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Global Convictions - January 2025

Global equities surged last year, with US stocks leading, while the bond market posted positive returns but failed to outpace inflation. Looking ahead, it’s impossible to predict exactly what will happen over the next 12 months. However, it’s unlikely that US stocks will replicate their recent performance trends over the long term. They are the most expensive market globally, with returns concentrated in a few companies, and there has not been a single 10% correction in over a year. In short, optimism is heavily priced into US stocks. The good news? Many equity opportunities exist beyond US stocks.

And while many risks likely lie ahead, this is always the case because the future is unknowable. Commonly cited risks include a new US administration and high equity valuations, but it’s important to remember the biggest risks are often events nobody anticipates. In our view, the best remedy to risk—whether known or unknown—is a diversified, valuation-driven investment approach.

Broad Investment Backdrop

It was a wonderful year for US equity investors as the market increased by more than 20%. While US large caps claimed the spotlight, not all asset classes matched their pace. US small caps (+11%), international stocks (+6%), and emerging markets (+8%) delivered positive returns but significantly trailed US large caps, a trend that has been rather persistent in recent years.

It’s well known that a few mega-cap stocks have driven most of the market returns in recent years and that has been largely reflected in the outperformance of growth indexes versus value indexes. With that said, signs of broader participation began to emerge in the second half of last year, and it will be interesting to continue monitoring that in the year ahead.

From a sector perspective, communication services, financials, and consumer discretionary led the market as the top performers last year. Utilities were close behind—which is rare to see in a bull market—driven by investor interest in their role in powering the rise of artificial intelligence, a dominant market theme. On the other hand, real estate, health care, and materials were the year's worst-performing sectors.

In our view, valuations in many top-performing areas of the market have stretched beyond fair value, warranting caution and potentially greater diversification. Unsurprisingly, many of our highest-conviction opportunities lie in contrarian segments of the market, including:

Defensive equities, like healthcare and consumer staples
US banks
Chinese equities
Emerging-markets debt
Government bonds and inflation-protected securities

Many of our high-conviction asset classes trade at valuations that are extremely discounted when compared to the mega-cap stocks. And while valuations are not a timing tool, they offer insight into the expectations embedded in prices. In short, the bar is set exceptionally high for US large caps but less so for other asset classes. We believe this should inform investor thinking about how they position portfolios in the years ahead.

In fixed income, while returns were positive, the year fell short of expectations. The Fed’s rate-cutting cycle, which began in September, theoretically should have benefited bonds. However, reality diverged as the 10-year Treasury yield climbed over 100 basis points following the first cut, creating significant headwinds. Looking ahead, with yields at current levels and the potential for additional Fed rate cuts, the outlook for the bond market appears more promising.

US Equities - Low to Medium Conviction

2024 proved to be a stellar encore to 2023. US large-cap stocks finished up nearly 25%, following a gain of 26% in the previous year—one of the rare sequels that surpasses expectations. Notably, it marked the first back-to-back years of 20%-plus gains since 1999, and US large-cap stocks are up nearly 80% since the October 2022 lows. It should also be pointed out that these returns were achieved without sacrificing much scar tissue as US stocks were able to avoid a 10% correction for the full calendar year.

In short, it’s been a smooth ride. The question becomes: Can this continue? While it's impossible to predict a sea change in markets, we believe the best opportunities in US equities aren’t necessarily the ones celebrated on the front pages—such as technology stocks or AI-related themes. We've held that the market is likely to become less concentrated over time, though we can’t set a stopwatch to it.

As we consider starting valuations—together with our belief that the price you pay for an asset plays a prominent role in long-term investment returns—our most reasonable view is that defensiveness should likely play a more prominent role in portfolios. US large cap stock valuations—measured by the CAPE ratio—sit in the 98th percentile of historical readings, nearing the heights of the 2000 tech bubble. Moreover, the valuation gap between US stocks and the rest of the world is at its widest point in recorded history, dating back to the late 1980s.

