The CIO view: Shifts in the balance of risk and return

Supportive market backdrop but with new risks

US President-elect Donald Trump’s radical policy agenda has created some financial market uncertainty, in terms of the outlook for investment returns. Nevertheless, we believe the central macroeconomic outlook remains favourable for bonds and equities. Growth, stable inflation and lower interest rates should support markets. But investment decisions need to consider cashflow resilience and valuations, given policy risks and broader concerns. For now, we don’t expect a recession in 2025 which should help deliver positive equity returns, while credit markets should provide attractive income opportunities.

US policy agenda should be equity positive

Trump’s agenda creates a potentially positive growth impetus. Lower corporate taxes and deregulation should support equity markets. The extension of earlier income tax cuts and positive real income growth will underpin consumption. Despite the new administration’s expected preference for oil and gas production over subsidies for renewable energy, investment in the green transition will remain a major theme – at least outside of the US. Forecasts of significant increases in electricity consumption – driven by the technology sector and China’s power demand – will promote further integration of solar and wind energy assets into power networks. Investment opportunities in sectors such as electrical components, equipment and renewable energy production continue to be an option for a sustainably focused equity approach.

Earnings momentum will be a key driver

Equity returns have historically been positive outside of periods of US recession, with an average 12-month total return of around 15%, compared to a mean return of -6% during recessions (as identified by the National Bureau for Economic Research). After solid earnings growth in 2024, the consensus forecast for 2025 is for around 13% growth in earnings per share for the S&P 500. Much of this will continue to be driven by the technology sector with there being no evidence of any softening in demand for artificial intelligence (AI) related technologies. In 2024, close to half the growth in the entire market’s earnings per share came from the US’s information technology and communications sectors. Policy may stimulate stronger earnings growth in areas such as financials and energy although the impact of potential tariffs is unknown for other industries. Overall, however, US equities are likely to retain their leadership position. Small-cap equities could also benefit from lower taxes and interest rates with upgrades to earnings expectations already having been seen (Exhibit 1).

Mixed outlook outside US borders

Elsewhere the outlook is mixed. China appears likely to continue rolling out policies designed to stimulate domestic demand. This should be positive for Chinese equities, but any improvement needs to be judged against the potential negative growth impact from US tariffs. A global trade war is not helpful for companies relying on exports, and performance between domestic stocks and exporters could diverge significantly. This may not be something confined to China if Trump does go ahead with tariffs targeted at many countries. Emerging market equities may find this a more difficult backdrop with a less benign US interest rate outlook and a stronger dollar also being headwinds.

Europe’s growth outlook is subdued, although equities could get some support from lower interest rates and the improvement in real incomes via lower inflation. European stocks benefit from more attractive valuations than in the US, and they boast a higher dividend yield. But expected earnings growth is only about half that forecast for the US. Interest rate-sensitive and consumer-focused sectors should continue to perform well, with some potential upside for industrials – provided the global industrial cycle shows signs of an upturn and if the worst fears of a trade war do not materialise.

Lower interest rates are good for bonds

The baseline for fixed income markets is defined by interest rate expectations. The US’s potential policy mix has some upside inflationary risks. Moreover, inflation in some economies is settling slightly above central bank targets. Market-based expectations of terminal rates (neutral policy targets) have moved higher in recent months as a result. However, this is not bad for bond investors. The prevailing level of yields in developed bond markets provides the basis for robust income returns, which should remain above inflation.

Short duration strategies remain attractive

There are risks around longer-term interest rates coming from policy uncertainty and the profile of government debt in many countries. This has already led to a cheapening of longer-term government bonds on a relative value basis, when compared to the interest rate swap curve. For some investors, this could provide opportunities to move out of longer-term corporate debt into government bonds, particularly for institutional investors that have an interest rate swap benchmark.

However, for short and intermediate maturities, the bond market looks healthy. We see yields as fairly valued given the interest rate outlook – so much so that investors are unlikely to experience similar duration shocks to those seen in 2022 and 2023. On the credit side, despite spreads being tight, the additional return and the continued healthy state of corporate balance sheets underpins the attractiveness of both investment grade and high yield bonds. Of course, investor sentiment towards credit will be subject to the uncertain evolution of policy and geopolitical risks but on a risk-adjusted return basis, credit is attractive. This is especially the case for short-duration strategies. We continue to see US high yield, a short-duration asset class, delivering healthy returns.

Europe vs. the US

Our forecasts allow for greater monetary easing in Europe than in the US, reflecting softer growth. Thus, European fixed income investors may see total returns boosted by some decline in bond yields. Additionally, the relative picture should continue to support a strong dollar. For non-dollar investors, on a currency hedged basis, European fixed income looks more attractive especially as we continue to see opportunities in the credit markets (Exhibit 2).

Risk premiums

Global economic expansion – while likely to ease in 2025 – will underpin corporate earnings and support returns from equity and credit markets. However, valuations are a concern. This is particularly the case in the US where equity multiples and credit spreads have reduced risk premiums. The simple US equity risk premium has turned negative on some measures. Any indication that radical policy making could disrupt corporate profits could impact US equity multiples, hitting total returns in the process. Given the level of yields, bonds should provide some offset to any decline in equity valuations.

Credit spreads are also tight, however. This does reflect healthy demand for credit assets which itself is a function of strong fundamentals. But again, any threat to the macroeconomic outlook could push credit risk premiums higher and reduce the excess returns from corporate bonds.

Investors will need to be flexible in 2025. The benign soft landing and lower rates story helped returns in 2024. Yet, as the year closed policy and geopolitical risks came back into focus. Tariffs, concerns about government bond supply, and trade or commodity disruptions due to geopolitical developments are threats to discounted cashflows and therefore current valuations.

Cash returns will ease further as rate cuts continue but income should remain the focus in bond markets and compounding returns from short-duration exposure in credit and high yield remains a favoured strategy. A US growth focus in equities is also seen as core with upside coming from thematic sectors like automation, the green transition and the broader continued strong investment in technology and AI.