P(review)

The return of Domestic Politics matters as much if not more than GeoPolitics for 2025

45 x 45 = 2025

This time last year we write a P(review) for 2024, (albeit featuring Janus rather than Trump) which concluded that the macro consensus, having been too bearish in 2023, was too bullish in early 2024. We were nevertheless constructive on equity, wary on bonds and saw cash as a hurdle to be beaten rather than an asset class in its own right.

We saw Politics as an important background and GeoPolitical uncertainty as a reason to hold gold, but as we explored in the almost 50(!) pieces we wrote over the course of the year here on substack, markets were being more heavily influenced by issues such as swinging bouts of optimism and pessimism in bond markets, the collapse of the Yen carry trade and (particularly) the momentum investing in mega cap by index managers, where once again a handful of stocks dominated not only US , but Global equity returns.

As we look ahead to 2025, we still like equity, but our call for diversification, both geographically and by asset class is now effectively consensus from the year ahead reports - if not yet in actual portfolios.

While GeoPolitics continues to grab the headlines, we think that the re-emergence of national rather than supra national bodies is going to have a bigger influence on markets this year, particular through the earnings line, as policies are targeted at voters rather than donors.

(Note that anything underlined is a link to an earlier piece written on substack)

Review

The narrative background for markets in 2024 was dominated by Politics and GeoPolitics, with over 40 General Elections around the world, culminating in the re-election in November of ‘45’ (as the 45th President of the US Donald Trump is known in some quarters - now presumably to be known as 102, ie 45+ 47 or perhaps 45^2.) The fact that 45^2 is 2025 is a statistical quirk rather than any insight, but amusing nonetheless.

A year ago this was far from certain, although as we discussed in our Market Thinking in January the rise of Populist protests from both left and right was an early signal of a ‘change in the weather’ and in our February issue we discussed the re-emergence of Trump as a likely winner.

And yet, despite a number of dramatic exits from the political stage, the Politics had relatively little impact on markets in the first half, although both India and Japan, the two main ‘not China’ asset allocations, did have a poor end to the year, part catalysed by elections that led to a rotation out of those two markets. Japan had also seen a sharp selloff in August (even though it was supposed to be quiet )as the long running Yen carry trade began to unwind, causing some problems for a lot of international investors.

Not coincidentally, q4 was also when China had a dramatic spike - albeit in our view this was more about short covering than any fundamental buying and of course when Trump was re-elected the risk premium returned somewhat as the anti China rhetoric returned.

For markets generally though, it was only when ‘45’ achieved a clean sweep in November that the US markets responded, first with a bounce associated with a reduction in the uncertainty risk premium, then a post Thanksgiving rally that reflected a swing to optimism that saw the US equity markets hit new highs as the meme stocks rallied along with Bitcoin in a manner very reminiscent of the end of 2021.

GeoPolitics also had relatively little impact on markets in 2024, save in Gold, which was one of the best performing asset classes, again until q4, when the prospect, and then the realsiation, of Trump 2.0 led to a modest rotation out of Gold and into ‘growth’ as well of course as ‘digital gold’ or Bitcoin - the relationship between the two was something we discussed back in q1. It also led to an end year rally in the US $, which hit multi year highs on almost all the crosses - most notably against the Euro, but also challenging once again the already weakened Yen.

Earlier fears of a $ Plaza accord may not be misplaced for 2025

This was in direct contrast to the consensus mid year, when the prospect of Trump organising some form of Plaza accord was causing allocators to try and diversify from the $. The fact that the markets seem to have forgotten about this risk is exactly why we should look at it once more. Perhaps after he buys Greenland? Certainly after Private Equity has swapped its dry powder in highly rated dollars for real assets in the rest of the world - something we discussed in Political Cicadas.

The Fed, usually the biggest influence on ‘noise traders’ in FX and fixed income markets, actually did relatively little in 2024, confounding some of the more dramatic predictions from a year ago, meaning that the long end of the bond market struggled. Having begun the year at close to 4% on the 10 year yield in the midst of a ‘Pivot Panic’, it range traded aggressively as the noise traders swung from boom to bust. As we noted in our September monthly, The market probability of a 100bp September cut went from 1% to 58% and back to 3% in a period of 6 months. Hardly helpful.. This behaviour pushed the bond volatility index up ahead of the equity equivalent, causing problems for a lot of risk parity managers and ultimately leading to the long bond selling off steadily into Q4, with a final drop after the Fed cut rates ‘in a hawkish fashion’ in December. As a result, the long bond ETF TLT ended the year down around 11%, confirming our views that it was demonstrating rallies within a bear trend.

