidity and depth of capital markets anywhere else in the world. Now may be a bull market in diversification (away from the US), but it is also a great time to be a contrarian.
The disconnect, of course, arises from the fact that although markets may recover quickly from the tariff episode, it will practically take longer before confidence is restored among consumers and corporates. Persistent macro and policy risks are keeping many investors currently cautious and markets reactive. Policy developments may matter more than fundamentals in the near-term. More broadly, investors may need to recognise that we are in an era of regime change. There does seem to be a secular shift towards politics driving economics, or economic policy. The boundaries between capital markets and national security policies are becoming increasingly blurred.
As far as the macro is concerned, a brief slowdown in growth looks a far more likely outcome than either a severe correction or a stagflationary bout. Sure, the US economy reported a 0.2% drop in GDP in the first quarter of the year – its first contraction since 2022 – but the Atlanta Fed’s latest estimate for second quarter GDP stands at over 2%. The Fed’s 2025 forecast of 1.7% looks achievable. A weaker Dollar and a lower oil price (down 8.5% and 15.3% respectively year-to-date) will both be helpful for the US economy too.
Investors are effectively discounting the slowdown scenario, with the Fed Funds Futures assuming only two interest rate cuts in the US this year now, versus as many as five at peak fear in early April. Should disinflation play out for the remainder of the year, then this may even put the Fed in a position where it has increased flexibility over interest rate policy. CPI inflation readings have fallen for three consecutive months. April’s 2.4% figure was the lowest since February 2021. Estimates for PCE inflation continue to come in below expectations too.
The problem with data is that they tend to be backward looking, while softer metrics that seek to gauge sentiment have been wildly inconsistent. The damage may already have been done. Uncertainty is unhelpful for both businesses and consumers. Corporates have front-run inventories with inventory-to-sales ratios lower than during the pandemic (per Bloomberg). First quarter earnings calls have helped prepare investors for tariffs to have a negative impact on profits. The damage may show up in Q2 and Q3 earnings reports. Meanwhile, consumer balance sheets are not as strong as they were, with pandemic-accumulated savings now broadly drawn down. The New York Fed reports that the share of credit card balances at least three months delinquent stands at its highest in 14 years.
Worst-case scenarios may now be off the table, but it does seem reasonable to assume that there will be no permanent trade peace in this administration. World trade does not get re-ordered overnight. Signing deals takes time and is complex. These dynamics are now much better understood – and discounted – than at the start of the year and for as long as de-escalation lasts, the path of least resistance may be higher for equities.
If only it were as simple as just tariffs. The other issue with which investors have had to contend in the last month is fiscal sustainability. If tariffs won’t (or can’t) make America great again, then perhaps a stimulative budget with tax cuts will. The problem with this strategy is that a pro-growth approach encounters restraints. As soon as yields rise, so do the costs of servicing debt. Even if the metaphorical can has been kicked down the road many times, there are limits. The bond market can (and should) act as a constraint on fiscal largesse. The cost of servicing US debt is already the highest it has ever been outside a war, recession or pandemic and is set to remain above 6% of GDP, or over $2.5tr annually, through until 2050, according to the Congressional Budget Office.
Both the tariff and budget episodes can act as useful case studies for investors. As we have written in previous commentaries, the reaction of financial markets to the policies proposed by the Trump administration acts as an effective barometer. The extent that protectionism and fiscal stimulus can and will be pursued will be dictated by the performance of the economy and the markets (not to mention the courts).
To plot an appropriate path forward, assume then that the economy slows but does not crash, politicians compromise through necessity and the Fed steps in as appropriate. Such an outcome would see equities trade higher and bond yields lower. Were AI to result in true productivity gains for the economy (and investment in the area is certainly not slowing) then this could be a further source for upside. Geopolitics remains a wildcard. Nonetheless, investor expectations and corresponding are markedly more cautious than six months ago. This creates clear opportunities even if we are not out of the woods yet.
Alex Gunz, Fund Manager, Heptagon Capital
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