While valuations are not a timing tool, they offer insight into the expectations embedded in prices. In short, the bar is set exceptionally high for US large caps but less so for other asset classes. We believe this should influence thinking about portfolio positioning in the years ahead.

Outlook

Our conviction for the US equity market is Low to Medium.

Valuation spreads—the disparity in valuation levels between sectors—is where we see opportunity. We are constructive on defensive areas of the market, led by health care, which have improved in our relative rankings and could help offset equity risk as they are not highly correlated with economic cycles. On financials, a more cyclical part of the market, our research leads us to believe that large US banks are still worthy of consideration, though not without risk. Regarding high-flying technology stocks, we don’t assess these stocks with a broad brush, though we are wary of the potential for a “crowding situation,” which in aggregate, has been “over-earning” relative to its own history (meaning, profit margins of late have been elevated versus long-term averages). So, care is required in this space, especially with interest rates rising and valuation multiple implications from those increases. Lastly, while we were very high on the communication services sector in prior periods, strong performance has led to a degradation of conviction down to low-to-medium and the sector is no longer a standout opportunity with the US market.

Europe ex-UK Equities - Medium Conviction

Eurozone equities ex-UK ended the year with a positive return of nearly 7%, despite a decline in the fourth quarter. While solid in isolation, this performance was middle-of-the-pack when compared to other asset classes globally and significantly trailed US equities—a persistent trend.

As noted in our US backdrop, the CAPE ratio for US stocks remains near historical highs. In contrast, European equities are more attractively valued, with the valuation gap between US and non-US stocks now at its widest point since the late 1980s.

Europe’s sector and industry composition differs significantly from the US, with a much lower weight in technology stocks. This difference has been a key factor in the relative underperformance of European equities. However, if market leadership shifts, the performance dynamic could favor Europe, offering further diversification benefits to investors.

Outlook

Our overall conviction score is at Low to Medium, while relative valuations is at Medium, indicating neither a strong reason to underweight or overweight this asset right now.

UK Equities - Medium Conviction

UK equities reflected many of the same trends observed in European equities ex-UK backdrop. The market ended the year with a positive return of nearly 7%, though it faced a decline of approximately 7% in the final quarter.

The sector and industry differences between the US and Europe are similarly applicable to the UK, offering valuable diversification opportunities. Notably, the UK equity market boasts one of the highest dividend yields among developed markets. While this is partly due to weaker share prices, it also highlights unique equity income opportunities.

Looking ahead, investors should focus on future prospects rather than past performance. Attractive valuations and the UK’s distinct industry composition are compelling reasons to consider this market. When combined with macroeconomic tailwinds such as rising GDP, easing inflation, and lower interest rates, the outlook for UK equities could be among the most promising across developed markets.

Outlook

Our overall conviction score for the UK remains at Medium. While relative valuations remain at Medium to High, absolute valuation is Medium. This means our long-standing belief that investors were being well compensated for the risk of investing in UK stocks has softened, coming more in line with international peers.

Australian Equities - Medium Conviction

Australian equities ended the year slightly positive, up nearly 1% in US dollar terms. However, a sharp decline of almost 11% in the final quarter erased most of the year’s gains.

Australia's equity market is heavily influenced by its industry composition, particularly its large materials sector dominated by mining companies. China, a major buyer of Australian commodities like iron ore, coal, and metals, plays a significant role in shaping market outcomes. This dynamic was evident last year: Australian equities rallied in response to Chinese government stimulus in the third quarter but retreated as the impact of that stimulus faded.

Outlook

Australian shares retain a Medium conviction, but strength among the banks and weakness in miners has been driving dispersion within the broader market. The sectoral mix of the Australian market also means that the prospects for aggregate earnings growth are more tempered.

Japanese Equities - Medium Conviction

Japan’s equity market ended the year up nearly 7%, despite posting a negative return in the fourth quarter.

The year was eventful, marked by a major market correction in early August when the unwinding of a popular "carry trade" led to some single-day moves that exceeded the year’s total return. Historically, such volatility is not unusual for Japanese equities, which have often alternated between booms and busts rather than enjoying sustained periods of moderate growth.

