Observations by David Robertson, 1/3/25, Outlook edition

Happy New Year! I hope everyone had a nice break over the holidays and got a chance to rest and recharge a little bit.

There are a lot of different reasons to provide an outlook so I’ll be upfront with mine. Mainly, it forces me to think through issues clearly and completely. I also find the exercise of going through and comparing current views to documented views from last year to be useful for identifying changes and mistakes. As such, it is also useful for rethinking and updating mental models and frameworks. Finally, it creates a nice opportunity to highlight signposts from which to evaluate progress during the year.

As a reminder, virtually everything discussed here has been reported in previous editions of Observations; it is not meant to break a lot of new ground. Rather, it is more of a compendium designed to pull several interrelated threads together into a cohesive outlook. It is longer than usual so if you can’t see the piece in its entirety, please access it by way of the Substack app.

As always, this is for information purposes only; it is not investment advice.

If you ever want to follow up on anything just let me know at drobertson@areteam.com.

So with that, let’s dig in.

Investment philosophy

For starters, and in order to provide some context, it is important to understand what I try to accomplish with investing. My orientation is very much to long-term investment. Think saving for retirement over a horizon spanning years and decades rather than days and weeks. While much of what I do can inform shorter-term trading as well, that is not the focus of decision making. This stands out as a very different orientation than most of what you find on Wall Street or social media.

I work from two major assumptions. One is that things change. Because things change, it requires an active effort to maintain an advantageous investment position. “Set it can forget it” can work if you are lucky, but it is not a robust strategy. Sometimes stocks are attractive, and sometimes they are not. Same for bonds. Investment success over time depends on rigorous, ongoing research and analysis to make those determinations. It is not an inalienable right.

It is also important to consider multiple perspectives. Differing viewpoints and perspectives provide important context for understanding and interpreting various phenomena. Investing with a long-term orientation, for example, means it is important to incorporate perspectives from disciplines that span longer periods of time such as history, politics, and geopolitics. It is also important for equity analysts to understand fixed income markets and vice versa.

The best and easiest way to consider multiple perspectives is to read a lot. I focus on content providers who I find to be insightful and who are also independent thinkers. The list includes people like Russell Napier, Ben Hunt, Peter Zeihan, John Hussman, Michael Howell, and Michael Pettis, among others. In addition, I find the Substacks of Mike Green, Russell Clark, Michael Kao, and Paulo Macro to be consistently insightful.

Investment process

Mainly, I am trying to inform an asset allocation that stacks up favorably against a traditional 60/40 (stocks/bonds) portfolio.

In doing so, I employ a three-pronged process that involves a formal valuation model (of stocks, bonds, and bills), a consideration of uncorrelated asset classes, and an analysis of narratives (for more detail see the 2023 edition).

Investment landscape

By and large, the broader trends I highlighted last year continued to shape the contours of the investment landscape this year. The issues of excessive debt and aging demographics continue to slowly, but surely, constrict the operational flexibility of governments around the world.

The response of those governments has mainly been to pursue any number of means by which to delay or disguise the ultimate consequences. For many years after the GFC, loose monetary policy, led by the Fed, was the go-to policy for delaying consequences. More recently, large fiscal deficits have been the means by which to keep the economic wheels turning at the desired pace. At the end of the day, however, neither policy initiative has accomplished much more than buying time.

At the same time, while fiscal challenges have been formidable enough, political challenges are proving every bit as onerous. With the aging population increasingly dependent on government aid, there is virtually no openness to reducing entitlement spending, and therefore little room to reduce fiscal shortfalls. Almost regardless of what politicians do, they suffer backlash from their electorates. As I wrote in the 11/8/24 Observations, “Voters are dissatisfied everywhere. Problems have been kicked down the road by politicians for too long.” There just is not any tolerance among electorates for making the sacrifices necessary to restore sustainable finances.

Fortunately for politicians, their efforts to delay and disguise consequences has been aided by a couple of global phenomena. The first, Russell Napier describes in his Solid Ground letter from 10/28/24: “The current global monetary system was established in 1994 by China’s decision to devalue and then manage its exchange rate”. This had the effect of creating a “large gap between the developed world’s growth rate and discount rate”.

