Insight Investment: Thoughts for 2025

Executive Summary

• Global rates – time for a reality check: Real policy rates have moved from deep negative territory to the highest levels since before the global financial crisis, providing central banks with the flexibility to start easing. Although prudent rate cuts are necessary to underpin growth and ensure a soft landing, the exuberance of rate markets is questionable. Markets are now pricing in a faster easing cycle than previous crises, which seems at odds with an economy that is still growing and an equity market close to record highs. Unless economic data deteriorates significantly, markets may need to reassess expectations for both how rapidly rates will decline and the terminal level of rates.
• Global inflation – the best news is behind us: The outlook for global inflation remains uncertain despite the gravitation of headline rates towards central bank targets. We believe factors such as the shift from globalization to deglobalization will keep inflation structurally high in the coming years. In the US, sticky inflation, monitored by the Atlanta Fed, is declining at a slower rate than the headline consumer price index and has stabilized at around 3%. Stickier inflation is just one of the challenges facing central banks, with food prices and money supply turning upwards once again.
• Asset allocation – a simple approach is unlikely to work in 2025: Our regime-based framework became more neutral in Q3, and we adjusted our cyclical exposures downwards. However, we are conscious that easier monetary policy should support economic activity, potentially shifting us into a more positive growth regime in 2025. One concern we have is the lofty valuation of US equity markets, as history suggests valuations do matter. This may mean a more targeted approach to risk-asset allocations may be necessary in the year ahead.
• Investment grade credit – time for active managers to shine: Robust investor demand has compressed spreads to below long-term average levels. Despite this, current absolute yields remain high relative to the past decade. We believe this environment presents the opportunity for active managers to enhance returns. In a striking contrast with research focused on active equity managers, data from Mercer indicates that median managers in global credit and aggregate strategies have historically outperformed their benchmarks. High levels of issuance should provide ample opportunities for stock selectors to capitalize on new issue premiums and unique investment stories in 2025.
• Municipal bonds – prudently enhancing yield: Taxable municipal bonds typically offer a higher yield compared to US Treasuries and can periodically even offer higher yields than US investment grade corporates. These issues are backed by tax revenue streams and have historically had a low likelihood of default. In our view this puts taxable municipal bonds in a sweet spot between Treasuries and investment grade credit, offering a prudent way to potentially enhance yields while minimizing credit risk.
• High yield credit – maximizing exposure to the higher rates environment: High yield credit is particularly suited to compounding returns over time, with current market yields high enough to amplify the power of compounding. High yield corporates have weathered the sharp increase in interest rates over recent years, and defaults in the current cycle are at relatively low levels. We believe a focus on shorter-dated strategies and larger corporate issuers that have been downgraded from investment grade can help reduce default risk.
• Structured credit – an esoteric future: The esoteric structured credit market includes unconventional asset pools and innovative private structures and is the fastest-growing segment in non-traditional credit. This rapid growth is being driven by digital infrastructure, where demand for AI is accelerating the need for data centers and fiber-optic cables. Esoteric structures typically offer significant premiums over corporate bonds but require specialist teams with experience in ABS and esoteric private lending. Despite challenges like uncertainty and complexity, esoteric structured credit can extend core fixed income holdings and enhance liquidity portfolios.