View From The Top: The new reality

View from the very top: Despite Donald and DeepSeek dominating recent headlines, equities have risen and bond yields have fallen since the start of the year. The new reality may be one of economic unorthodoxy and revisions to the AI narrative, but there are also good reasons to believe that positive momentum can be broadly maintained. Resilient US economic activity, strong corporate earnings and a potential reignition of capital markets activity lend support to the narrative. There is little more difficult in finance than standing against euphoria. Being too conservative has been the wrong strategy for the last two years. However, do not expect the path forward to be smooth. Tariffs could prove a major source of uncertainty. Equally, stubborn or rising inflation may put Jerome Powell on a collision course with Donald Trump. And, the onus on businesses to continue delivering relative to elevated earnings expectations remains high. Nowhere is this risk more pronounced than within the highly concentrated AI arena. The logic for diversification both within equities and across asset classes therefore only continues to grow.   

Asset Allocation:

• Equities: Stock markets globally have begun the year in a robust fashion. However, market breadth remains at an all-time low. The emergence of DeepSeek has done little so far to change the concentration problem in equity indices. It is notable that equally weighted indices are outperforming their market-cap weighted counterparts year-to-date. With fewer than 30% of actively managed equity funds outperforming last year (per Bloomberg), we see ample scope for mean reversion. The current earnings season is just getting going, and has proven generally supportive to the equity narrative, but do not rule out the risk of a growth disappointment and corrective phase later this year. Shift to active over passive.
• Fixed Income/Credit: Government bonds have been in a clear bear market since 2021. 10-Year US Treasury yields are ~60 basis points higher than a year ago despite 100 basis points of interest rate cuts in this period. The good news is that yields look well anchored at current levels, at least for as long as inflation remains under control. Indeed, yields have fallen slightly since the start of this year. Any reassessment of the AI narrative may see a move into safer havens such as government debt. For now, investors are markedly underweight bonds (see later in this note for details) even if over $200bn of Investment Grade issuance in January (per Grant’s Observer) speaks to the desire to lock in currently high yields. We counsel selective investments.   
• Currencies: The US Dollar Index reached a two-year high in mid-January but has fallen since, consistent with Donald Trump’s wishes. How it trades from here is contingent on the White House’s approach to tariffs – which would elevate the Dollar – as well as global Central Bank interest rate policies. The Fed seems on hold for now, in contrast to the ECB loosening and the Bank of Japan tightening, potentially provoking a relatively weaker Euro and stronger Yen respectively.
• Gold: The precious metal remains the obvious safe haven asset, in our view. Its price has continued to strengthen since the start of the year. Gold can continue to play a crucial diversifying role in investors’ portfolios since it can act as a clear hedge against geopolitical uncertainties. No surprise that Central Banks across the world are continuing to buy gold.
• Alternative Assets: We see such assets as providing another useful form of diversification. Many alternative assets can deliver collateral-based cashflows. At the same time, they benefit from an illiquidity premium too. We advocate being highly selective across this broad and diverse area, favouring differentiated and uncorrelated strategies.

He’s back. Donald Trump has returned to the White House and the implications have already been felt in all spheres. Buckle up for the ride. As we’ve noted elsewhere, the President’s only constancy is his unpredictability. In Trump-world, however, a rising stock market counts for something. Higher share prices are a marker of both endorsement and success. What we do know is that equities are currently priced with little room for disappointment, especially in the world of mega-cap tech, just at the time that prior assumptions about AI are being reassessed. Welcome to the new reality. Where markets end the year will, of course, also be a function of how inflation and interest rates evolve over the coming months. The many unknowns support the case for ongoing diversification within portfolios.

Countless column inches already been written on Trump. We will spare readers here other than noting that conventional wisdom does not sit easily with America’s President. Forget economic orthodoxy and replace it, perhaps, with radical capitalism. At a headline level, the administration appears long on ideas and short on specifics, but there seems to be a clear prioritisation of domestic policies over international engagement, with an emphasis on a growth agenda. So far, so good, based on the market’s initial reaction, albeit that it is far too short a period to judge. How the imposition of tariffs changes the narrative remains to be seen. The President and his team seem to recognise the difference between policy rhetoric and practical implementation. A deeply transactional approach can yield benefits, if executed appropriately..

All the above matters since equities are at, or close to, all-time highs. Optimism has prevailed in markets since late 2022 and has been broadly sustained since. Enthusiasm continues to be applied to all things AI. The implicit assumption is that the Magnificent Seven mega-cap tech behemoths will continue to be successful. Think of this group of businesses as being the gift that keeps on giving, or the problem that keeps on growing – depending on whether you are invested. Despite all the above (and not to mention the extensive passive buying of equities without full consideration of valuation), the bar is now higher than a year ago, in terms of expectations around both forward economic and earnings growth. Put another way, the market remains desperate for news that will help sustain current momentum.

