Q4 Multi asset perspectives: American era

Julian Howard, GAM’s Chief Multi-Asset Investment Strategist, outlines his latest multi-asset views, exploring how we are in the midst of a new American era, defined by a strong economy privileged by its relative isolation and a stock market uniquely placed to benefit. Investors will, however, need to be aware of risks around inflation and over-valuation.

07 January 2024

Review

The MSCI AC World Index gained 1.4% in local currency terms during the fourth quarter of 2024, taking the full-year return to a heady 20.7% return. But even this was bested by the US S&P 500 Index’s 25.0% gain for the year. These figures were way in excess of the 7% real return in stocks observed over time and encapsulated by the ‘Siegel Constant’. The fundamental drivers behind the moves coalesced around US economic and capital market dynamics, with economies and markets outside America offering limited cheer at best. The US economy defied fears of slowdown as expressed through the long-running (and unimaginative) debate around whether it would pull off a soft or hard landing.

With unemployment barely over 4%, job additions for November in excess of 220,000, economic growth running at just under a 3% annualised clip and consumer confidence broadly rising over the course of the year, talk of ‘landings’ in the first place now seem somewhat moot. Compare with the rest of the world where the eurozone felt compelled to commission Mario Draghi to write a policy paper on how to improve European competitiveness amid political instability in France and Germany, with the latter now facing economic stagnation in the face of oppressive fiscal rules and tough outside competition in traditionally strong sectors such as autos, machinery and chemicals.

Emerging markets (EM) meanwhile faced lacklustre growth in due to a stronger US dollar and slowing Chinese consumption. A stimulus announcement from China was met with scepticism given the apparently limited appetite for fiscal largesse from the authorities, perhaps understandable given how the economy’s imbalances were arguably brought about in the first place by the outsized role of government in the economy. Stock markets duly reflected this multi-speed economic story, with the US boosted further by two additional tailwinds. The first was the on-going artificial intelligence (AI) revolution as reflected in the consistently strong earnings of US-listed supplier firms such as Nvidia.

The second was of course the outcome of the US election in which Donald Trump claimed a resounding victory. The prospect of tax cuts and deregulation propelled US stocks ever higher versus their global peers, most of whom failed to provide a competing economic or market narrative. Amid all this, the Federal Reserve appeared to struggle for relevance. Monetary policy did start to be loosened in September as inflation (more goods than services) came down, but it could hardly be claimed that this made a significant difference to consumers, corporations and markets given the far more powerful forces at work during the review period. 2024 may have begun amid doubts around the US economy but it ended on a note of near-total US supremacy.

Chart 1: America goes into 2025 with rising growth expectations

Consensus GDP % growth expectations for 2025 (From 22 February 2023 to 20 December 2024)

Positioning

Our positioning remained broadly unchanged during the final quarter of the year, with portfolios structurally placed to take advantage of the superior real returns that stocks can offer over time, carefully diversified by capital preservation allocations sized according to each multi-asset strategy’s risk/return objectives. We are broadly engaged or overweight in equities across all our strategies, with a continued emphasis on US stocks in particular, given that market’s clear competitive advantage in return on equity, innovation and management quality.

Indeed, the way in which the AI revolution has been made a reality by listed US corporations demonstrates the unique ability of the US market ecosystem to innovate and monetise. With that said, within the US we favour more cyclical areas of the market given the fundamental economic strength described. Our US allocation is ‘funded’ by a neutral allocation (versus the MSCI AC World Index) to Japan as well as outright underweights to EM (including China), Europe and the UK.

While Japan is perhaps spared some of the structural malaise that affects the latter markets, its export-orientated economy remains vulnerable to the Bank of Japan’s enthusiasm for normalising (ie tightening) monetary policy and the concurrent strengthening impact on the Japanese yen. The case for underweighting the other markets has already been made in the Review section above, but it’s worth highlighting that the lack of any catalyst for change is what makes us comfortable overlooking an admittedly good value European equity market.

The continent’s markets are fragmented and lack the scale needed to offer a funding ecosystem able to compete with that of the US. EM meanwhile, at the index level at least, need China’s economy to profoundly turn around. Away from stock markets, our diversification strategy rests primarily on fixed income and credit. Highlights within the allocation include short-dated bond and money market instruments which continue to offer compelling risk-adjusted yield characteristics since central banks in the US, eurozone and UK are finding that inflation does not offer a smooth downward pathway.

We also have some exposure to traditional longer-dated government bonds for both yield (US Treasuries offer over 4%) and portfolio crash protection. Carefully selected investment grade bonds play a role too. These positions form the core of our fixed income allocation, but we also hold mortgage-backed, subordinated financial and insurance-linked bonds depending on specific strategy. We maintain lower exposure to alternative investments given the slightly more inconsistent history demonstrated by the asset class. However, we favour long/short merger arbitrage which can potentially generate steady, modest returns from the flow of corporate mergers and acquisitions (M&A). And macro investing across interest rates and FX has generally been shown to perform well when volatility is elevated.

Taken together, all the above strategies are designed to offer smooth equity upside participation thanks to effective and reliable portfolio dampening during periods of short-term volatility. This in turn allows for potentially more accurate mapping of our strategies to specific client risk-return profiles.

Outlook

The relative strength of the US, in both its economy and its listed companies, dominates the outlook. The economy should drive corporate earnings, particularly in mid- capitalisation stocks. Meanwhile the US stock market should still continue to enjoy the additional kicker of the AI revolution. From this perspective, the world beyond America remains relatively unappealing.

However, there are two risks to continued US dominance. The first is inflation. Much money has already been thrown at the economy recently in the form of the Biden administration’s stimulus programmes. These contributed to the inflation of 2022 onwards. But now with the new incoming Trump administration the presumed renewal of expiring tax cuts in 2025 could add fuel to the existing fire. Swingeing tariffs, if imposed, would also surely see imported consumer goods rise in price. And then the election pledge to deport “millions” of illegal immigrants could also have inflationary consequences.

According to the Pew Research Center, there were some 8.3 million undocumented migrants in the US, just under 5% of the total workforce. Many of them work in hospitality or agricultural roles which American-born workers are simply not interested in filling. The mitigation from an investment perspective is that US firms, particularly large ones, have historically been adept at riding out inflation and exerting their own pricing power without sacrificing margin. So while inflation and – imagine it – potentially higher interest rates will be something to look out for in 2025, over time steady engagement in high quality US firms has proven to be an effective hedge. The second risk to on-going US dominance is valuations. By 20 December, the S&P 500’s forward earnings yield was just 4.0% compared with 4.6% for the risk-free 10-year US Treasury bond. The burden of proof that US equities continue to be ‘worth it’ is surely higher than it was even a year ago. The economy will need to continue thriving and its stocks to generate upside earnings surprises. This is achievable, but investors may need to revise down their elevated expectations – history suggests double-digit equity returns are not the norm and indeed the market drop in late December hinted at some consolidation after such a strong run.

But perhaps the biggest challenge for investors going into 2025 is conflating political and geopolitical risk with investment outcomes. It is true that stock markets are governed by sentiment in the short term and 2024 has seen much drama which will doubtless continue into 2025. But the role of professional investment management is surely to remind investors that in the longer term it is fundamentals which matter more than anything. As described earlier, the long-term real rate of return for stocks has historically been around 7%, and this is net of decades of turbulence including wars, political upheavals, pandemics, and crashes.

Today’s geopolitical outlook may appear bleak, but it surely offers nothing worse than has been seen before.

Chart 2: US stocks now more expensive than risk-free bonds

Earnings yield from 30 December 1990 to 20 December 2024