Challenge presents opportunity

Equity markets delivered strong performance in 2024, largely driven by the continued rally in tech stocks. Bond markets faced challenges, posting a return of -1.7%, while gold maintained its strong momentum. Financial conditions eased over the year, largely driven by Donald Trump's election victory and subsequent planned return of pro-growth policies. These were announced alongside the start of rate-cutting cycles across the US, Europe, and the UK.

The market's initial exuberance in response to these adjustments prompted Federal Reserve Chair, Jerome Powell, to temper expectations, emphasising that the pace of rate cuts in 2025 would likely be more gradual. This caution was driven by concerns various potential upcoming political developments - including a series of immigration policies and tariffs - could reignite inflationary pressures.

Central banks worldwide now continue their fight against persistent inflation. Many long-term challenges remain including an ageing population, migration and widening inequality. These issues all need solutions otherwise they will create enormous tensions for markets. Climate change and geopolitical risk also pose a significant threat.

But in amongst all this change and challenge, there is opportunity. We think investors should remain optimistic in the long run; human ingenuity is immense. Artificial intelligence and automation offer amazing potential for future productivity and growth.

We believe that in this environment (of stronger growth and higher inflation), value stocks, which are currently trading relatively cheaply, should perform well. These assets tend to be less susceptible to any multiple contraction that comes with an inflation shock. In uncertain times, investments that offer protection are also a valuable part of any portfolio.

November’s re-election of Donald Trump resolved some uncertainties, but they’ve swiftly been replaced by others. Markets are now facing a broad range of possible outcomes according to which of the President’s proposed policies are actually enacted. Outcomes from debates around tax policy, deregulation, tariffs and deportations all have significant social and economic repercussions. Decisions made in favour of tax policy and deregulation may offer huge potential for growth.

However, any boost to growth would likely be accompanied by an inflationary boom and higher inflation volatility. The Federal Reserve might then be tempted to tame inflation with rate hikes but that runs the risk of short-circuiting growth with it, threatening serious downside for markets. Alternatively, central bankers may decide to let inflation run a bit hotter. Assets would get expensive, and growth would lift, but not forever.

There could be huge swings either way. Until these policy uncertainties are resolved, we plan to stay protected against any serious downside, while also positioning to capture a broadening out of growth. To benefit from a potential short-term cyclical upswing, we favour equities over bonds. Fixed income may deliver 5%+ nominal, but there’s significant risk of inflation diminishing those returns in the long run.

As Trump’s proposed policies are generally against trade and for domestic earnings, if we do see an earnings bounce, cheaper areas will do better. That means favouring value over growth, and small caps over large caps. In that case, US small cap value stocks could offer real potential.

Gold and gold miners should also do well in an inflationary environment. Gold miners have an equity kicker which combines well when held with gold itself, offering inflation protection thanks to its intrinsic worth. The whole is greater than the sum of their parts. Gold and gold miners have driven robust positive performance over the past year, and they retain an important place in our portfolios as a valuable hedge against inflation.

By harnessing biology, the biotechnology industry develops new technology, products and methods intended to improve our health. A form of biotech has been around for centuries, as early biologists thought to use microorganisms to make beer and yogurt. But the field has since evolved dramatically, rising to public attention through advances in genetic engineering, in particular. Today, the sector’s success offers the potential for long-term secular growth, especially given the ongoing innovations in genomics, artificial intelligence and the drug industry. An ageing population in need of medication is pushing plenty of development in small and mid-size public biotech companies.

But it isn’t an easy sector in which to pick and choose investable companies. Biotech is a complex subject, and grappling with its products and services requires a sophisticated understanding of both science and technology. Will the new solution work? And will it actually be used in healthcare? The sophisticated science behind biotech doesn’t make those crucial insights straightforward.

Major scientific breakthroughs and drug failures mean the sector sees big and volatile movements. At a long-term level, biotech products tend to have a binary outcome; it either works or it doesn’t. The dispersion and volatility this leads to are attractive to active managers who try to identify any potential excess return available from stock picking. They look for areas with big inefficiencies which offer scope to make money, even net of costs. More efficient areas of the market are more difficult to make money, and these are perhaps looked to by passive investors.

When it comes to biotech, special skills are required to understand these complex biotech businesses, to actively pick the winners and losers. And actively picking the right ones is crucial as there’s a big dispersion in outcomes at an individual company level.