The result, he concludes, “has been a major distortion to US interest rates, gearing levels and asset prices”. This has created at least the appearance of prosperity in the US. As a result, more vigorous efforts at reform have been neutralized.

Second, the proliferation of passive investing turbo-charged the appreciation of financial assets by corralling flows of money and allocating them according to mechanical, non-fundamental rules.

These two dynamics also help explain other unusual phenomena. For example, they explain why valuations rose to a noticeably higher level beginning in the mid 1990s — because the discount rate was locked below the growth rate. They describe why US assets have outperformed other global assets since then — because passive funds amplified momentum which increased buying of the largest stocks (which were US-based).

Further, the strong performance that ensued has been rationalized through simpler and more accessible narratives. US exceptionalism is one. Innovativeness driven by the technology sector is another. Persistently accommodative policy is yet another. While each has an element of truth to it, they fall far short of providing compelling evidence of causation.

Yet another glaring element of the investment landscape has been the broad based enthusiasm for stocks. Several factors have contributed. Policy actions to attenuate volatility have made it almost impossible to bet against markets. Pure speculative fervor emanating from a long winning streak (noted in the December 6 Observations) played a role. So too did financial nihilism (mentioned in both the March 15 and March 22 editions of Observations). As upward mobility has stalled, many younger adults feel they need to “take bigger risks.”

All of this creates a very interesting paradox: The world’s major economies have been contending with an overburdened, unsustainable system, but a system in which the political incentives have been in favor of kicking the can down the road. Strong market performance has been less a projection of a powerful economic engine than a mechanism by which to forestall meaningful reform.

The consequences of that can kicking exercise, however, have been borne disproportionately by young people. Now the scales are tipping and the irresistible force of change is beginning to gain ground on the immovable object of the status quo.

While I (and many others) have underestimated the durability of unsustainable trends, the misjudgment is only one of timing. What is different now is there is an identifiable catalyst. I believe the politics that ravaged incumbents in democratic elections in 2024 is the force that will finally demand a break from the past.

Implications and outlook: Macroeconomic

Politics

I moved the section on politics up this year because politics, and the public policy deriving from it, were key drivers last year and promise to be so again in the new year.

In that vein, a good deal of effort has been focused on trying to identify key points of focus for the incoming administration. Given the evidence and mixed bag of characters involved so far, I think the most productive course is to consider what the new administration is likely to NOT be.

For one, given Trump’s nature as being transactional, impulsive, and mercurial, I think it will be a mistake to extrapolate too many policy threads from the first Trump administration. Trump ver 2.0 may not look a lot like Trump ver 1.0.

For another, Trump’s super power is mainly the ability to incite and channel outrage. He is not a builder of things or an advocate, but rather a loud complainer.

As it happens, there are plenty of things that aren’t working well — from institutions that are no longer fit for purpose to outdated agreements to a blatantly unfair social contract — that can be the source of outrage. Demand for change is not just a matter of ideology. So too is the degree to which any given person feels the existing system is worth keeping.

Consider, for example, a post by Bruce Mehlman which highlights some values of Gen Z. For one, “41% of Gen-Zers found the cold-blooded murder of a defenseless family man (UnitedHealthcare CEO Brian Thompson) ‘completely’ or ‘somewhat acceptable’ vs. just 40% unacceptable.” If this strikes you as “shocking”, consider this a wake up call as to how unjust younger people consider the social contract to be.

He also reported Gen-Z was “a lot less likely to prioritize more traditional community values.” More specifically, 32% of Gen Z prioritized patriotism relative to 76% for Baby Boomers, 26% for religion vs. 65% for Boomers, 23% for having children vs. 52% for Boomers and only 33% agreed America is the best place to live vs. 66% for Boomers.

While Gen Z certainly wasn’t the only reason Trump won the election, it does represent the cutting edge of political sentiment — and it is not happy. With Trump being the avatar of disruption that he is, he is well placed to channel the outrage younger people feel about the way things are.

