Every December, we publish our predictions for the year ahead. We believe these predictions have at least a 1-in-3 probability of materializing – making them realistic, while not necessarily being our base case expectations. We also ensure our predictions are not currently priced into the markets – making them surprises relative to investor positioning.
Here are our 2025 predictions:
1. Emerging Market Debt (EMD) and Emerging Market Currency (EMFX) will post double-digit returns
Since the US election, the markets have swiftly priced in a world incorporating policies from President-elect Trump and a Republican Congress. Expectations of the new administration’s policies have been punishing emerging markets, especially their currencies, as tariffs are expected to be a significant policy tool in a USD-centric environment. We think too much pessimism is priced in and the new administration will be more judicious with tariffs than feared. While 25% tariffs on Canada and Mexico have already been mooted, we believe tariffs are likely to start at a couple percent and then slowly ratchet up to a reasonable level…. far below levels that would concern the markets. While pressure from the administration on China is likely to be greater, we think the market is underpricing China’s policy response. Borrowing rates are being cut, liquidity is being injected into the system (especially housing) and fiscal stimulus will increase. On top of all this, there have been consistent outflows from EMD mutual funds and ETFs over the last couple years. Sentiment is as negative as it’s been since the 2013 taper tantrum and markets are ready for a meaningful bounce. The 2016 US election is also a reminder of what can happen: after external EMD returned -4% in Q4 2016, it returned +10.3% in 2017 and local EMD returned +8.9%.
2. West Texas Intermediate (WTI) Oil trades below $50 a barrel
President-elect Trump’s ‘drill, baby, drill’ declaration has the potential to overwhelm the oil market which has struggled to find support despite the OPEC+1 production cuts. After peaking at close to $88/bbl in April, WTI has failed to hold $70/bbl. Treasury Secretary nominee Bessent’s 3-3-3 plan calls for an additional 3 million barrels per day in production (to go along with 3% GDP and 3% deficits). As oil prices start to come down, the risk is that producers try to make revenue targets on volume rather than price. On the flip side, any upward movement in prices will elicit plenty of excess capacity from OPEC+ and US producers will also be incentivized to boost production.
3. High yield bonds outperform investment grade bonds for the 5th consecutive year
Corporate America has rarely looked better. Revenue and earnings continue to grow, and capital is readily available from the public markets, banks and private credit. The default rate in the public high yield market is about 1.1%, par-weighted including distressed exchanges, which is surprisingly low for this point in the cycle. It is true that broadly syndicated loans are running with a 4% default rate (reflecting the higher propensity of smaller issuers to default) and the private credit markets are experiencing a rash of distressed exchanges and payments-in-kind. However, the public high yield market looks clean. History tells us that unless the US is headed into recession, back ups in credit spreads are buying opportunities and the current ~7% yield on the Bloomberg US Corporate High Yield Index is a comfortable margin over the ~4.5% yield of the Bloomberg US Aggregate Bond Index.
4. 10-year government bond yields for Italy-France and Germany-Japan converge to zero
A pair of yield relationships we thought we would never see. Since the Great Financial Crisis (Dec. 2008), the median yield spread that Italy has funded itself over France has been 117 basis points (bps). The yield spread narrowed to single digits in 2003 but never fully converged. During the height of the European debt crisis (2011/2012), the yield differential grew to over 400bps. Since then, Italy has improved its fiscal trajectory. France, on the other hand, is struggling with political turmoil and concerns over excess borrowing and spending. The market is considering the risk of a credit rating downgrade for France, dependent on the budget process over the next few months. Welcome to the periphery! In core developed market rates, the last time Germany and Japan converged to the same yield level was in 2022. From 2019 to 2022, German yields traded below Japan, becoming deeply negative during the pandemic. While the post-pandemic economic recovery in Germany has been full of fits and starts, the European Central Bank (ECB) managed to hike rates considerably by 450bps through most of 2023 with a singular focus on combatting inflation. At the same time, Japan remained mired in low inflation expectations. Now, while inflation has been extinguished in Europe, inflation in Japan continues to look to be trending higher. Meanwhile, Germany continues to struggle with lackluster growth in its export-oriented economy. With the Bank of Japan poised to deliver more rate hikes, it is also possible that the ECB is forced to cut rates more quickly below the perceived neutral level. The current ~100bps yield spread could quickly converge to zero.
5. 10-year US Treasury Yield trades in a range of 75bps or less
The new fiscal regime in the US has investors braced for another year of high interest rate volatility in 2025. So far in 2024, the 10-year US Treasury has traded in a range of over 100bps. Meanwhile in 2023 and 2022, the 10-year US Treasury traded in a ~150bps and ~250bps range, respectively, as the Federal Reserve (Fed) roiled the bond market with an aggressive rate hiking cycle after letting themselves get too far behind the inflation curve. Next year, the Fed may actually find itself at the right policy setting without having to do much at all! The last time the range was less than 75bps was in 2017 when the Fed was hiking at glacial pace and inflation was stable. Today, the Fed has eased 100bps already, taking the edge off the economy, but policy remains restrictive enough to counter any fiscal impulse. Meanwhile, with so much cash on the sidelines, we expect captive buyers to jump in on any meaningful backup.