On a positive note, Japan continues to implement reforms aimed at attracting global investors, including government mandates designed to boost company valuations by encouraging greater capital returns to shareholders. One notable shareholder, Warren Buffett, highlighted his interest in Japan, referencing his substantial investments in five major Japanese trading companies and his intent to explore further opportunities.

Outlook

While much of the structural tailwind is now behind us, we still see scope for a continuation of improving shareholder interests, rising dividend payouts, and board independence. Japanese stocks also carry attractive diversifying properties that can help in broad market setbacks.

Japanese equities hold a Medium conviction score.

Emerging-Markets Equities - Medium to High Conviction

Emerging markets ended the year with a gain of nearly 7%, despite a decline in the fourth quarter. Zooming out, this marks the seventh consecutive calendar year that US large caps have outperformed emerging markets. While some investors may view this as a reason to abandon emerging-market equities, we believe such a move could be shortsighted.

China accounts for roughly a quarter of the emerging-markets index, significantly influencing the trajectory of broader emerging-market equities. Stimulus measures introduced by the Chinese government in the third quarter sparked a sharp rally, which later faded as investors seek more answers on the impact of these measures on economic growth and corporate earnings.

Emerging markets rarely follow a smooth path—volatility is a constant factor. However, we find encouragement in recent efforts by Chinese authorities to restore confidence in the economy and incentivize consumers to shift from saving to spending.

Outlook

We retain our conviction at Medium to High. We consider emerging-markets equities to be among our preferred equity regions (alongside selected European equities). Many structural (and cyclical) challenges remain for the Chinese economy, but recent performance shows how low expectations had become. We expect Chinese companies to deliver moderate earnings growth over the next decade and remain favorable towards key consumer-facing Chinese technology companies.

Global Sectors

The global equity narrative, from a sector perspective, is largely defined by the rising dominance of technology, while other sectors have diminished in relative size. Although this is a generalization, it highlights an important reality. Conversely, technology's ascent has created more attractive valuations in other sectors for those willing to look beyond recent performance trends.

As valuation-driven investors, we are always peeling back the layers, attempting to identify sectors that hold some combination of factors (depressed valuations, upward earnings revisions, catalyst, etc.) that might indicate where better opportunities exist. We often tend to think of this as The Three U’s: unloved, underappreciated, and undervalued. And right now, the opportunities that fit this description exist outside of technology.

Of course, bells never ring to inform us when a market inflection point has been reached, which means we approach each situation cautiously.

Outlook

We continue to see opportunities at the defensive end, as well as financials. Defensive value-oriented areas of the market have struggled, despite generally robust earnings. Sectors include healthcare and consumer staples, all of which provide services that are required in both good and bad times. Generally, stocks in these categories should be less volatile and less affected by the ups and downs of long-term market cycles. Yet, following weakness, they now present decent valuation opportunities.

Developed-Markets Sovereign

US Treasuries - Medium Conviction
Europe - Low to Medium Conviction
Japan - Low to Medium Conviction

September marked the first Fed rate cut in more than four years, and all signs pointed to an era of lower rates ahead. In theory, this should have provided a favorable backdrop for the bond market, as lower rates generally lead to positive bond returns. Yet, markets love to fool the masses. While the Fed lowered short-term rates in September, long-term interest rates have risen—a surprising twist. The result? Bonds delivered negative returns in two of the three months following the rate cut.

High-quality bonds—represented by the Bloomberg US Aggregate Bond Index—ended the year with a positive return of 1.4%, but this still lagged behind inflation. Moreover, high-quality bonds remain in a drawdown that began in July 2020, making this the longest streak in history at over 50 months, leaving many investors to question the role of this critical asset class.

When performance falters, it’s natural to question everything—that’s human nature. However, there are still compelling reasons to believe that bonds should remain an essential part of portfolios. For instance, the yield curve has normalized and is now positively sloped, after being inverted for much of 2022. This means investors no longer face a yield penalty for extending maturities. With more rate cuts expected this year, longer-maturity bonds offer both income generation and potential price appreciation. In contrast, cash returns are limited to income and could decline further if rates drop due to additional Fed cuts.