I’m not the only one thinking along these lines. According to John Ikenberry of Princeton University in the FT ($), “Trump is poised to contest ‘almost every element of the liberal international order — trade, alliances, migration, multilateralism, solidarity between democracies, human rights’.” He continued, “As a result, rather than supporting the international status quo, the US is poised to become the leading disrupter.”

Of course, few incoming administrations come into office with a clean slate and unlimited capacity to enact their agendas. Pre-existing problems divert energy away from the primary agenda. Often the mandate gets overstated and political capital gets burned up on political squabbles. Further, disparate agendas within the administration can tap valuable energy and resources as well. All of these challenges undermined the greatest hopes of the Biden administration and most likely will do the same with the Trump administration.

In addition, Trump brings some unique characteristics into the fold. If an America first agenda is aggressively pursued, it is likely to spawn retribution from countries that had been allies. Aggressive tax cutting without commensurate cost savings could very well spawn a “Liz Truss” moment and cause long-term yields to spike. These possibilities are all too real because Trump himself does not seem to have much heart for the sustained effort of governance. Will he be able to maintain his often cult-like support when things go south? Or will he be forced to moderate his agenda?

On the policy front, a couple of ideas stand out for their potential to significantly affect the investment landscape. First, Secretary of State nominee Marco Rubio views China as an aggressive adversary that must be confronted. Second, he believes a massive effort to rebuild the country’s industrial base will be required to succeed in this conflict.

The Rubio quote below was highlighted by Russell Napier to give “colour of the new relationship between the US and China”:

“They believe in raw power. They believe that because they are a big country that their smaller neighbours have to be their tributaries. And they believe that the only way for them to become more powerful is to make others weaker, particularly America.”

“The result is a rising Communist China determined to replace the United States on the world stage, making Americans more dependent on and ultimately subservient to Beijing. If China succeeds, the world’s dominant power will be a brutal, authoritarian police state. The Chinese Communist Party is a racist, genocidal regime that spies, imprisons, and enslaves its own people and others.”

“The Chinese Communist Party controls the largest industrial base in the world. Through theft, market distorting subsidies, and strategic planning, Beijing now leads in many of the industries that will determine geopolitical supremacy in the 21st century. This report should serve as a wakeup call to lawmakers, CEOs, and investors. We need a whole-of-society effort to rebuild our country, overcome the China challenge, and keep the torch of freedom lit for generations to come.”

A few things stand out. First, this is aggressive language. It is not remotely suggestive of a grand bargain with China. Second, it largely represents a continuum of foreign policy direction. The first Trump administration singled out China as an important geopolitical adversary. The Biden administration mainly picked up the baton and carried on. Now the second Trump administration is doing the same in picking up the baton from the Biden team.

Another thing that stands out is the strong advocacy of industrial policy. Rubio’s argument sounds a lot like the one Biden’s National Security Adviser, Jake Sullivan, made in 2023 when he highlighted that “America’s industrial base had been hollowed out.”

I find this especially interesting for two reasons. One, the articulation of similar policy outlines by people on nearly opposite ends of the political spectrum is yet another instance of a phenomenon I have highlighted in the past whereby the major parties are actually converging in several policy arenas. As I noted last year, this suggests “several general policy directions are likely to remain in place regardless of who is in power.”

This phenomenon of apolitical policy continuity suggests investors may be able to use some elements of policy direction as a guide over a longer time horizon despite the vicissitudes that emerge over intervening periods. That’s a start.

Mostly though, policy direction remains a wildcard. Nor is it at all clear how much sustained effort or commitment might be given to any particular position. The clearest thrust is to start tearing down things people don’t like. The process of formulating better alternatives and rebuilding seem to be lower priorities.

Geopolitics

Last year I wrote:

Two big factors continue to impinge upon the geopolitical landscape. The first is the persistence of aging demographics and high debt burdens which change the state of play to a much more competitive orientation from a more collaborative one. The second is the effort of the US to forge an alternative path from the “Washington consensus” or, loosely, the neoliberal order. Bottom line: The US just can’t afford to operate under those conditions any longer.

In general, this means more conflict around the world - and that is exactly what we are seeing.

That statement proved to be a useful guide for the year. We did see more conflict during the year. We also had a year in which incumbents lost each of ten democratic elections in a sign of widespread political discontent (11/8/24 Observations).

