The Pulse – February 2025

Executive summary

• Despite several negative factors, the stock market has continued to perform well. However, there is a sense of caution among investors given Donald Trump’s proposed trade tariffs which could see prices increase.
• In addition, some major US companies like Microsoft, Amazon, and Alphabet have reported disappointing results, contributing to market concerns and rising risks.
• The risk of stagflation, characterised by low growth and high inflation, poses challenges for various asset classes.
• However, we believe that by being selective in our asset choices, we can achieve decent returns without relying heavily on stock market growth.

Outrunning market risks

In the old Looney Tunes cartoons there’s a repeated scene where one of the characters – usually Wile E. Coyote – accidentally runs off the edge of a cliff.

At first, he doesn’t notice he’s running on thin air, everything is fine, and he just keeps going. But as soon as he realises, he plummets…

Some days the stock market feels a little like that! Over the past few weeks, we’ve seen plenty of things we might expect to negatively impact stocks. But, aside from a few blips, the market has seemed to carry on regardless.

Whilst we always like it when the market goes up, we feel somewhat wary. Recently, there’s been plenty of news coverage of Donald Trump’s plans to levy trade tariffs on various goods and countries. Most economists expect this to increase prices and reduce economic growth (if and when they are actually applied!).

We’ve also had somewhat disappointing results from some of the big US companies who’ve been driving the market over the past few years, such as Microsoft, Amazon and Alphabet (Google).

Meanwhile, Nvidia saw the biggest one-day plunge in stock market history, with the company shrinking by $589bn after the release of the Chinese artificial intelligence (AI) program DeepSeek. This appeared to demonstrate that steps forward in AI can be taken without the need for the advanced microchips which Nvidia sells (and that all the other big US technology firms have been buying in abundance).

We think these are all evidence of rising risks and have made some changes to the portfolio as a result.

Realistic, not pessimistic

If this seems a bit pessimistic, then we apologise! We think we’re simply being realistic. Our job is just as much about managing risk as it is to maximise opportunities when they arise.

However, despite appearances, we’re actually feeling cautiously optimistic about portfolios as a whole. There are several asset classes we think could produce decent risk-adjusted returns. But first, a bit more detail on those risks…

A trade war and the extensive use of tariffs have the potential to be “stagflationary” (a state of relatively low growth and high inflation). Meanwhile, here in the UK, the increase in taxes on businesses, the higher minimum wage and other factors might also push up prices and depress growth.

Stagflation can be a problem for various asset classes because:

• Low economic growth isn’t usually good for company earnings and therefore share prices.
• Normally, central banks cut rates when the economy slows, which supports growth.
• However, central banks are also responsible for keeping inflation at around 2% p.a. If it’s above that, they have little room to cut interest rates. We might have fewer rate cuts than expected or, though unlikely in our view, even a reversal with rates rising again.
• Higher interest rates are not usually good for government bonds and high-growth stocks like technology stocks.
• A slowing economy might mean more companies default on their loans, so we might want to be careful about who we lend to (in the shape of corporate bonds).

Stagflation was the reason that 2022 was such a bad year for investors. Most asset classes fell as inflation soared to 11.1% in the UK, growth slowed (with a UK recession in 2023) and interest rates surged by 5% in the UK in just over a year.

It’s NOT 2022 all over again

To be clear, we do not expect anything like the extremes we saw in 2022. Even if our fears are realised, we think we might see inflation go to perhaps 3% or 4%. We expect interest rates to remain steady or, at worst, see a slight increase – nowhere near a 5% jump.

However, the main reason we’re not that worried, is that many assets outside of equities are starting from a much better place than they were at the start of 2022.

One of our favoured asset classes at the moment is short-dated fixed interest. These are bonds where we lend money to companies, governments or individuals, for a relatively short period of time. Generally, the shorter the term of the loan, the lower the risk of it not being repaid.

Right now, the yield on the short-dated funds we hold in portfolios is around 6.4% p.a. (Source: the various fund managers / Equilibrium Investment Management as of 31/12/24). In other words, if nothing changes (good or bad) then our expected return over the next couple of years should be approximately 6.4% p.a., which we think is attractive relative to the amount of risk we’re taking. (Note: Returns aren’t guaranteed – see further info on the risks below).

Contrast this to late 2021. If you bought a 10-year UK gilt (lending to the government) on 31 December 2021, you would have got a yield of just 0.97%. If you’d bought a typical corporate bond (lending to a company), your yield would have been only around 2.24% p.a. (Source: LSEG Datastream).

As interest rates on cash went up sharply in 2022, these yields needed to go up too. Otherwise, why take the risk of lending when you could leave your money in cash and earn more interest? That meant the price of the bonds had to fall sharply, in order to push their yields to acceptable levels.

But after those falls, the yields on bonds are now much more attractive.

Quantifying the risk

So, what is the risk of similar falls in our short-dated fixed interest portfolio in the future?

Well, luckily this is something we can quantify! (Warning, maths ahead!)

The “duration” of the short-dated portfolio is estimated at 1.1 years. Duration is a technical term, but essentially it tells you the sensitivity of the fund to changes in interest rates.

The duration tells you the expected change in capital value for each 1% change in yield.

Imagine that interest rates go up, and therefore investors want a greater level of interest in order to lend money. If they want a yield of 7.4% from our funds rather than the current 6.4%, the funds are likely to lose about 1.1% of their capital value.

Whilst that wouldn’t be great, with a starting yield of 6.4% p.a., a 1.1% loss would only reduce our likely return to about 5.3% p.a. (Remember, all these figures are estimates and used as illustrations of what might happen rather than being guaranteed).

In our view, you would have to see a very extreme set of circumstances to lose money over any meaningful period of time with this asset. On the flip side, there are also circumstances where the return might be significantly higher than the current yield.

For our lower-risk portfolios, we think this asset class is fantastic, as the expected return is around the target level of growth for our Cautious portfolio (for example), with a low risk of losses.

For those able to stomach greater short-term volatility, we still think defined returns look great value. Whilst the risk of a short-term stock market correction has risen, when we buy these products, we’re asking ourselves whether we think markets will be higher in the next two to five years?

The answer is “yes” – we think that even if they could fall in the short term, in two years we’d expect markets to be at or above current levels.

If so, our defined returns will have kicked out and should provide a return of over 11% p.a.

Even if markets fall over two years, our historical data shows they very rarely fall over five years (the typical life of a defined returns product). Even if they do, the products have some capital protection built in.

We have recently reduced exposure to both equities and the riskier corporate bonds, given the risks outlined above. However, please don’t mistake that caution for pessimism. By being selective over the assets we buy, we believe we can still achieve some decent returns without relying so much on stock market growth.

Past performance is for illustrative purposes only and cannot be guaranteed to apply in the future.

This newsletter is intended as an information piece and does not constitute a solicitation of investment advice.