In short, bonds appear to offer better value than cash. This has historically been the case, though recent investor flows have favored money-market funds. We believe investors should think twice before using cash as a fixed-income replacement. For example, over the past 35 years, bonds have returned about 400%, while cash has lost nearly 60% after inflation.

Given where yields stand today and the Fed's potential plans for further rate cuts, it's not unreasonable to think there are better days ahead for the bond market.

Outlook

The material increase in bond yields has improved forward-looking prospects, which applies positively to the US, UK, and Australia. Europe is also rising from a very low base, although absolute yields remain broadly unattractive. Yields now cover inflation in many instances, offering positive “real” yields.

Going slightly deeper, the ability to add income to portfolios while mitigating duration/default risk looks attractive to us currently. Healthy government bond yields are a positive for future return generation, and we expect this asset class to continue playing a role for investors. That said, overall, we believe that managing duration risk makes sense in most scenarios. We are cognizant of the potentially sizeable drawdown risk from longer-duration assets and adjusting our bond allocations higher at a moderate pace. Adding materially to duration might make sense at some point, but any changes should be measured and deliberate, given the fast-changing response from central banks and the threat of stickier inflation. The key risk for fixed income is that interest rates fail to sufficiently slow economic growth and inflation.

For corporates, many firms are using free cash flow to fund capex, not debt, and service-oriented firms are less reliant on debt financing than industrials. At the consumer level, most mortgages have locked in lower rates, and while we are seeing signs of slowing housing activity, the risk of a collapse is relatively contained. In this sense, government bonds are in an odd spot. On the one hand, the global macro environment is widely uncertain with a range of outcomes. The domestic economy is challenged with slowing growth and persistent inflation that has the potential to reduce aggregate demand. To complicate matters, central banks have been late to make decisions to address inflation, which could ultimately lead them to a tough bridge—balancing between a hard and soft landing. Further, given the delicate nature of both the domestic and global economies, long-term sovereign bonds seem appropriate to hedge against risks, whether that is aggressive central bank action, a weakening of demand, or both.

Investment-Grade Credit

US - Medium Conviction
Europe - Medium Conviction

Much of the discussion surrounding developed-market sovereign bonds also applies to investment-grade (IG) bonds. IG bonds delivered a modest return for the year, up nearly 1%, but retreated significantly in the fourth quarter, falling by more than 4% as rates rose.

That said, we continue to believe that investment-grade bonds remain an invaluable component of investor portfolios. The potential for declining interest rates, combined with the higher yields currently available, should provide a strong benefit moving forward.

Outlook

Both locally and globally, the higher yields have improved the attractiveness of this asset class over the long run, albeit from a low base. A key element is credit spreads—the difference between corporate-bond yields and government-bond yields—which remain below where they should be, in our analysis, and not enough to be deemed attractive. In this regard, one should be careful of lower-rated companies with high debt levels, as a heightened default cycle can’t be ruled out.

In summary, this space has improved, but the inherent appeal remains muted relative to government bonds. We see some attraction as a middle ground—providing some extra yield versus government bonds and a duration profile that can help in portfolio construction.

High-Yield Credit

US - Low to Medium Conviction
Europe - Medium Conviction

High-yield bonds were the only fixed-income category to deliver a positive return in the fourth quarter, finishing up 0.1% and capping off a yearly return of nearly 8%.

Generally, the high-yield bond market in the US and Europe offers yields in the high single digits, and in some cases, low double digits. While these bonds carry higher risks, their advantages become more apparent when managed with a diversified portfolio that includes high-quality bonds.

Outlook

Our overall conviction is Low to Medium. In our view, this bears watching. While headline default risks are still deemed to be low, this could change if rates stay higher for longer. A shorter duration profile relative to other bonds is also a potential negative in a falling-rate environment.

Emerging-Markets Bonds

Local Currency - Medium to High Conviction
Hard Currency - Medium Conviction

Emerging-markets bonds had a strong year, finishing up more than 6% in dollar terms, which includes a more than 2% decline in the fourth quarter. While the risks of emerging-markets bonds are discussed frequently, they also provide meaningful diversification benefits, especially considering the higher yields compared to other parts of the bond market.