The same perspective is also likely to be a useful guide for the upcoming year. We start off with France, Germany, Japan, and Canada either having new elections or at the risk of doing so. The Eurozone is primed to contend with some truly existential challenges. Meanwhile, autocratic China continues to struggle with debt deflation resulting from the collapse of its real estate sector. Russia, Ukraine, Israel, Syria and others add even more combustibility to the mix.

As I noted in the “Investment landscape” section, the makings of much of this turmoil are best understood from the perspective of China’s decision to manage its currency in the mid 1990s. Initially, that decision helped to boost growth by facilitating the build out of China’s manufacturing and export machine and by pumping global trade.

However, that policy-induced boost also came with a cost. The cost to China has been a global system that became dominated by the US dollar, and therefore US policy. The cost to the US has been huge trade deficits and exploding levels of debt. So, while the engineered imbalance started off as mutually beneficial, over time it has become mutually harmful.

This is also why the geopolitical landscape has now migrated from one of heightened tensions and players jockeying for position to one of imminent disruption. Now, there is a catalyst: Both major players want change. As Gideon Rachman recognized in the FT ($), “But now, in different ways, the US, China and Russia have all become revisionist powers that are seeking radical change to the current world order”

For investors, this means geopolitics should no longer be treated as mainly innocuous background noise. Geopolitics has taken on a new complexion during the course of the year and is now more fundamentally a driver of events. When national security becomes a pervasive concern, geopolitics jumps to the front of the line of national priorities. This is prime time for geopolitics.

As the geopolitical tug-of-war plays out, there will be some useful guidelines. First, although the US is in a better competitive position than other countries, no country is exclusively in control of its own destiny. As this reality becomes increasingly apparent, the world will start feeling like a more uncertain place.

Second, the policy of “national capitalism” (h/t Russell Napier) that China and the US are pursuing is likely to be adopted by others as well. As old rules of cooperation come down, new domestic priorities will take their place. As a result, any set of policies initiated by one country will be countered by others. This is likely to be a messy process and it will take time to arrive at stable relationships.

Finally, with major changes brewing in China, Japan, the Eurozone and other places, there is a great deal of potential for consequences to wash up onto US shores — and to surprise a lot of people.

Economy

Last year’s view that “Economic growth in the US is likely to be stronger than in most other major economies” proved to be prescient. It was right to focus on government spending and fiscal deficits as key drivers and that avoided an unduly pessimistic outlook for unemployment and credit.

This year we are in a different starting position. The bolus of Biden administration spending is tailing off. That spending covered up a lot of problems, but those problems didn’t go away. What remains is an economy that is starting to resemble a wobbling Jenga tower.

For instance, low income consumers have been under pressure for some time and are reaching the breaking point. Even if deep and rapid cuts in interest rates did happen, they would be unlikely to provide much reprieve. At the same time bankruptcies and commercial real estate defaults keep piling up. Credit, which has held up reasonably well, could turn south in a hurry as a wall of refinancings come to market at higher rates. Inequality in both the business and consumer world is also hitting a breaking point.

Unemployment, which has been broadly in check, is also at risk. Numbers have been creeping up that last few months but strong employment numbers for government workers have concealed weaker results for the private sector. Further, employment conditions at public companies have been on razor’s edge. Strong stock performance has kept pink slips at bay but any glitch could launch a round of layoffs. Fundamental performance has not been nearly as strong.

In sum, the can of economic problems has been kicked down the road a long time and the road is running out. This is happening at a time when it is not at all clear whether the incoming Trump administration with have the same inclination to paper over problems with government largesse. While having your cake and eating it too was an effective campaign proposition, it is not a practicable governing one. Something is likely to give.

Compounding the challenge is that as much as any time in recent history, economic outcomes are likely to be affected by factors outside of the country. Whether in the form of escalating frictions with China, global currency disruption, significantly reduced global demand for whatever reason, or some other influence, there is no shortage of factors that can undermine US economic performance from afar.