We have recently added such a fund to portfolios. We partnered with a manager that invests with a long/short strategy, allowing them to capitalise on both rising and falling prices within biotech. We believe this approach is best suited to biotech given the sector’s volatility and dispersion in returns at the underlying company level.

After several booming years, the private equity (PE) sector peaked in 2021 before falling into a correction. Since mid-2022, investment activity, fundraising activity and exit activity have all fallen.

This can be partly attributed to a higher interest rate environment. Some PE funds relied heavily on low interest rates to achieve the returns clients were demanding. Higher borrowing costs also make it harder for PE firms to exit their investments through sales or IPOs. That’s left capital silted up in the system, stuck in unexited investments or just accumulating in dry powder (capital which has been committed by investors, but has not yet called down and spent on assets and businesses). This has put growing downward pressure on prices and transaction volumes.

However, there are signs of green shoots in the sector. We’ve noticed dry powder beginning to fall for the first time in a while. We’ve also seen transaction activity pick up slightly and a surge in enthusiasm, not just from equity market investors. Now there’s a greater chance of decent growth in the US, we’re also seeing a pickup in the M&A and IPO cycle, unlocking markets. Many businesses have needed to be sold but the price they were willing to sell at was not where the buyer was, so there was a disconnect in the bid/ask price. That gap is seemingly now starting to narrow.

Greater activity is good news. Investors are feeling more positive going into the new year, so it’s likely that activity will continue to pick up. But the low distributions suffered for the past couple of years have created another problem. It’s led to a concentration effect where investors have stuck to holdings they know and like. In effect, they’re staying with familiar quality names and not increasing their investments to all the funds they’ve done in the past. Excellent managers still raise capital very quickly, but picky investors mean mid-range funds have found fundraising hard.

Although this is a more challenging environment for PE than we have seen for many years, the sector opening offers opportunities we can harvest. In this environment, it’s crucial to identify the best names, including among smaller and more niche firms whose calibre is showing through now the environment is more challenging. There are opportunities for investors with capital to deploy, if they have the knowledge and patience to wait for the best.

Throughout 2024 we viewed the risk of recession as elevated, with two possible routes to slowdown. Our first scenario was one in which growth was already slowing, and that slowdown would continue until we reach recession. This scenario was supported earlier in the year by the weakening manufacturing sector, and steadily increasing jobless claims data. The second path stipulated that the recent strength in the economy would continue, but persistent inflation and higher interest rates would eventually lead us to a slowdown. Falling inflation isn’t typically associated with a strong economy, so if the economy is as robust as it could appear, inflation is likely to remain sticky, driven by consumer spending.

Donald Trump’s victory in the US election has increased the likelihood of scenario two. Robust US-driven growth is now the consensus view, partly thanks to some pro-growth policies. However, this resilient growth will likely be accompanied by persistent inflation, as we’ve already seen markets positioning for. The Fed confirmed their concern about sticky inflation after their December policy meeting. This threat of long-term inflation is our key concern. Fixed income markets expect it to return to 2%; we believe it could stay higher.

This higher inflation means interest rates will probably need to remain elevated for longer. Some view interest rate policy risk as ‘two-sided’, implying the possibility of a hike is back on the table. Higher for longer rates run the risk of short-circuiting growth, leading to a long-term slowdown. Risks remain skewed to the upside. Inflation hedges remain in our portfolios to manage these risks.

Various other long-term risks persist, including geopolitical tensions, tariffs, and debt overhangs, which may either emerge later or unexpectedly disrupt markets in the near term. The timing of a US dollar reversal is another critical uncertainty. We, and many others, think markets are pricing in substantial positive news, which influences short-term price movements and encourages M&A and IPO activity amid easy financial conditions.

The long-term range of potential outcomes is wide, so we have positioned portfolios to deliver strong returns across various scenarios. Challenge can present opportunity; you just need to be more active. We prefer equities over bonds, including corporate bonds as credit spreads appear less attractive, though default rates are expected to remain low. One of our most significant moves in the latter part of 2024 was to increase public equity exposure and reduce the relative underweight to US growth stocks. We’re now positioned for greater exposure to high-quality, high-growth US technology businesses.

We believe sectors such as financials, defence, cyclicals, and technology are well-positioned to outperform, supported by a rebound in domestic US earnings. We expect value stocks to outperform growth, and small-cap equities should outperform large caps in this environment.

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