Exploring the 2025 outlook: Insights on bonds, equities and alternatives

Key points

• Bonds appear to offer portfolio diversification attributes.
• Equities look expensive owing to the technology sector, but earnings numbers seem to be broadening out across sectors.
• Alternatives have shown weakness, but there are reasons for multi-asset investors to be attracted to the likes of renewables once more. 
  
  

Bonds: A safe haven in volatile times? 

We have been adding to bonds across portfolios in the belief that they provide diversification. At the beginning of 2024, we felt a lot of interest-rate cuts were being priced into the market, so we reduced the allocation to fixed income. During the growth scares we saw in August 2024, when equity markets declined, we saw good returns from the bond market, giving confidence that amid pessimism about the economic outlook, bonds are once again delivering the diversification benefits that investors look for, in contrast with the lack of diversification from bonds that we saw in 2022.

In terms of market observations, since the US presidential election, yields on the 10-year US Treasury and 10-year UK gilt have been moving towards 5%. This shows the market pricing in inflationary concerns arising from both government fiscal spending and some potential policies of US President-elect Donald Trump.

More recently, since the end of Q3 2024, we have been adding back into the bond market at the longer end where we were seeing yields of up to 5%, particularly in the UK gilt market. We think 5% sounds reasonable, given where inflation is. If the central banks are successful in keeping inflation at target, that could lead to a real return of about 3%, which we believe is attractive.

Equities: Navigating high valuations

Equity-market valuations are elevated. In fact, valuations are in similar territory to early 2022, being driven by growth stocks, particularly the ‘magnificent seven’ US technology companies. We reduced equity exposure going into 2022, and increased it going into 2023. More recently, however, we have been conscious of valuations. So, while equity weightings have not changed dramatically, we have made reductions within technology, given how strong this sector has been.

Increased concentration within indices and equity portfolios is something we are concerned about, but earnings are starting to grow across the broader market. One area of opportunity stems from a manufacturing renaissance, particularly in the US. The boom in artificial intelligence, and the related increase in data centres and areas like cloud computing, is likely to create significant demand for electricity.

Alternatives: A renewed interest

Alternatives have seen weakness. This can be explained, in part, by the fact that higher interest rates have resulted in greater demand for bonds, so competition for investors’ capital has been fierce. Other contributors to weakness have included the debate around cost disclosure for investment trusts, as well as pension funds selling liquid assets to raise collateral and de-risk their portfolios to better match their liabilities. With rising bond yields, this helped to move many pensions from a deficit position to a surplus. As portions of schemes’ investments have been in illiquid assets, this has exacerbated their dependence on the liquid assets, such as the listed alternatives markets, in which they had invested to match their inflation-linked liabilities.

We reallocated some of the alternatives exposure during 2022 and 2023 into the bond allocations within portfolios, but we are now more optimistic about alternatives. One reason for this is that financial services retail disclosure requirements are being reformed. This could entice multi-asset investors back into the investment trust area. Another reason is the inflation-linked nature of some renewables. With concern around inflation remaining higher, the inflation-linked cash flow characteristic of the renewables area could be positive for investors and provide portfolio diversification against bonds and equities.

THIS ARTICLE FIRST APPEARED IN MONEY MARKETING

Authors

Paul Flood

Head of Mixed Assets Investment