This suggests an interesting possibility. If the Trump administration simply allowed slowing economic momentum to take its course and for a recession to develop, it could blame the downturn on the Biden administration. Then it could harness the discontent to pave the way for Marco Rubio to unveil a new and improved industrial policy. That would be a relatively painless way (at least politically) to get from point A to point B.

Obviously there are a lot of other possibilities. What all of them have to contend with is a starting position that isn’t incredibly strong but with expectations that are remarkably high. This is a good formula for disappointment.

Inflation

My view on the longer-term risk of inflation remains unchanged: “monetary inflation is a long-term policy and therefore is likely to be around for years”. Everything I said last year remains valid and can be reviewed in the 2024 Outlook piece.

There is, however, a great deal more uncertainty around the short-term outlook — namely because the policy position of the incoming Trump administration is more uncertain. Trying to handicap the net effect of countless possible policy permutations is mind boggling enough, but we don’t even have a good sense of how sensitive the new administration will be to inflation.

There is also a great deal of uncertainty emanating from abroad. Will China’s economy continue to struggle and pull down global prices with it? Will Eurozone growth continue to falter in the new year? Weakness in commodities currently suggests these are distinct possibilities.

As a result, the inflation outlook for 2025 is a crapshoot. While the dominant mental model last year was one of a soft landing, this year it may be hard to tell if we are taking off, landing, or crashing. It may be all three at various times. The wide range of possibilities is likely to rattle a few cages.

Monetary policy

My decidedly nonconsensus view of the Fed is that it is essentially a stalking horse for a wide range of investment issues. Despite its poor record of managing monetary policy and economic growth, it nonetheless gets trotted out onto the global stage for the purpose of distracting attention away from other important drivers that may be more sensitive to public scrutiny.

This hasn’t stopped the investing public from hanging on every word that comes out of the Fed. The Fed in turn obliges its audience by sharing its deep economic insights (sarcasm), proffering guidance on a regular basis, and assuring Americans that it is acting in their best interest. I tend to view this as so much Kabuki theater, but it does create a self-fulfilling prophecy because it is hard to bet against the Fed.

At least it has been, but I think that is about to change. For one, too much power is attributed to the Fed. While the Fed did keep rates low from the GFC through the pandemic in 2022, and stocks did rise during that time, the ultimate cause was China’s currency policy. That policy enabled the Fed to pursue unusually accommodative policy by suppressing inflation.

Now that China is on the cusp of changing its policy, the Fed will no longer have the luxury of maintaining accommodative policy without inflationary consequences. The easy sledding is over.

Markets are catching on to this emerging reality. After the Fed skipped at rate cut in July, it went for 50 bps in September. After admitting it underestimated inflation in the latter part of the year, the Fed still cut in December. Not only has the Fed looked less sure-footed in the last several months, the market’s confidence in the Fed is also wavering as long-term yields rose at the end of the year despite the Fed’s cuts to short-term rates. Bond investors are correctly anticipating limitations on the Fed’s maneuverability without help from China.

The implications of this transition will be significant. For example, any potential advantage of returning to near-zero interest rates must now be offset by the considerable risk of rekindling inflation. That policy was a luxury of past circumstances.

Another belief that is due to be seriously challenged is that of the Fed always stepping in to support stocks when the going gets tough. This belief is widely held and explains a great deal of risk-seeking sentiment. I suspect this may be one of the biggest surprises of the new year.

Given the Fed’s new ample reserve regime, the risk of the Fed needing to buy assets in order to preserve financial stability is greatly reduced. Further, past episodes of Quantitative Easing (QE) have been shown to exacerbate inequality and thus have acquired a stigma in the central banking playbook. As a result, the Fed’s reaction function to a market downturn is likely to look a lot different than it has in the past.

A few other outstanding issues are also likely to weigh on the monetary policy environment in 2025. For one, the incoming Treasury Secretary will most likely need to increase issuance of bonds. How high will yields go? At what point do higher yields slow down economic growth? At what point do higher yields cause stocks to sell off? We are likely to start finding out.

In addition, how much longer is Quantitative Tightening (QT) likely to continue? The longer it goes, the more liquidity gets mopped up. What is the “right” level?

