Annual outlook for 2025

Summary

Bright spots

• World economy to benefit from slowing inflation, China recovery
• US stocks to retain global leadership due to pro-business policies
• Prospects positive for EM bonds outside China

Threats

• Valuations for equities at historically high levels
• Inflationary pressures to pick up in US due to fiscal largesse
• Trump administration could yet implement harsh tariff regime

Overview: It's not (quite) all about Trump

Donald Trump’s victory in the US presidential election casts a big shadow over global financial markets.

But it’s by no means all bad news. That’s because unless he sticks rigidly to the most extreme elements of his agenda, the global economy’s broadly positive fundamentals should assert themselves and provide a benign environment for risky asset classes in 2025.

To be sure, the fact that Trump will take office with a staunchly loyalist cabinet and the support of  Republican majorities in the Senate and House of Representatives and a right-leaning Supreme Court means that he faces little effective opposition to his radical agenda. How much of it he actually decides to implement – and its sequence and timing – is another matter.

Good Trump vs bad Trump

Since the election, investors have broadly priced in a “good” Trump. That’s to say, they have focused on the market-positive elements of his promised policies, such as tax cuts and de-regulation, while downplaying the risk that he fully implements a 60 per cent tariff on Chinese imports, a 20 per cent tariff on imports from the rest of the world and draconian anti-immigration policies.

A “bad” Trump, where all of the market-negative policies are implemented fully in his first year of office, could be expected to cause significant economic damage in the US and abroad.

The Congressional Budget Office estimates that the US is running a debt burden equivalent to 100 per cent of GDP, and expects it to rise to 143 per cent in 10 years if Trump’s policies are implemented. The US deficit is growing from an already high 6 per cent to 9 per cent of GDP – one of the highest in the world. Those numbers are not sustainable and could play on market sentiment.

We estimate a 15 per cent chance that Trump triggers a recession while there is a further 25 per cent chance that the President-elect's fiscal programme and deficit expansion trigger an inflation shock, with additional volatility coming from a trade war were Trump’s tariffs to set one off. 

However, our base case – to which we give a 40 per cent probability – is that he only partly implements his policies. Here, tax cuts offset tariffs allowing the economy to continue growing at trend, while inflation continues to edge back towards target, leaving the Fed scope to ease policy further towards a neutral rate. 

The best case, a Goldilocks outcome, we give a 20 per cent chance. Here, his tax cuts plus a surge in productivity thanks to deregulation and technological innovation, allows the economy to grow at well above trend while inflation drops below 2 per cent, allowing the Fed to maintain an easing bias. This should reinforce the generally positive global economic trend and global central banks' tilt towards easing (see Fig. 1).

Looking on the bright side

Given the importance of the US for global growth and weakness in Europe and China, we expect global growth to remain stable at some 2.8 per cent in 2025, broadly its trend rate – assuming our base case for Trump’s policies (see Fig. 2). Inflation will continue to drift lower, though developed market central banks are unlikely to hit their 2 per cent targets during the year (see Fig. 3).

There are hopeful signs for China and Europe, which should at least stabilise, if not start to recover, with the second half of the year looking better than the first. More generally, support for risk assets is likely to come from further monetary easing, as central banks respond to improvements in inflation. The Fed could disappoint by cutting less than the market hopes – we see its funds rate at 4.25 per cent by the end of 2025, marginally above market consensus. But this could be offset by a relatively deeper cuts by the European Central Bank. This should spur credit demand and private money creation, and this increase in liquidity should underpinning what are otherwise rich asset valuations.

That said, it’s important not to ignore the two big tail risks, which the market is currently under-pricing: an all-out global trade war and a surge in bond yields – above 5 per cent on the US 10-year Treasury.

While geopolitics could yet derail 2025, we think there’s more of an upside risk – i.e. that conditions get better rather than worse. Even without Trump, there appears to be a desire for some sort of peace deal to be struck in Ukraine, with both countries are showing signs of exhaustion. Separately, we think the risk of a Chinese attempt to force Taiwan back into its orbit is overstated. And the Middle East crisis is less significant than it was in the past, not least because the US is now a net oil exporter.

But it’s a multi-polar world with many moving parts. And though the risks appear greatest for emerging markets, we feel they offer value under out central scenario.

