Looking Back
2024 was a positive year for global equity markets. Bond markets were more subdued, but overall, investors in diversified portfolios should have experienced a reasonable time. Inflation continued its downward trend, allowing central banks to lower interest rates and thus provided a tailwind for many asset classes.
2024 was also a year marked by many important elections across the world’s democratic countries. Some of these created immediate challenges for their populations – Emmanuel Macron’s call for an early parliamentary election resulted in the loss of his majority, paralysis in French politics and a failure to agree on a budget for 2025 – while others set challenges for the future.
The UK and US are two such examples, and the consequences of these elections are creating an unsettled environment for investors in 2025 so far, with rising bond yields and a falling pound being the main focus from a UK perspective.
Prior to 2022, bond yields had been incredibly low (meaning that prices were high) for more than a decade, but in that year conditions changed, with surging inflation and the prospect of higher interest rates leading bonds to fall in value and causing yields to rise. This trend was then exacerbated by Liz Truss and Kwasi Kwarteng’s mini-budget, which shook investor confidence in the UK’s finances, causing them to shun UK government debt (gilts).
Since that time, stability has returned to global markets and bond valuations have been closer to what feels like fair value overall. However, there has remained a risk for longer-dated bonds. In ‘normal’ conditions where an economy is moderately positive, bonds which mature further into the future would be expected to deliver a higher return as compensation for the longer investment period involved compared to shorter-dated bonds. In industry terminology, this is known as a ‘steep yield curve’. Yet, since 2022’s market collapse, the yield curve has been stubbornly flat, meaning there has been no extra reward for holding longer-dated bonds. This has made short-dated bonds more attractive on a relative basis and has meant that risk has continued to be present in longer bonds.
Risk Materialises
As we have previously written in this newsletter, we believed that the re-election of Donald Trump would bring an expectation of higher interest rates, which would be particularly challenging for long-dated bonds. This risk has materialised over recent weeks and particularly over recent days. Trump is expected to pursue an economic agenda focused on tax cuts, which is likely to lead to higher economic growth, which will be inflationary, but also a higher fiscal deficit, meaning more debt will need to be issued.
Also, his expected use of tariffs is likely to increase prices that Americans face, therefore further adding to inflation. Add this higher borrowing and higher inflation together and you have an environment in which bond prices are likely to come under pressure, and yields will rise, as we have seen in 2025 so far.
Data released last Friday showed an unexpectedly high level of US jobs created and has added further fuel to this trend, with the economic strength it shows needing higher interest rates to prevent overheating, which is a further negative for US and international bond markets.
UK Perspective
As with many stories in global markets, therefore, this is primarily a US issue which is having global ramifications. As such when turning our attention to the UK, US factors explain a significant amount of the movement in gilts experienced since the turn of the year. Yet, the UK market experience is not solely down to Trump’s spending plans. While the US influence has put markets in the mood to sniff out weakness, with the UK’s finances already on questionable foundations, a lack of confidence in the UK specifically has developed, with the yield on UK government debt rising to its highest level since 2008.
Rachel Reeves’ Autumn Budget raised taxes and increased borrowing, but despite that, it left a relatively small amount of fiscal ‘headroom’ in the forecasts, before more taxes and spending cuts would be required to avoid breaking her pledges on the path of public borrowing. Given the rise in bond yields since the budget and the higher cost of servicing the national debt this creates, this headroom has now likely been used up. This means further tax rises, spending cuts or increased borrowing could be in store, which is creating concern for our future economic growth.
As a consequence, not only have UK gilt yields increased, but the value of the pound has also fallen. Prior to Trump’s election in November, the pound was trading at $1.30, whereas at the time of writing on 13th January it has fallen to $1.21.
Market Opportunities
For investors, this means that 2025 has started in a negative mood, continuing the uncertainty that has been present since soon after the US election. With debt to GDP around 100% in the UK, US and France and with interest rates at their highest since 2008, public finances are in a challenging state. Investors have now turned their attention to this and further losses are possible as markets try to establish the fair price for government debt. Nonetheless, with yields already at a high level, there is a lot more negativity already priced into bonds than there was in 2022, meaning a repeat of the scale of losses experienced then seems unlikely.
What’s more, with the yield curve having steepened in recent weeks, this means that future returns on longer-dated debt are looking more appealing. In the investment portfolios managed by Future Money , we have so far made small movements to increase exposure here, and we will be watching this area closely for the right opportunity to further adjust positions. We believe that volatility is likely in the short term, but this could create longer-term opportunities.