Finally, will bank lending finally start picking up? Arguably the most potent source of money supply for generating economic growth, will the Trump administration try to boost lending or not?

The pervasive theme is that all signs point to major changes in how the investing public currently views monetary policy.

Interest rates

Last year the main show was the Fed’s path on short-term interest rates. This had less to do with the actual impact of slightly lower rates on economic activity and more to do with providing a signal that the Fed was supportive of risk assets.

This year the spotlight is more likely to turn to new domestic policy initiatives and geopolitical events. One consequence will be that an especially wide range of outcomes is possible. Rates could be set much lower if recession sets in — or higher rates if inflation resumes. Both are quite possible.

The bigger story, however, is going to be with longer-term rates. These rates have been suppressed for various reasons but the capacity to continue to do so is running out. The new administration will have the unenviable task of matching an ever-growing supply of bonds to demand that is becoming increasingly price-sensitive. In addition, it will be constrained by the real risk of higher long-term rates choking the economy.

Amidst this high wire act will come the potential for some strong cross winds. A rapid loss of economic momentum could send yields lower while a display of fiscal irresponsibility could send yields higher. This suggests bond volatility may be higher than many people expected as inflation eased.

Longer-term, the most likely destination is still financial repression — which will involve keeping longer-term rates below that of inflation. In the meantime, the path there promises to be a circuitous one.

Culture

Given that it has become virtually impossible to understand or evaluate the investment landscape abstracted from consideration of social media, I decided to add a section that encompasses the forces that push and pull our society in various directions. Social media is on the top of the list.

To a large extent, social media has become the water in which we live. It is the primary way many of us get news, it shapes the ways in which we interact with one another, and it is central to the types of narratives that get told and how those narratives spread across society.

Indeed, a new brand of narrative formation facilitated by social media has been an important factor enabling stock prices to become increasingly disconnected from underlying fundamentals. Short, punchy social media posts can be very effective at hitting emotional hot buttons and inciting action. They are also advantageously designed to propagate misinformation. In short, it is pretty hard to understand today’s investment narratives, especially relative to those of years past, without understanding the role of social media.

One important element of the social media phenomenon is that people are increasingly becoming aware of its corrosive effects. Jon Haidt brought many of these to attention in an Atlantic article entitled, “Why the Past 10 Years of American Life Have Been Uniquely Stupid”:

But by rewiring everything in a headlong rush for growth—with a naive conception of human psychology, little understanding of the intricacy of institutions, and no concern for external costs imposed on society—Facebook, Twitter, YouTube, and a few other large platforms unwittingly dissolved the mortar of trust, belief in institutions, and shared stories that had held a large and diverse secular democracy together.

This creates an image of large tech companies less as paragons of technological innovation and more as banally opportunistic profit seekers wholly unconcerned by the consequences of ripping apart the social fabric.

Rusty Guinn ($) also highlighted another deleterious side-effect of social media which he described as the outsourcing of our consciousness. He explains, “With one hand, these symbols [memes, etc.] guide us to perceive them as the product of our own reason, yet with the other they supplant that reason with meanings determined in the minds of other men.” In short, we think we are thinking for ourselves, but instead we are being led like sheep.

He arrives at a similarly gloomy outlook as Haidt: “it’s probably not a literal burning of the world, but an ugly period where society just doesn’t function.”

One takeaway is that social media has created an unusually harsh environment for democratic governance — and this reality does not seem to be well appreciated by the investment community. Yes, we have lots of smart people and natural resources. Yes, we have lots of great technology. However, we do not currently have an effective public square by which to promote and resolve constructive conflict. Social media has ripped that apart. Our great resources as a country cannot be leveraged until this gets resolved.

That said, there is a silver lining. As awareness of the effects of social media have improved, so too have efforts to push back against the most harmful tendencies. Parents and schools are limiting access to mobile phones. Younger people especially are voicing the negative impact of social media on their lives. If a groundswell of resistance forms and/or if government picks up the mantle of protecting its citizens, things could change quickly.

Implications and outlook: Investments

Given the primary goal of my investment outlook is to inform and guide a strategic allocation, I will emphasize the absolute and relative attractiveness of major asset classes for long-term investors. As a result, the outlook for assets tends not to change a lot from year to year. That said, I will also share thoughts about shorter term outlooks where appropriate.