By contrast, the equity markets around the world had double digit gains once again, with all the attention being taken by the Market Cap weighted US indices, which recorded gains in the 20 per cents, twice that of their equal weighted equivalents. This continuation of the Magnificent 7 effect was a function of the increased dominance of the valuation and risk agnostic Index tracking industry, which exists simply to buy more of what has just gone up in price and vice versa. The relative ‘success’ of this strategy of extreme concentration is, of course, encouraging yet more assets to flow into passive instrument as the FOMO trade chases returns ‘without risk’.

Being risk and valuation agnostic was a blessing in2024

As we noted last year Indexattion means never having to say you are sorry but importantly, for actual underlying investors seeking to balance risk and return and reduce their downside risk, 2024 was a year of above average returns, albeit far closer to the 10% of equal weighted markets than the 25% of the passive index or the 65% of the truly concentrated Mag 7. Hindsight is a wonderful investment tool and taking massively concentrated bets paid off in 2024. Being risk and valuation agnostic was a blessing.

Like the FOMO trade of bitcoin and the meme stocks these should not distract from the task in hand for wealth managers which is to help grow and preserve capital for their clients.

Preview

Ahead of the actual arrival of Team Trump, we are in something of a ‘phony war’ with much talk and speculation, but little to actually go on. We know from Trump 1.0 that it is important to take him seriously, but not literally and while this time around he has a much more formidable team around him, we also know that realpolitik usually trumps (sic) campaign rhetoric.

As we noted in the wake of his victory (The X Factor) the arrival not just of Trump, but of Team Trump, marks not so much a political shift as a generational one. This is about Generation X, the fifty somethings with a practical and pragmatic mindset, most of whom have earned their spurs in the real world and are sceptical of institutional authority, taking over from the starry eyed Millennials, who have prospered under the wing of the now exiting steely eyed opportunists of the boomer generation. Actual war mongers and culture war mongers are being pushed aside by pragmatists and realists.

Thus while talk at the macro level continues to be about Geo-Politics and the upcoming Trump policies on Trade, Tariffs and the conflicts in the Ukraine and the Middle East (see T.R.U.M.P) arguably more important is the structural change going on beneath the surface - the Death of Davos, or to put it less alliteratively, the unwind of the latest iteration of the great Globalisation experiment and in particular the phase that emerged post the Financial Crisis in 2009 when the technocratic elite (represented by Davos) assumed control of everything from Monetary Policy to Health policy and, via the explosion in ESG, economic and fiscal policy as well. Deglobalisation is the emerging trend.

The populist uprising is a rejection of the Double Dogmas of Davos

The Gilded bubble of neo-feudal globalists is deflating rapidly, Klaus Schwab is retiring this year and the A list attendees at Davos are anything but, certainly compared to the old days. The star turn is probably President Milei of Argentina, but in the light of his excoriating attack on the UN, to the UN itself, it’s hardly going to be a comfort, either to the political technocrats or the C suite of ratchet ratchet and bingo.

A year ago in our P(review) we suggested that cash would go from the one asset that wouldn’t give you a capital loss to the one that wouldn’t give you (much) of a capital gain and that its role would now be as a hurdle for other assets. We also said that the periodic claims of a ‘Pivot’ were overblown and highly unlikely to occur. As such, we saw Bonds as continuing to struggle. We also saw a feedback loop in which Fed action takes into account the stability of the Bond markets first, equities second and the economic data that markets obsess over very much third. This remains our key approach to bonds.

At these levels, Bonds can act as a tactical hedge against equities

This year, with US 10 year yields nearer to 5% than the 4% s they were a year ago, there is room for Bonds to fulfil some of their role of a balancing asset against equity, albeit the higher volatility and the risks of inflation need to be traded off against the gains from a modest further cut in bank rates. The lesson from 2024 is that bonds need to be seen as more of a tactical than a strategic hedge against equity risk. Meanwhile, rather than just straight US bonds, some might prefer a more synthetic basket of high yield bonds, high yield equities and gold for example.

Cost push inflation in the UK and elsewhere threatens stagflation, which is bad for equities as well as bonds

When it comes to inflation it is important to distinguish between ‘demand pull’ and ‘cost push’. The former can be good for equities in so far as it reflects excess demand versus supply and thus the opportunity for windfall profits, but the latter is usually a warning of margin compression and when it is driven by externalities can act to compress disposable income and deliver stagflation, especially if it is met with inappropriate policy response.

This is particularly true in the UK at the moment, which has the long term Achilles heel issue that monetary policy in a floating rate mortgage debt environment (most of the attractive fixed rates are expired) acts like fiscal policy. Raising mortgage rates is like raising taxes. Thus in the orthodox mind of (too many) at the Treasury and Bank of England, a rise in costs that is a reflection of higher taxes that needs to and can be passed on in higher prices needs in turn to be countered with higher taxes in the form of increased mortgage costs! We have seen this movie before (sadly).

