By David Knee, Deputy CIO, Fixed Income at M&G Investments
The last two years have challenged accepted economic theory: despite the 5% rise in US interest rates, and elsewhere, advanced economies have displayed remarkable resilience. The US, in particular, has surprised the world with above potential growth spurred by higher productivity.
However, with economic norms challenged, markets are left struggling to interpret what might happen next as long-term anchors have weakened; instead, investors pore over every data release for indications of the potential path of the global economy. Even the Fed isn’t immune from this self-doubt with the dispersion of long-term interest rate views of its governors at its most extreme since the advent of the dot plot in 2012. As a result, markets will enter another new year faced with uncertainty; so what will we be looking at in 2025?
The impact of Trump 2.0
In markets, the predictable response to a more unpredictable environment is increased volatility. The election of Donald Trump only serves to amplify this with markets waiting to see how his second administration might pan out. Trump campaigned on some broad-brush policy statements. However, only time will tell whether these become reality. The first Trump presidency showed what Trump said he would do and what he actually did were very different. Bond markets will be watching for key policies such as tariffs, tax and immigration. These policies could potentially reignite inflation and limit the ability of the Fed to act, as well as add to already growing deficits.
Economic reality doesn’t change
Despite the uncertainties, economic facts don’t change: deficits are rising. The upward sloping nature of the long end of developed market yield curves suggest bond investors are cognisant of this. After more than a decade of real interest rates sitting below real growth rates and the subsequent belief there was no limit to the ability to borrow (remember Modern Monetary Theory), the environment has pivoted. Debt interest for the fiscal year 2024 stood at $1.1 trillion8, exceeding the cost of the Medicare healthcare program ($1.05 trillion) and military defence spending ($830 billion)9. Going forward, Trump’s potentially expansionary fiscal policy may even accelerate the deficit, leaving the Treasury market to bear the burden.
Where next for growth and inflation?
For bond investors looking into next year and beyond, the International Monetary Fund (IMF) does not offer much solace. In its October World Economic Outlook, the organisation paints an uninspiring picture over the next five years. Global growth for 2024 and 2025 is predicted to be 3.2% and is forecast to bumble along at a similar pace, hitting 3.1% in 202910. If AI is really going to be the driver of the fourth Industrial Revolution, there’s scant sign of it here. Nor do we see it in productivity figures either; in the US, productivity has been strong, which in no small part has been attributed to a surge in immigration. However, this seems unlikely to persist. Still, if there is a silver lining in this mediocracy, it’s that there’s no dramatic downside either. Moderation in inflation will allow interest rates to fall (perhaps more slowly than fixed income investors would like), counteracting rising protectionism and other anti-growth policies, like curbing immigration.
Attractive yields going into the new year
For global bond investors, as we enter 2025, absolute yields are still attractive at both the very short and the longer maturities, in our opinion. These offer some protection against prospective inflation, with real yields on government bonds close to 2% – a level not seen since before the Global Financial Crisis (GFC). Longer maturity bonds also offer a decent hedge for equity exposure if the macroeconomic story weakens. Given that expectations for rate cuts are embedded in mid-maturity bonds, this makes them a more difficult call, as what happens from here will continue to be very data dependent.
What to watch in 2025
The case for corporate bonds is nuanced. The credit spread across almost every category of the fixed income market is below its long-term averages. Investors are not being well compensated for longer term corporate risks, either in investment grade (IG) or high yield. That said, absolute yields look close to long-term averages, for example US IG yields are at 5.2% now versus an average of 4.8% since 199611. This is attracting capital into the market which drives a self-reinforcing cycle of lower spreads making credit increasingly expensive. It will be impossible to see the catalyst that leads credit spreads to normalise but with four cycles in the last 15 years, the odds don’t favour an indefinite continuation of the present trend. Against this backdrop of tight spreads, burgeoning deficits, as yet unknown fiscal policy and moderating GDP growth, caution is required for 2025 and it is beneficial for portfolios to be defensively positioned.