What could be crucial is how China responds to any tariffs.

Although the Chinese economy continues to struggle we believe recent fiscal and monetary support measures should stabilise conditions. And even Trump tariffs need not be a disaster, not least because it has a big domestic market and so has the internal capacity to offset a drop in trade. But it also has fiscal and monetary scope to reflate its economy.

There had been concerns the Chinese leadership didn’t care about short-term growth as it pursued other policy goals. But this autumn’s stimulus plans make it clear that it intends to draw a line under the country’s cyclical weakness.

In Europe, inflation is coming down as wages have peaked, economies at the core are weak – with Germany in a recession for the second year in a row and a general election coming up next February. That will leave the European Central Bank with scope to cut rates, perhaps even below neutral.

The UK, however, is in a better position than Europe – albeit still vulnerable to volatility. We see the UK as a stagflation play: it has energy and defensive sectors, it runs a small trade deficit with the US and, in any event, UK trade is heavily tilted towards services,  which Trump’s tariffs will not affect.

Equities regions and sectors: US supremacy

Resilience will be the distinguishing feature of global equity markets in 2025, with companies likely to deliver steady earnings growth, translating into single digit returns for investors.

That may seem disappointing after this year’s stellar performance, but it is actually pretty impressive when you consider that stocks are ending 2024 trading at lofty valuations – globally and particularly in the US.

We believe the pricing can be justified given the current benign economic environment. Global economic growth is around trend at 2.8 per cent a year, corporate and household balance sheets remain solid, and inflation is slowly easing. Rate cuts from major central banks will continue to support risky assets, even if the scale of those cuts may prove less extensive than previously envisaged.

However, there is little room for further expansion in stocks’ earnings multiples, which means performance must come from corporate earnings. These should be respectable, but slightly weaker than in 2024 and below the current consensus from bottom-up analysts. We see global earnings per share increasing by some 7 per cent next year, compared to consensus of 12 per cent.

Risks to our base case scenario for equities are skewed to the downside. The negative shock could come from a classical recession or more likely from a stagflationary impulse of renewed global trade wars and the accompanying turnaround in central bank policy back towards rate hikes. If either scenario comes to pass, equity returns could turn sharply negative.

Among regions, we expect US equities to outperform. The US economy is still growing much faster than that of any other major developed country (albeit the gap is set to narrow somewhat in 2025). US corporate earnings are also increasing at a faster pace than elsewhere with continued traction on AI adoption benefitting the US-centric ecosystem.

The tax cuts and deregulation measures expected from the Trump administration should deliver a significant boost to corporate bottom lines. However, we expect this to be largely offset by the negative impact of increased trade tariffs and tighter immigration rules. 

Stagflation hedge

Our wild card pick for 2025 is the unloved UK equity market. The UK is less exposed to US tariff hikes than the euro zone because it is more focused on services (which are unlikely to be impacted by Trump’s measures) and has no goods trade surplus with the US. The dominance of energy stocks and defensive sectors in the FTSE 100 also makes it an attractive hedge for stagflation – which we see as the biggest risk to our base case scenario.

We are more cautious on the euro zone. Although economic growth appears to be stabilising, it is still lacklustre and could be significantly impacted by Trump’s tariffs  (particularly in manufacturing-heavy Germany). The region is also less focused on tech and related industries than the US, so may lag as the AI revolution continues.  Moreover, political uncertainty in both France and Germany means it is unlikely that the region would, in the near term, be able to produce a coherent and credible growth strategy.

We find Japan to be a market caught between sound medium-term fundamentals and increased near-term uncertainties. With the Bank of Japan raising rates and a minority government at the helm of the country, are a bit less confident on Japanese equities than we have been for the past couple of years. However, we expect a domestic consumption-led recovery in economic growth through next year and continued progress on corporate governance reforms, offering some support to the country’s financial markets.

Emerging market stocks will be supported by globally coordinated easing and benign domestic inflation dynamics while growth conditions remain robust. Such a macro backdrop would have typically been ideal for strong emerging market outperformance. However, the likelihood of increased headwinds to global trade makes us more circumspect about EM’s prospects.