Easier Rates in the US will drive Fund houses to try and push lucrative Money Market Fund liquidity into equally lucrative ‘Alternative Assets’

For US rates, we remain of that view that cash is now the hurdle and that rates will ease a little with the important additional point that as rates ease the big fund houses will try and encourage their highly lucrative Money Market Funds to move into their alternative products, making alternative assets one of the big calls for the consensus this year, wrapped up as it is in a call for diversification and a sotto voce admission of the embedded concentration risk in client portfolios something we discussed in a recent post (Risk and Reform)

For bonds, the one big difference from last year is that while last January bonds had rallied to a 4% yield, now they are back at the low end of their trading range, closer to 4.8% and thus offer some of their traditional hedging advantages - certainly for those in the 60:40 paradigm of passive asset allocation.

Consensus is tacitly acknowledging the concentration risk in US Equities - advising diversification

For 2024 we were constructive on equities, although we were obviously way too early on the end of the Magnificent 7 as a concentrated equity strategy, preferring a more diversified portfolio, which while performing handsomely enough would have disappointed the FOMO crowd as well as encouraging the view that a simple (market cap weighted) S&P500 tracker was all that was needed.

This year we stick with that view, while respecting the power of the Index tracking machine to overwhelm value with momentum. We note that the consensus of year ahead notes is tacitly acknowledging the increased concentration risk in the US mega caps with a variety of diversification strategies, both geographic and by asset class.

A positive view on China economically remains our main contrarian call, and something we discussed many times last year, including here , here and here but as with last year we recognise that the negative momentum has to disappear first. We felt that it was largely done by the summer and that by end of Q3 there was a lot of trader negative positioning rather than asset allocator selling. That was reflected in the sharp bounce in early q4 - an over-reaction to policy measures on housing mis-interpreted as a western style stimulus. As such, the 16% return from the MSCI China occurred in a mater of a few weeks as a near 50% jump gave back half its gains before trading sideways.

At the stock level though, there remains a lot of interesting companies (not all listed) but (and with the usual caveat that this note is not investment advice and readers should do their own research and talk to their financial advisor) a classic example is a favourite of ours, Xiaomi, the Apple of China, which along with many other Chinese companies has pushed heavily into the EV space and whose stock is up almost 150% this year.

Indeed, the sudden and surprise dominance of China in this and other areas of advanced manufacturing is a real world example of how the YouTube click bait ‘China is collapsing because of Housing’ has encouraged a false comfort zone around the competitive threat from China. It’s not entirely a nil sum game, but for every western corporate loser (eg VW, Rivian) there may well be a Chinese winner. It would be foolish not to look for them.

The real attraction for investors from China however is a long term structural one. As we explained in Building a Capital market with Chinese Characteristics, the channelling of trillions in cash from Chinese savers into more western style capital markets is a plan in progress. As western markets lose sight of their primary role of matching long term saving to long term investment and become short term option and momentum machines, the role of cash flow, dividends, valuation and diversification is going to emerge in China and by extension Asia.

Global Themes are our preferred way of diversification

Overall though, we remain largely in western markets by default as that is where the benchmarks, liquidity and regulatory preferences remain. While it might feel a little like having almost half your assets in Japan in 1989 ‘to reduce your risk’, the reality is that we need to operate within certain parameters. In these markets the main strategy call is similar to last year; dividends, diversification and disciplined investing.

While we see broad political push back against the strictures of ESG (and note it has fallen heavily out of fashion amongst the larger financial institutions - another reason for the diminution of Davos, as well as the COP jamborees - investors can and should still look at the actual investment in actual solutions, such as Nuclear and battery storage. Effectively, renewables have hit a limit until there is sufficient scale storage and part of the populist push back is going to be against the ever increasing expansion of renewables that either provide too much electricity (that can not be stored) or not enough and require expensive fossil fuel back-up for base load.

These themes are probably best played through ETF baskets at the moment, with the caveat that these newer themes can be quite volatile - and with thins like Nuclear also quite ‘commodity like’ in their short term behaviour.

Also themes like AI, where again some more lateral thinking points us to Robotics as the application of AI to industrial processes is more obviously profit enhancing than automated power point presentations and fancy image generation from LLMs as well as to some of the infrastructure plays around supplying power hungry data centres.

And to return to our opening remarks on populism, watch out for the risk to strategic ‘moats’ from the continued emergence of populism, something encapsulated by the upcoming work of RFK jnr, who is going to be going after the monopolistic practises and regulatory capture of the big food and drug companies. Making America healthy again is not the same as keeping mega corp profits (exceptionally) healthy.

Finally, one of the most popular posts of last year was one on re-dollarisation rather than de-dollarisation . Just as Elon Musk worked out the best way to beat Twitter was to buy it and Donald Trump worked out that the best way to beat the Republicans was to take the Party over, so perhaps the Chinese may be thinking that the best way to beat the power of the offshore US$ markets is to take them over. China issuing US$ backed debt to the countries of BRICS doesn’t undermine the $, but it does undermine the US banking system….