Like high-yield bonds, headline yields in emerging-market bonds remain enticing, typically in the high single-digit range. For example, Brazil’s 5-year bonds yield around 14%, while Mexico’s 10-year bonds yield approximately 10%. Both offer attractive real yields, considering inflation rates hover around 4%.

While emerging-markets bonds carry more risk than other parts of the bond market, there is a substantial yield cushion in place. This reflects the reality that many emerging-markets central banks have raised interest rates far more than their developed market counterparts to combat inflation pressures. As the inflation outlook in most emerging-markets countries continues to improve, so has the resilience of the asset class.

Outlook

Emerging-markets debt in local currency, which we still prefer over hard currency, continues to offer healthy absolute yields, accounting for the added risk. Our view remains that many emerging-markets sovereigns, though with notable exceptions, have improved their fundamental strength compared to history. This includes improved current account balances, enhanced reserves, movement to orthodox monetary policy, and a buildout of a local investor base allowing for a shift to local currency funding. In addition, the aggregation of emerging-markets currencies also looks undervalued overall and could offer a tailwind over time.

The area can be volatile, yet even allowing for some pessimistic assumptions, our research suggests that investors could see upside if they’re willing to risk short-term volatility. In other words, we think investors can expect to be compensated for this risk over time, especially for local-currency bonds.

US Agency MBS - Medium Conviction

US mortgage-backed securities (MBS) were positive for the year, with a gain of 1.3%, although they experienced a decline of more than 3% in the final quarter of the year.

The MBS market still presents an interesting investment opportunity as new issuance (supply) is effectively frozen. New MBS supply often comes in two forms: 1) home sales and 2) refinances. Using data from Bankrate, the average existing mortgage rate in the US is around 3.7%, while the rate on a new mortgage is around 7%. Given that backdrop, refinancing has ground to a halt, leaving home sales as the only source of new supply.

From an investment perspective, the lack of new supply should create interesting opportunities to selectively own this asset class.

Outlook

Overall, fundamentals remain solid. Given the sharp rally in mortgage rates and significant duration extension, the attractiveness of this asset class has improved. Investors will continue to watch inflation and the result it has on overall consumer demand. The idea of slowing economic activity should support higher-rated assets, such as agency MBS, as there is no inherent default risk. That said, further spread widening may take place before it turns in investors’ favor should the economic environment turn sour.

Global Inflation-Linked Bonds - Medium Conviction

Treasury Inflation-Protected Securities (TIPS) ended the year with a gain of around 2%, although they saw a nearly 3% decline in the final quarter as rates rose. Despite this, TIPS ranked in the top half of fixed-income categories for annual returns.

Inflation data has been moving in the right direction (lower), but it remains a very real concern. And a key point to remember is that TIPS generally protect against unexpected inflation, meaning if there was an inflationary event, this asset class would be a potential winner.

Outlook

TIPS should eventually benefit from higher interest rates, and it wouldn’t take much for markets to re-price inflation, which could offer upside. One important consideration is duration risk, where inflation-linked bonds are often longer-dated securities with meaningful interest-rate sensitivity.

US Municipal Bonds - Medium Conviction

Municipal bonds posted a modest gain of just over 1% for the year, although they experienced a slight decline in the final quarter as rates rose.

Generally, municipal bond yields have increased with the broader bond market, and credit fundamentals remain solid. Record employment and increasing wages (especially real wage growth) have bolstered tax receipts. Home values, a factor in property tax revenues, continue to hold up as low levels of inventory have proven to be more important than high mortgage rates.

Outlook

Yields on high-quality municipal bonds have trended higher and look attractive on a tax-adjusted basis. Considering the uncertain economic environment, we expect volatility to persist, however, given the higher-quality nature of municipal securities, downside risks look manageable compared to similar-quality corporate bonds.

