The global economy is in reasonably good shape. Global growth is slowing down but the likelihood of a recession remains low. Unemployment remains at the lower end of historical ranges and labour markets have now normalised after Covid-19-related distortions. Inflation remains slightly above target but has fallen enough that it allowed some central banks, including the US Federal Reserve, to ease interest rates.
Markets believe that the re-election of Donald Trump will have a net positive impact on the US economy, with deregulation and tax cuts supporting household consumption and the corporate sector. However, macro uncertainties remain, particularly from upside risks to inflation from tariffs, immigration policies and Trump’s intention to lower the value of the dollar to boost US exports. Emerging markets in particular could face challenges from tariffs as well as from interest rates remaining high, but a potential weakening of the dollar later in 2025 as well as easing geopolitical tensions could benefit them.
Fixed-income returns are expected to be positive, supported by falling but still elevated policy rates. The key strategic question for fixed-income investors will be whether extending duration is the right move given persistent high US long-term interest rates and rising concerns over public debt sustainability. With policy rates falling the yield curve is normalising.
US equities have continued to outperform ex-US equities, but valuations are a growing concern. While US equities might benefit from additional tax cuts, supporting growth and corporate profits, diversification into less pricy equity markets may be needed to mitigate US concentration risk in 2025.
Private markets, particularly real estate and private infrastructure, are expected to recover in 2025, offering value compared to public markets. Key secular trends such as decarbonisation, digitalisation (including artificial intelligence), deglobalisation and demographic change present new investment opportunities but also create disruptions. Investors will need to be more active in picking winners and avoiding losers through thematic and country, sector and company selection.
On a portfolio level, correlation between stocks and bonds surged in 2022 and remained positive for parts of 2023-24, challenging the diversification benefits that balanced portfolios had during the ‘Great Moderation’. However, as inflation fell sharply and confidence returned, the stock-bond correlation turned negative once again in 2024, reinstating the diversification benefits of balanced portfolios.
We expect the stock-bond correlation to remain slightly negative in 2025 as inflation continues to fall towards target. However, geopolitical tensions or tariff wars could lead to higher-than-expected inflation, raising the relevancy of including inflation hedges in sovereign portfolios.
Scenario approach required to navigate uncertainty
As public investors navigate this uncertainty, the best approach to asset allocation is to look at macro scenarios. In our framework, a ‘softish landing’ scenario (with no or only a mild recession) has the highest single probability (Figure 1). However, the combined probability of the more negative recession and the stagflation scenarios is still high and should be accounted for in asset allocation decisions.
The softish landing (baseline) scenario would be beneficial for risky assets. Global equities are expected to generate annual returns of 6.7% over the next five years, below the long-term historical averages given current valuations, particularly for US megacaps. Government bonds are expected to generate returns of around 4% in this scenario. As a result, a balanced portfolio is expected to generate good returns in the baseline scenario, allowing reserve managers to achieve their primary investment objective: capital protection.
Figure 1. Expected returns for cash as well as short- and long-term government bonds
Source: UBS Asset Management. Projections as of 4Q 2024. This does not constitute a guarantee by UBS AG, Asset Management.
The stagflation scenario is the most negative for sovereign institutions and it would represent a return to the severe market conditions that investors experienced in 2022. In this scenario, inflation would remain high for a prolonged period, forcing the Fed to increase rates again, keeping them high for a prolonged period of time. In this 1970s-style scenario, both (long-term) fixed income and equities would generate negative nominal and even lower real returns over the next few years, leaving little room for diversification. In such a scenario, cash and short-duration bonds would provide some protection, but only in nominal terms.
The challenge for asset allocators is the largely symmetrical probability of these adverse scenarios. Should a deflationary recession scenario materialise, markets could go back to a lower-for-longer regime similar to that seen in the 2010s, and having locked-in rates at current levels would turn out to be very profitable. If we instead enter a higher-for-longer inflationary regime, even risk-averse fixed-income managers like reserve managers could face longer periods of equity-like volatility while struggling to achieve positive real returns.
Still, what emerges from our capital market expectations is that considerably higher yields now provide a cushion for fixed-income investors. Government bonds and other investment-grade fixed-income assets therefore are expected to still play an important role in the portfolios of public investors.
Massimiliano Castelli is Head of Strategy and Advice, and Philipp Salman is Director, Strategy and Advice Global, Sovereign Markets, UBS Asset Management.
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The views expressed are as of February 2025 and are those of the authors and not necessarily the views of UBS Asset Management. This article is a marketing communication and the information herein should not be considered investment advice or a recommendation to purchase or sell securities or any particular strategy or fund. Information and opinions have been provided in good faith and are subject to change without notice.
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