Even if diagnosing bubbles in real-time is difficult, it seems reasonable to ask what could undermine the outlook. Begin with the economy. The US has certainly entered 2025 on a firm footing, although the same could not be said for other regions. The IMF upgraded in January its year-end estimate for American GDP growth by 50 basis points to 2.7% while both the Eurozone and China saw downgrades. With current economic growth running at 3.0% (per the Atlanta Fed’s GDPNow calculator), business sentiment ebullient, the jobs market in good shape and core inflation at 3.2%, if anything risks to growth lie weighted considerably more to the upside than the downside at present.

The US economy seems far from a state of stable equilibrium; rather, characterise it as a fragile equilibrium. This could easily be distorted by any or all the initiatives being mooted by the White House: deregulation, deportations, tariffs, tax cuts, cost cutting and more. More importantly, irrespective of Trumpian bluster, investors remain acutely sensitive to inflation and, by implication, Fed policy. The data suggest that we can’t yet forget about inflation. Recent figures suggest that it may not be getting any worse per se, but equally, it remains above the Fed’s target (2.9% headline versus a 2.0% goal) and does not seem to be getting any better. With respondents to the University of Michigan’s last survey forecasting inflation of 3.3% one year out (and 3.2% over a 5-10 year period), the case for the Federal Reserve maintaining maximum flexibility seems clear. Such as view was echoed by Jerome Powell in his most recent press conference.

Strong economic growth is not reason enough to raise rates. The Fed would only likely tighten were growth or other adjacent policies to push inflation up. No interest rate cuts are discounted until June at the earliest based on Bloomberg’s World Interest Rate Probabilities analysis. Some commentators have even suggested that a rate hike may be necessary before the year-end. To our mind, there are lots of hypotheticals: were inflation to fall, then the Fed has lots of room for manoeuvre, but were Trump’s policies to prove inflationary, then it may have its hands tied. Do not rule out then a possible Trump-Powell collision course before year-end, especially if rates do have to stay higher for longer.

The second major risk for investors would be if corporate earnings were to disappoint. Expectations are certainly set high, with FactSet forecasts at the start of this year discounting 11.9% annual growth in fourth quarter 2024 EPS and 14.8% for full-year 2025 across the S&P 500 Index. Were such results to be achieved, then this would be highly encouraging, demonstrating that earnings can clearly expand in a high-rate environment. The current earnings season is only roughly a quarter through, but the data are encouraging: the average business has beaten consensus earnings expectations by 5.9%, with annualised earnings growth coming in at 11.7%. The major tech businesses that have released figures for the most recent quarter have generally reassured.

The challenge will be to maintain this momentum through the remainder of this year (not to mention the current earnings season, with Alphabet, Amazon and NVIDIA among others yet to report). FactSet data discount a 13.0% net profit margin for the S&P 500 Index for 2025. This compares to a 10-year average of 10.8%. Any reversion towards the mean would, therefore, be a big disappointment. Given the disproportionate weight carried by the Magnificent Seven tech businesses (which comprise over 30% of the S&P 500 Index), were the AI bubble to burst, then this could have major implications for equity investors.

The sudden emergence of DeepSeek does call into question the underpinnings of the rally that has added over $10tr of value to the S&P 500 Index since the end of 2022. The Chinese start-up seems to have weakened the link between AI progress and AI chips. We are believers in technological advancement as a source of upside and first referenced Jevons Paradox in November. Cheaper AI should spur more demand. However, given that many equity bets have been premised on NVIDIA’s chips (and the related ecosystem of its supply chain, adjacent data centres and power suppliers to them), reducing reliance upon them may force a reassessment of how these businesses – and by implication a large chunk of the stock market – is valued. The current earnings season may provide sufficient near-term reassurance, but the going may get harder as 2025 progresses.

Despite the above uncertainties – not to the seemingly wilful denial among investors of a still-febrile geopolitical environment – the stock market can still go higher. Resilient economic activity, positive earnings and a reignition of capital markets activity can provide a helpful lift to equities. There is little more difficult in finance than standing against euphoria. Both 2023 and 2024 showed the dangers of being too conservative. With a net 41% of investors overweight equities and 29% net underweight bonds (per the most recent Bank of America Merrill Lynch Fund Manager survey), we wonder where all the bears have gone. Bubbles can clearly overshoot. Equity corrections are also hard to time. Any resets will provide some great opportunities, especially for contrarians. For now, enjoy the likely volatile ride.

Alex Gunz, Fund Manager, Heptagon Capital