Investment Strategy
Q1 2025 Investment Review: Rotation and Consolidation
Sentiment rules, tariffs loom, and central banks are ready. What does this mean for investors? Get the full story in our latest article.
Stewart Edginton
Head of EMEA Managed Solutions
Published Apr 1, 2025
IN BRIEF
- Sentiment has outweighed fundamentals
- Valuations have seen a healthy consolidation
- Tariff headlines remain a concern but are yet to impact the real economy
- Central Banks are primed to cut rates if needed
Market Comment
What a difference a quarter can make. Coming into 2025 consensus opinion was to back US exceptionalism, manifested through an overweight to US equities, funded from the much unloved Europe, which looked on the verge of recession or, at best, low growth. Over the quarter, we’ve seen European equities surge and, within fixed income, yields rise in Europe and fall in the US. Essentially the opposite of expectation coming into the year.
So what’s changed?
In terms of fundamentals, not that much. Corporate earnings season was strong, with US earnings growing double digit and Europe high single digit. Hard economic data remains relatively resilient in the US; consumers are still spending and the jobs market is robust. The most recent March US composite PMI (purchasing managers index) actually showed an increase in growth at 53.5 vs the last reading of 51.6 (a reading above 50 indicates growth). So at the time of writing, the US economy does not seem to be impacted by the swirling tariff headlines and potential negative impact on growth.
That means that market movements are being driven by sentiment and valuation changes. There are three key factors that have impacted sentiment this quarter:
- News from Deepseek suggesting that AI can be delivered much more cheaply than expected, which undermined the valuation multiples of key AI stocks such as Nvidia.
- The announcement by Germany to break their previous fiscal rules and exempting a planned $500bn infrastructure fund as well as allowing increased defence spending from previous debt limits.
- President Trump’s hard and fast use of tariff threat against trading partners.
We view the Deepseek news as rightly taking some froth out of related AI tech valuations but not changing the adoption and spending on AI by corporates; if anything, it may help speed up and cheapen wider adoption.
The German fiscal news is indeed significant and the first major break in policy that we have seen in many years from the lead Eurozone member. The spending could boost German GDP by 1-2% - a significant amount for an economy that was teetering on recession. We feel some of this excitement should be tempered by the fact that increased infrastructure spending will take a period of years to flow through into the real economy and defence spending will in part be spent on imports but also has a lower ‘multiplier effect’ i.e. consumers will feel very little direct benefit from it.
As evidence of the perceived impact on German growth, it’s worth looking at the 10 year German Bund yield:
Source Bloomberg. Data as of 25/03/2025.
The yield has moved up by c.40bps and given German equities have moved positively, markets are pricing in future growth already. By comparison the US 10 year treasury has fallen in yield by c.30bps. We think this is a more understandable move in that we do indeed see tariffs as a tax on growth. Whether that comes to fruition or not we’ll have to see but what it does do is impact corporate spending & acquisition activity until there is clarity; corporates are unlikely to geographically expand until they have more clarity on the local tariff regime. Therefore how long this process goes on is relevant to how much growth could be impacted.
The other key consequence of this relative movement in yields is a weakening of the US dollar. The move here seems rational to us; both growth differentials and consequently Central Bank rate expectations have narrowed. For the USD to continue weakening, we would need to see either a further weakening in perceived US growth from current levels or growth upgrades from the rest of the world. We see both prospects as relatively unlikely and therefore think the bulk of the FX move has happened.
Q1 index returns across various asset classes
Bloomberg Finance L.P. as of 31/03/2025,. You may not invest directly in an index. Fixed Income returns represent hedged to base currency returns. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
Key portfolio activity over the quarter
Despite the volatility we saw during the quarter across fixed income and equity markets, activity in the portfolio was low. To the previous commentary, our team’s view was that fundamentals haven’t changed significantly and hence there was little reason to change our positioning from year end. Furthermore, we had well diversified exposure coming into the year and so there was little that needed to be re-balanced.
The one change we made at the end of the quarter was to rebalance some investment grade fixed income exposure from Europe to the US. This was driven by valuation change in that throughout all of last year, spreads on European investment grade (i.e. the premium yield over government bonds) were higher than US spreads. As the news from Germany took hold, spreads in Europe tightened and became more expensive than US investment grade. As such, we felt this was an opportunity to rotate some of that exposure back to the US.
High-level positioning
We continue to run a moderately pro-cyclical position; 1-2% overweight equities and 4% overweight high yield – split equally between Europe and the US. Geographically, we are overweight the US equity market vs Europe. At the sector level, our key overweights are technology, financials and consumer staples – a spread of secular growth, cyclicality and quality. Within fixed income, we are underweight Core bonds in favour of high yield and neutral duration at around 6.5 years. Following the investment grade switch, we are now only moderately overweight European duration given the potentially beneficial impact of increased German fiscal spending. That means that we are balancing a pro-cyclical overall position with some defence in fixed income should growth disappoint.
For portfolios with hedge funds, we are positioned in line with the strategic allocation and have a slight bias to relative value and global macro.
Returns
Returns for the World MSCI equity index were negative over the quarter, led by the US. Additionally, the rise in European fixed income yields has been a headwind for the European aggregate. However, returns for the US aggregate have been positive, as yields have declined in the face of growth concerns, and hence global diversification has helped.On a relative basis, the overweight to US equity and European duration has detracted but given these weren’t significant positions, the impact has been slight. Positive absolute and relative performance has been helped by our overweight to credit, particularly high yield. Equity sector positioning has been well diversified and so not a significant driver of relative performance. For Euro and GBP base currency accounts, USD weakness has impacted returns. At this stage, we see that as a give back of the benefit of a stronger dollar last year and are not inclined to hedge FX at current levels, even though it’s possible that FX volatility remains elevated.
Outlook
As noted, we feel that negative sentiment around tariffs and consequently the growth impact has out-weighed the fundamental picture, which remains relatively robust, favouring US growth over Europe. However, the longer the tariff saga continues, the longer corporates may defer capex spend. While we haven’t seen a hit to consumer spending yet, confidence surveys (‘soft data’) are beginning to be impacted. Only time will tell if that feeds through into actual activity. It’s worth keeping in mind that while the Trump administration needs to raise tax revenue through tariffs and potentially weaken the dollar, it’s not in the administration’s best interests to cause a recession ahead of the mid-term elections. Indeed, should data further weaken, Chairman Powell has indicated that the Fed is ready to cut interest rates further. Such a move would be supportive of risk assets and so we view the market action this quarter as a healthy rotation and consolidation of valuations. We are watching developments closely and much attention will be paid to Q1 corporate earnings, which will start to be announced in April. Taken all together as things stand and noting that we are currently only modestly pro-risk in positioning, our inclination is to add risk should volatility increase again. Particularly reassuring is the return of ‘negative correlation’ between bonds and equities; where there have been growth concerns, bonds have delivered positive returns. We think this dynamic will continue and therefore favour being fully invested in equities combined with the protection value of duration within fixed income, rather than increasing cash levels. For long term investors, we feel this is an opportunity to take advantage of uncertainty.
Important Information
Stewart Edginton
Head of EMEA Managed Solutions
Published Apr 1, 2025
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