Last year was a good year for balanced, globally diversified portfolios with a mix of bonds and equities. The Euro Stoxx 600 returned 6%, the MSCI World Index appreciated 17%, whereas EUR Investment Grade (IG) and High Yield (HY) bonds returned 4.75% and 6.88% respectively. If your portfolio was more biased towards US stocks, returns were even better, with the S&P 500 generating a 23% return whereas the Nasdaq was up 27%.
These returns were made despite rising geopolitical risk, wars, relatively high interest rates, and a US general election. One could easily assume that this year will simply be a repeat of the last and investors may merely extrapolate return expectations for another year, selling any losers and holding onto, or even adding to, winners. However, this year will almost surely be different and what follows are some of the most important risks and opportunities that investors will face.
Starting off with the risks, the potential for a global trade war is of prime concern. Donald Trump promised a blanket 10-20% tariffs on all US imports and tariffs as high as 60% on China. Whereas it remains to be seen how much of it is a negotiating tool to enable countries to yield to US demands on various fronts, investors cannot discard the possibility of tariffs being enacted.
Europe is seen to be at risk of a growth slowdown both directly and indirectly through its trade with China whereas US inflation might buck its decelerating trend, even if temporarily. The ultimate impact will depend on the exact tariff rates being applied, on whether only particular industries will be targeted and on any retaliatory measures by other countries.
Tariffs will also impact currency markets, likely resulting in a stronger US dollar, a weaker Chinese Renminbi and a weaker Euro. Global supply chains may also change. Therefore, investors will not have an easy task navigating the potential impact of tariffs and positioning their portfolios accordingly.
The equity market rally of the last two years pushed the valuations of US large caps higher. The S&P 500 is trading around 22 times earnings compared with an average of around 16 times since 2005. The ‘Magnificent Seven’ were responsible for the lion’s share of gains, with the top 10 stocks of the S&P 500 accounting for around 30% of its value, even though recently there are signs that the rally has been broadening.
Artificial intelligence (AI) played a big role in driving investor optimism about future profitability as well as taking NVIDIA’s market capitalisation to dizzying levels. Whereas the promise of AI to boost the economy’s growth potential is undisputed, so far it is unclear to which extent the massive capital outlay of companies such as Apple, Microsoft, Google, Meta and Tesla will be monetised.
Reducing portfolio concentration risk is advisable and one should consider reducing exposure to such winners, and rebalance in companies that have lagged in the rally but have potential to converge.
For example, some European companies are trading cheap after investors sold European stocks across the board due to the threat of tariffs; banks should benefit from cheaper valuations, lower policy rates and a steeper yield curve that make lending more attractive, with deregulation in the US another positive factor, while utilities should benefit from lower rates and AI investments.
Defence stocks should also benefit from geopolitical conflicts as governments around the world seek to boost their defence capabilities. Another way to reduce concentration risk is to diversify in countries such as India; whereas its equity index is not trading cheap relative to earnings growth forecasts, it should be seen as a long-term investment that capitalises on its expected high GDP growth of 6 to 7%, strong and growing domestic demand, favourable demographics, and even the potential to attract companies away from China.
Rich valuations in certain segments of fixed income should also not be ignored. Both IG and HY bonds can be considered expensive as they are trading at tight spread levels compared to history. Stretched valuations leave less room for disappointment and may lead to sharp knee-jerk reactions to negative news.
However, a steeper yield curve creates opportunities for investors who have appetite to increase the duration of their portfolio and lock in yields for longer, and reduce the reinvestment risk of constantly having to re-invest maturities in very short-term fixed-income investments in a falling interest rate environment.
One of the reasons that the US economy continued to grow strongly in the last few years, despite a sharp increase in interest rates, is the large fiscal deficits the government has been running since COVID. As a percentage of GDP, the deficit has been running at around 6%, and the expectation is that it will stay elevated and even gap wider under a Republican government if a full extension of the Tax Cuts and Jobs Act and the potential for a lower corporate tax rate for US based companies exceed spending retrenchments.
This is likely to create inflationary pressures and keep rates higher than would otherwise be the case, in turn increasing debt interest payments and worsening debt sustainability. According to the Congressional Budget Office (CBO), the debt-to-GDP ratio will exceed its post-WW II high of 105%, to reach 107% in 2029. This might put upward pressure on yields, especially at the long end of the yield curve, and increase bond volatility, thus tightening financial conditions and potentially creating a headwind for equities and risky assets.
Another factor that can fuel US inflation, apart from tariffs and wider fiscal deficits, is a limit on labour supply through immigration caps. However, in a soft-landing economic environment that is susceptible to renewed inflationary pressures, investment in assets such as equities and gold should yield better returns compared to nominal bonds.
To sum up, in 2025, investors should not leave too much cash in low-yielding bank deposits and short-term fixed income beyond their liquidity needs at a time when interest rates, especially in Europe, should continue to fall. It is also important to reduce concentration away from the stock winners of 2024 and invest across currencies, geographies and industries that are better placed to navigate the risks associated with tariffs and elevated valuations.
Colin Attard is head of investment strategy at Curmi and Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.