Stocks

The long-term outlook for stocks remains extremely negative on the basis of extremely high valuations. This means future returns (over a ten year period) will be low and by my measures significantly negative.

This longer-term risk has butted heads with short-term sentiment that is extraordinarily bullish. Strong performance has continued to attract speculators and more skeptical investors who are afraid of missing out. Strong inflows into US stock funds have created a positive feedback loop that keeps driving prices higher. In short, it’s been really hard to sit out the rally in stocks even despite the longer-term risks.

What is changing in this equation, however, is that there is now a catalyst to effect change. With both China and the US leading the charge in throwing out the rule book for the old international order, they are also dramatically changing the policy priorities which had artificially sustained financial markets.

Ample liquidity was part of that deal. A supportive Fed was part of that deal. A reasonably strong US dollar was part of that deal. Strong inflows from international investors was part of that deal. Now, with a political agenda for “change”, those tailwinds are all set to subside or even reverse.

Bonds

Bonds yields rose and fell over the course of the year and rose again to end higher. This happened even as short rates got cut later in the year. As a result, bonds do offer some attractiveness relative to cash in a broad allocation.

In addition, with the distinct potential for a growth slowdown, there could well be opportunities for tactical allocations.

The longer-term position remains the same, however. Since financial repression is by far the most likely policy direction, bond holders will be at greatest risk. Undoubtedly, there will be efforts to mask this and to impose it where possible. That just makes it all the more important to maintain some distance.

Cash

Treasury bills, i.e., cash, are less attractive than at the beginning of last year but are still the outstanding investment option in the standard asset allocation mix right now.

With most other assets still unattractive, cash still provides a decent yield. It also provides important option value to buy other assets at a discount should asset prices fall. As was the case last year, cash should be the benchmark by which to judge any other asset.

Gold

Gold is still an extremely important asset that is hugely under-owned in most investment portfolios. Despite a strong move during the year, it is still very early innings for this must-have asset in a world moving toward financial repression.

Gold had an interesting year in 2024. Most notably, it was up about 26% which was right in line with the stellar year stocks had. Central banks continued their purchases of gold which makes perfect sense in the context of increasing geopolitical instability and imminent changes to the global financial system. No doubt, early investors are also increasingly tracing out the path to financial repression and getting ahead of the game. Notably, retail investors in the US still have virtually no interest as they seem to be mesmerized by the bright shiny object of the stock market.

As well as the year ended up for gold, it certainly didn’t start off that way. The metal fell about 4.5% through the middle of February and gold miners were down even more. There were no clear, fundamental reasons, just a sell off. Then, out of nowhere, gold just started putting in one up day after another. The lesson is timing can be extremely challenging. If you want a significant longer-term position it’s usually best to average your way in.

Commodities

I still like the longer-term case for commodities. As noted in the 9/6/24 Observations, the longer-term opportunity is clear.

The shorter-term outlook continues to confound, however. Continued deflationary pressures out of China, a surplus of oil production capacity, and signs of slowing growth elsewhere continue to impinge upon the case for commodities.

It rarely pays to be too cute by trying to time the market too closely though. When prices move they often move fast. Commodities have underperformed stocks and as a result may be prove to be an attractive alternative if stocks start selling off. Finally, any number of geopolitical events could rapidly turn the tables as well.

Emerging markets

For the past several years, emerging markets have hugely underperformed the S&P 500 despite boasting much more attractive valuations. They have been the small caps of the global mandate.

In both cases, the underperformance has largely been mechanical. Large US stocks dominate global allocations and therefore attract disproportionate flows. Those flows pump up prices which in turn increase allocations. For as long as this dynamic is in place, it is fair to expect the same result.

There are good reasons to expect change in the not-too-distance future though. If and when the S&P 500 sells off, investors will likely look for a suitable replacement. A number of emerging markets will look attractive. Further, those markets will also largely be immune to the repatriation of excess savings that will consistently draw money out of US markets.

