Niall McDermott: Duck and dive, 25 – the outlook for the year ahead

Bingo is a game in which luck trumps skill. On further consideration, dare I say there isn’t any real skill involved at all? Sorry Nan. Buy a ticket with three rows of nine numbers (that’s a total of 27 out of a possible 90 numbers for all the geeks out there, but fret not, I won’t go into the odds). Then listen to the numbers bellowed out from the front of the house, daubing your way to success (hopefully). Get a winning combo, and (let’s all yell it), BINGO, you’re in the money.

Now, in the investment world, we tend to be less flamboyant when making a market call. Sometimes loud proclamations are indeed hollered from investment desks or, more likely in our case, my colleague James is singing something he thinks is a rock classic from the 80s. Psychologically speaking, however, bingo and the investment world share a similar bias. Something we aim to avoid, the ‘o’ word – overconfidence, especially in one’s own ability to foresee what lies ahead.

Now for a little controversy. If calling out bingo’s absence of skill wasn’t wild enough for you, we’d also like to admit that we don’t believe in forecasting. Who said fund managers couldn’t be edgy? Now, for a piece looking at the outlook for the year ahead, this might sound rather odd, but hear me out.

Forecasting specific numbers can be dangerous. By taking information at a point in time, you risk anchoring all future expectations to incorrect initial assumptions. To put it another way, you end up unable to separate the future from work you’ve already done. If we fall into this trap, it’s easy to be blindsided by changing dynamics and to fail to act quickly enough to correct past assumptions.

In the Marlborough bond team, we take a different approach. We see differing views on the outlook as a contest of probabilities. Ultimately the goal when investing is not to be right, but to make a return. Fortune tellers need not apply. It’s all about identifying the mispricing of risk. Or, in other words, it all boils down to our bingo word: value.

Our process begins with a high-level view of the different themes playing out in investment markets. While this will never be all-encompassing, it gives us a platform to assess potential market impacts, based on probability and what is already priced in. This helps us frame our investment view.

So ‘eyes down’, daubers at the ready, let’s outline our themes for the year ahead.

Our investment themes for 2025

Duck and dive, number 25

The big one on everyone’s radar is the extent to which US President Donald Trump will press ahead with trade tariffs. The picture remains unclear. The administration imposed, and then delayed, 25% tariffs on imports from Canada and Mexico and has slapped an additional 10% levy on goods from China. But are these tariffs intended to be long-term policy measures – or are they simply a negotiating tactic? Trump has also threatened tariffs against the European Union. Will this escalate into a global trade war – or will Trump pull back from the brink? At the time of writing, the picture is uncertain. We may see Trump press ahead with tariffs. But on which trading partners, and to what extent, is very far from clear. However, will they match the bluster and bravado we’ve heard from Trump? We don’t think so.

Two little ducks, number 22

In February 2022, Russia invaded Ukraine, in what Vladimir Putin believed was going to be a quick victory. Instead, it was the beginning of a war that continues to this day. Trump initially claimed he would broker peace within 24 hours of taking office. More recently he extended this to six months. We are seeing signs of war fatigue, not least among Ukraine’s allies, which is unsurprising given significant fiscal pressures globally. However, a conflict of this scale will be difficult to de-escalate. We believe the risk of a protracted war is not insignificant.

Knock at the door, number 4

France broke a record last year, with four prime ministers in a single year. This was the highest number since the Fifth Republic was established. Political turmoil is expected to continue, as parties on the left and right fight with centrist politicians and appear quite unwilling to make budget concessions to one another. It’s very much political stalemate at a time when fiscal discipline has been absent and both far left and far right want to turn on the spending taps. Given the horrible government balance sheet metrics, and the fact that economic growth is being propped up by government spending, we expect this situation to get worse, so we hold no French government bonds.

Gateway to heaven, number 27

The 27 member states of the European Union (EU) are required to keep their budget deficits within 3% of GDP and public debt within 60% of GDP. This ‘stability and growth’ pact is designed to avoid spending by one country being funded by the others. However, in the aftermath of the pandemic, and facing the strain of higher energy costs and waning exports, governments have let their borrowing get out of hand. Trump also wants NATO members to contribute more cash to the defence of Europe, at a time when the coffers are empty. It seems clear that tough decisions lie ahead. Ultimately, the stability of the EU is at risk, and this is very much evident from the political upheaval in many member states.

Jump and jive, number 35

Germany has long been lauded for its strong fiscal discipline. ‘Schwarz Null’ or black zero, restricts Germany to keeping its budget balanced. However, pressure is mounting to ease the German ‘debt brake’, which restricts annual structural deficits to 0.35% (35 basis points or bps) of GDP. The government has been dissolved, with elections set for February, and incoming politicians are expected to seek to find ways to spend as ‘investment’ to bypass the brake. How the market will view one of the most fiscally conservative members of the EU moving away from its roots remains to be seen. Again, our take is that this spells trouble for the EU.

Staying alive, number 85

Credit spreads narrowed to their tightest in 20 years towards the end of last year, falling to around 85 bps over government bonds. In other words, the extra yield paid by corporate bonds compared to government bonds – to compensate for the additional risk – reached the lowest level for two decades. Various arguments have been advanced to explain this, but ultimately for investors the risk is that spreads widen. And if corporate bond yields rise, that means their price falls. If our assessment of the economic cycle is correct and we are in a ‘late-cycle’ process – the slowing phase before a recession – then all it would take is for a string of weaker economic data to send credit spreads wider. When? We don’t claim to have the answer, and it may not be in 2025. However, based on our assessment we are continuing to shift from corporate bonds to government bonds, and, where we do hold corporate bonds, focus on those of higher quality.

Dirty Gertie, number 30

The overall price-to-earnings multiple for the S&P 500 index is currently above 30. This means that for each $1 of earnings you are paying $30. With valuations this stretched, everything needs to go perfectly for stocks to continue to rise. The slightest hiccup and a correction could snowball into an avalanche. We view current valuations as eye-wateringly high and this has reinforced our cautious stance for the year ahead.

Identifying these themes brings order and discipline to our investment process. It’s not about conjuring magic numbers out the air to tell us the secret of where to invest. Rather it’s studying the evolution of markets in a way that creates a repeatable framework for investing. Patterns are observed and thinking is challenged. We believe that’s a far more sensible approach than metaphorically sticking a finger in the air and coming up with the answer 42 (Winnie the Pooh).

‍

‍

This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.