The US Federal Reserve (Fed) delivered a ‘hawkish’ quarter-point interest rate cut to bring the key policy rate target range to 4.25-4.50%. While investors expected this move, what’s new is that the US central bank also signalled a slower pace of rate reductions: the policy statement was updated to include the consideration of the “extent and timing” of additional adjustments.
The 2025 median expectation by the policymakers now shows just two cuts rather than four previously, with some extra reductions in 2026 to get to a similar rate level at the end of the period. Predictably, the market reaction was negative: US Treasury yields surged higher, the S&P 500 equity index (-3%) suffered its largest post-Fed loss in years, and the US dollar continued to strengthen.
The one thing that didn’t change is that the US economy remains healthy. Economic growth, if anything, has continued to exceed expectations. Corporate earnings growth appears solid, and job growth remains strong, consistent with near-full employment. With the Trump Administration’s likely expansionary fiscal policy, including tax cuts and public spending, it’s no surprise that the Fed anticipates some upside risks to inflation.
The central bank’s preferred inflation measure, which is based on the core personal consumption expenditures index (which strips out volatile prices such as food and energy), is after all around 2.8%, above the Fed target of 2%. It’s these lingering inflation risks that have caused market volatility.
Market outlooks are a dynamic process and so, as new research comes in and events unfold, we keep refining our views, day in and day out. We were expecting a gradual pace of rate cuts, and our base case was that we won’t get to the ultra-low rates of the decade prior to the pandemic, given the US fiscal stimulus and a possibly stubborn inflation path. This is the view that we laid out in our 2025 Counterpoint Investment Outlook.
By and large, we think this view is valid, along with its investment implications: solid growth should support equities, especially in the US; and some inflation risks make us hold fewer US Treasuries than we typically would in our long-term asset allocation. In part this is because of lingering fiscal concerns (in yesterday’s market sell-off, this underweight position did benefit, mitigating the impact of falling equities). We estimate the Fed will end up around 3.5%, aligning with our projections. But rather than cutting once per quarter in 2025, we now think the central bank will reduce rates only twice next year, with a couple of extra cuts in 2026.
Let’s cover the key pillar of our investment philosophy with one analogy we already used in our research: if we knew with absolute certainty that there would never be another car accident, we wouldn’t need airbags; similarly, if we knew with absolute certainty that our market outlook forecasts were always going to play out as expected, we’d simply invest all the money into our predicted best-performing asset. But we don’t. So, while we believe we’ll get to our destination unharmed, we have the airbags just in case. Our airbags are a diverse range of investments across different asset classes, geographies, styles and instruments. This diversification reduces the impact on portfolios if the unexpected happens.
To give you an example, take artificial intelligence (AI). If this is such a revolutionary trend, and AI-related stocks have performed so well in 2024, why not invest heavily or exclusively in them in 2025? The answer is that we don’t put all our eggs in one basket. Instead, we invest broadly across US equities (where one can find quite a few AI stocks) and other equity markets globally, and safe-haven assets such as government bonds. If AI does well, portfolios benefit from that performance. If AI were to do less well, the rest of the portfolio would dampen the impact. This broad market exposure is our airbag, together with our quality bond investments – which tend to benefit when economic growth slows (which is when equities do less well).
Market volatility tends to ebb and flow as economic, corporate, and (geo)political events unfold. Rather than knee-jerk reactions, we seek to maintain composure, anticipating potential developments. We’ll readjust portfolios as required and maintain a globally diversified approach to mitigate the impact of local issues while staying invested for the long term. Despite volatility bouts, it’s this approach that delivered solid and consistent performance this year, in line with our objectives.
This diversification is evident in our recent tactical changes: as before, we continue to favour a slight equity overweight and, within that, prefer US equities; but as the Big Tech companies that dominate traditional indices tend to have more demanding valuations, we recently added an equal-weighted index, which emphasises financials and industrials that could benefit from forthcoming US policies. At the same time, our European equity exposure is now reduced and, should these recent events create extra volatility, our ‘insurance’ instrument that appreciates when equity falls could cushion any impact (in portfolios where client knowledge and experience, and regulations and investment guidelines, permit). We’re keeping an eye on this position and, depending on future market conditions, we might be looking to monetise.
Gold and commodities, which we currently hold in line with our long-term allocation, could help mitigate a range of inflation risks. As mentioned, we’re underweight US Treasuries and, strategically, with US fiscal policies potentially turning more inflationary, we’ve swapped shorter-dated US inflation-protected bonds for longer-dated ones. But there’s more room to cut rates in the eurozone and, to a lesser extent, the UK, as these economies are weaker than the US. So, we’ve recently raised our exposure to domestic government bonds, still preferring short-dated ones to help diversify risks, while further reducing our exposure to corporate credit, as we think valuations don’t adequately compensate for the risks. Taken together, these fixed income changes reduce the sensitivity to US rate movements, mitigating the impact of the rise in long-dated Treasury yields we saw overnight.