China will be the economy most negatively affected by tariffs, but it is also arguably in the strongest position to deliver defensive stimulus measures on both monetary and fiscal fronts. Investor mood is less negative than it was a few months ago, but we think it is too soon to go long in light of the imminent pickup in worrying news flow on US-China friction. Nevertheless, the policy cycle having turned supportive with the authorities showing clear intent to draw a line under cyclical weakness. We thus expect Chinese stocks to perform largely in line with global equities in 2025, albeit with periods of heightened volatility.

Among sectors, we see some of the best potential in banks, utilities and communication services. Banks are our preferred soft-landing play – we expect strong loan growth in a benign growth environment given healthy private sector balance sheets; valuations also remain very attractive. Utilities are our favourite defensive sector that typically benefits from lower bond yields and has a strong tailwind from increased electricity demand. In communication services we see continued strong earnings dynamics and exposure to secular growth themes of AI and digitalisation. It should also be less exposed to the fallout from increased tariffs compared to the technology sector.

Fixed income and currencies: UK a bright spot

After a year marked by escalating military conflicts and persistent
political uncertainty, growth in most major economies remains resilient and inflationary pressures have been easing off, albeit slowly. Trump 2.0 economic policies have mixed implications for growth and inflation, with stimulus from tax cuts and deregulation likely to be offset by proposed tariffs on imported goods.

All this means that while bonds may not deliver outsized returns next year, the investment landscape is unlikely to be hostile for fixed income assets. Investors, therefore, will be presented with several opportunities to secure positive inflation-adjusted return in the coming year.

Based on our base-case scenario – which is for benign growth and
moderating inflation - we expect benchmark bond yields to stay range-bound, but real rates will be positive for most developed government bonds.

We expect US Treasury yields to fall slightly to 4.3 per cent from the current 4.4 per cent, with the Fed cutting interest rates to 4.25 per cent. Real yields – a return bond investors can expect after inflation – are a positive 2.1 per cent.

A few markets stand out. Take the UK. We expect gilt yields to fall to 4 per cent from the current 4.4 per cent, supported by a more favourable inflation outlook compared with the rest of the Europe.

The Bank of England has stressed it will gradually ease monetary policy – where we expect it to cut interest rates by 2-3 times to bring the cost of borrowing to 4 per cent by end-2025.

Notably, the spread between UK and German ten-year bond yields has risen above 200 basis points – matching the historic peaks during the sterling crisis of the early 1990s and the budget crisis of 2022.

Emerging market bonds continue to offer the prospect of attractive returns (see Fig. 5). Further interest rate cuts from the Fed will encourage emerging market central banks to ease monetary policy further, at a time when they are enjoying better economic growth than their developed market counterparts.

What is more, real yields in most emerging market bonds – except for China – are attractive, staying well above their five-year average. Mexican sovereign bonds, for example, offer a real yield of some 7 per cent, at a time when the economy is expect to benefit from further cuts in interest rates. 

We are constructive on credit in the medium term. Even though corporate bond spreads have fallen to near all-time lows, company balance sheets remain healthy with ample cash. Default rates are low and falling, in line with our forecast for the average default rate over the next five years of 2.7 per cent. What is more, credit will benefit from further interest rate cuts.

The asset class also offers attractive valuation and risk-adjusted
returns at a time when equities are expensive and government bonds are held back by rising deficits. What is more, credit enjoys long-term demand from investors, especially those saving for retirement, for income-generating assets.

Gold, meanwhile, continues to offer a useful hedge against inflation, geopolitical risks and any unforeseen shocks from the Trump presidency. After a recent correction, the precious metal has already started trending higher and it is likely to attract safe-haven flows.

In currency markets, we expect the US dollar to overshoot in the near term. With resilient US growth and stalling disinflation, the Fed is unlikely to be able to cut interest rates aggressively. However, we think the dollar is approaching a cyclical and secular peak, under pressure from twin deficits of expanding government spending and current account imbalances, as well as expensive valuation.

We believe the yen will be the major beneficiary of the dollar’s long-term decline and will appreciate next year. The Japanese economy is set to accelerate while the Bank of Japan is one of the few central banks that will hike interest rates. According to our model, the yen is around 20 per cent below its fair value. 

Tactical asset allocation stance

Our annual outlook has also informed our tactical asset allocation stance, which is set out below.