Alternative investments

Investments such as real estate, private equity, and venture capital have long been pitched to advisors and retail clients as diversifying investments. They do add a few slices to the allocation pie charts and help create the impression of diversification. Bottom line though, these are all highly correlated to equity markets.

Even though stocks continued to perform well in 2024, alternative investments mainly had a difficult year. Exits were way down which lowered dividends. Financing costs are up. Greater competition means less low hanging fruit. Overall, an economy with little organic growth and a higher base level of interest rates has not served an industry built on financial engineering well.

This all suggests that private equity and its cousins will continue to have tough sledding ahead. Of course if all else fails, expect to see a lot more offerings of alternative investments to retail investors. After all, they have to dump the stuff on somebody.

Investment summary

As we start off the new year I see a couple of themes playing a prominent role in shaping the investment landscape. The first represents a big change from the past. Now, both of the world’s superpowers, China and the US, want to throw out the rule book of the world order.

This means all the risks and tensions and imbalances that marked the past will start transforming into actions for change.

Throwing out the rule book will mean breaking all of the relationships and assumptions and rules of thumb that went along with it. These will all need to be re-formed and renegotiated. It is likely to be a very disruptive process that will produce unintended and unpredictable consequences.

It is also likely to reveal a great number of misperceptions about how the global economy works. As a result, I am thinking of this process as the “Great awakening”.

It will shake many belief systems when the Fed either can’t or won’t provide a safety blanket for stocks. It will shock others that stocks can go down and stay down. A rising number of incidents around the world will make it feel like a much more uncertain place.

Another theme, and part of the awakening, will be the realization of how spoiled and unprepared we are. As Philip Coggan writes in the FT ($), “Investors got a very good deal out of the post-1945 international order in which, by and large, national governments played by the rules. But now the rule book is being torn up.” We may discover we have taken a number of things for granted once we start losing them.

Perhaps the biggest impact of the rule book getting torn up will be the reacquaintance with consequences. No longer will consumers be able consume so much without inflation. No longer will investors be able to count on stocks going up all the time. Investors are beginning the year with extremely high expectations. The stage is set for considerable disappointment.

While adjustments will need to be made, some of which will be painful, there is good news in these developments. For instance, there is striking inequality in our society and that undermines the social contract for too many people. Tearing down the institutions and practices that have caused that inequality is insufficient for reversing the process, but nonetheless is a critical first step.

We got a glimpse of what this might look like in 2022, but then we got a pass for two years. With stronger forces for change in place now, we are unlikely to get such a reprieve again. While the transition will be a process that takes time, it will require a fundamentally different approach to investing.

As we progress through the year, I will be monitoring a few items to mark progress in the transition. First and foremost will be policy direction coming out of the Trump administration. Will it be cohesive or more random? How much effort will be put into governance? In short, how serious will the new administration be?

In addition, much more than in recent years, actions taken by other countries are likely to weigh heavily on shaping the investment landscape. Will China devalue? Will Japan repatriate savings? How will the Eurozone forge ahead? Will conflict arise? I expect a steady stream of news from abroad this year.

Implications and outlook: Investment advisory

I would be remiss in describing implications of the investment landscape if I did not also discuss implications for everyday investors.

First, as I alluded to above, the outlook for stocks and balanced 60/40 (stock/bond) portfolios is terrible. It’s one thing to invest long-term and ride through the ups and downs. It’s a different thing to be overexposed to risk at a historic extreme of market excess. Make sure your level of risk is appropriate. What you don’t do can hurt you.

Second, by virtue of the strong run up in stock prices, there is an over-representation of followers, performance chasers, and risk takers. This strongly biases the types of information and advice that are available.

Finally, I founded my company, Areté Asset Management, because I didn’t think the investment industry had done a very good job of helping investors achieve better outcomes. That has not changed. I’ve seen it first hand too many times.

As a result, and especially in a time of a confusing and changing investment landscape, I think it is important investors understand exactly what they are getting involved in and why. There are no guarantees in life, but at least we should hope for a fair chance at getting ahead.

Good luck and best wishes for a successful 2025!

Note

Sources marked with ($) are restricted by a paywall or in some other way. Sources not marked are not restricted and therefore widely accessible.

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