Global Infrastructure - Medium Conviction

Global infrastructure represents a wide collection of income-producing assets, which includes utilities, airports, rail, and energy-related holdings. Global infrastructure indexes delivered mid-teens returns for the year, with utilities (notably within the US) benefiting from AI datacenter growth, and transportation infrastructure stocks posting more modest gains. Within transportation infrastructure, Airports performed well, while Railroads delivered negative returns.

An area that has been showing strength and remains appealing in our view is oil and gas master limited partnerships (MLPs). MLPs are publicly traded partnerships focusing on energy infrastructure, serving as “the pipes and plumbing” that move oil and gas. They trade like stocks, on exchanges, derive 90% of their revenue from energy activities, and pass along the bulk of their earnings through distributions. Those distributions mean a hefty yield bolsters the total return for these companies, but they also carry reasonable valuations compared to the broader US energy market, greater capital discipline in recent times, and stronger balance sheets.

Outlook

As an income-focused asset class, we continue to see the outlook for infrastructure as being strongly influenced by the outlook for interest rates. Utilities comprise a significant weight within infrastructure. We see greater earnings growth potential for utilities from AI datacenter growth and the transition to renewable energy infrastructure, however, these opportunities are not without risks as utility companies need to balance up their infrastructure spending plans against ensuring they receive attractive returns on these new investments in the face of higher cost of living pressures for its customers. Following a period of relative outperformance over the past year, we see utilities valuations as comparatively priced to transportation infrastructure.

Listed Property - Medium

US REITs ended the year up more than 5%, but gave up significant gains in the fourth quarter, declining by approximately 8%. Global REITs performed similarly to US REITs over the fourth quarter (down almost 8% on a local currency return basis) but fared worse than US REITs for the 2024 calendar year, only gaining over 2% on a local currency return basis. Negative returns experienced in UK and Continental Europe detracted from global real estate returns.

The biggest swing factor for real estate has been the path of interest rates. At the start of the second half of 2024, when it became apparent that interest rate cuts were coming, real estate was one of the best performing sectors in the market. However, as markets often do, they love to throw curveballs. And though we saw the first rate cut in September, long-term interest rates proceeded to rise (not fall) which dampened the mood for real estate during the fourth quarter.

Outlook

REITs continue to remain dually exposed to economic conditions—both from a top-line rental growth perspective and a funding conditions perspective. As trusts that pay out high levels of earnings as dividends, REITs rely heavily on debt (and equity) markets to fund their highly capital-intensive operations. We see real estate presenting reasonable value at the present time. While we expect trusts to generally benefit from lower property supply coming on as higher construction costs and increased interest rate funding costs discourage property development, we continue to note that investors need to tread carefully due to this asset class carrying highly leveraged balance sheets which are sensitive to the future path of interest rates.

Alternatives

Alternatives continue to provide a nice ballast, though the impact is less pronounced when strong equity returns are present. Of course, this depends on the strategy being adopted. Our view remains that alternative offerings should exhibit genuinely diversifying characteristics (i.e., low correlations to stocks and bonds), with reasonable costs and liquidity. More specifically, with rising bond yields implicating both stocks and bonds in similar ways, alternative assets can appeal given that returns from this asset class tend to have a lower direct relationship with the performance of traditional asset classes such as equities and bonds.

Currency

While currencies are notoriously volatile, we tend to think of currency positioning via the lens of portfolio robustness (focusing on those currencies with defensive characteristics where sensible), but also as a potential source of upside at extremes. Looking ahead, we continue to see merit in currencies outside the US dollar. The yen has the potential to provide diversification qualities and potentially help preserve capital in times of extreme economic and market stress, as well as provide potential upside.

Cash

Cash rates have improved, offering positive real yields in many developed markets. In the current environment, we see cash serving three purposes. First, cash helps reduce the sensitivity to interest-rate rises, especially relative to long-dated bonds, which is still an important risk to manage. Second, cash should help buffer from any future volatility resulting from a fall in equity markets. And third, cash provides ample liquidity to take advantage of investment opportunities as they arise. That said, as equity and bond markets have repriced lower, we see opportunities to keep money at work.

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