Five themes for 2025

Section 3: Five themes for 2025

1. Relative spreads and credit selection, not risk-free rates, will drive returns in public and private debt markets.
   
   It’s true that the U.S. Federal Reserve and most other central banks are in easing mode. But we believe the pace of interest rate cuts will be slower and the terminal rate will be higher than previously expected, as the Fed contends with sticky inflation and looser fiscal policy. We think 2025 will end with a fed funds rate of around 3.75% to 4% and the 10-year Treasury yield close to 4.5%. This view means focusing less on duration positioning and more on generating alpha by concentrating on relative spreads and careful selectivity among credit sectors.
   
   In this new environment, we think investors should diversify credit exposures through such areas as securitized assets (especially segments not included in broad market benchmarks) and senior loans, which should benefit from the higher-for-longer environment. More broadly, we are seeing solid opportunities across various credit sectors, especially compared to cash or Treasuries (Figure 1).
   
   Private credit also remains key for income seekers. Investor interest remains high, demand is strong, deal volume continues to rise and we expect M&A activity to increase in 2025, which should provide a tailwind. We remain particularly favorable toward middle market loans and more defensive areas of the market.
2. Real estate reality: it’s already bottomed.
   
   One of the most significant shifts in our heat map for 2025 is moving private real estate to an overweight position given our belief that the market has already bottomed. The stiff technical headwinds that held the asset class back for an extended period appear to be fading. Most global rate increases are in the rearview mirror, which is a plus for private real estate. Additionally, there is more clarity around pricing, and the spot market has stabilized. At the same time, investor demand is rising: Commercial real estate lending is growing, and overall liquidity is improving.
   
   While many headlines focus on high office vacancy rates (and we agree that the office sector will remain under pressure), we see ample opportunities across other areas of the market, including industrial and alternative segments. We also see value in publicly listed REITs, where valuations, fundamentals and earnings prospects all look fair to positive.
3. Energy demand charges ahead of capacity, creating opportunity for new infrastructure investments.
   
   Thanks at least in part to the massive AI boom, energy demand is growing exponentially. But new energy production can’t keep pace with demand. And equally critically, energy transmission is lagging demand. This is one reason we expect structural inflation to move higher, but it also creates investment opportunities.
   
   In part, it favors ongoing investment in green energy, such as solar and wind infrastructure around the world, including the U.S. (despite political shifts, we expect capital to continue flowing toward profitable investments). Additionally, we anticipate demand will grow for nuclear energy, new local electricity transmission facilities, natural gas-related investments and rapid development of data centers.
   
   Related, we also see growing opportunities in energy-related financing investments necessary to fund energy upgrades through mechanisms such as Commercial Property Assessed Clean Energy (C-PACE) financing.
4. Municipals are still the borrower of choice for investors in it for the duration.
   
   Our first theme spelled out the reasons we are not focusing on lengthening duration, but there is an important exception: municipal bonds. The municipal yield curve is steeper than the Treasury yield curve, and with credit fundamentals looking solid, we think longer-duration positioning in municipal bonds makes sense.
   
   Overall, municipal borrowing looks more compelling than U.S. government options. Significant federal fiscal reform remains a remote possibility, and deficit levels remain quite high. In contrast, municipal issuers are enjoying strong credit health. We also expect demand for and net issuance of municipal bonds will grow as the market continues to broaden and non-U.S. and institutional crossover investors add allocations to the asset class. Finally, related to our third theme, project-based financing should grow as a key mechanism for funding much-needed infrastructure spending, and tax-sensitive investors should remain willing to lend to these higher yielding issues.
5. Small caps are suiting up for the big leagues.
   
   Our last theme is based partially on the shifting U.S. political environment following the 2024 elections. All else being equal, we think the new political backdrop will result in lower corporate tax rates, less regulation and more protectionist trade policies. These trends should create tailwinds for U.S. small cap stocks, given they will likely result in new capital investment cycles.
   
   It’s probably too much of a stretch to hope for an earnings resurgence in U.S. small caps, but we see a strong valuation argument given that small caps have been lagging the broader market. Even if earnings remain relatively static, a good case can be made for valuation multiple expansion that could boost prices.

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