Five themes for 2025

Section 4: Five themes for 2025

1. Relative spreads and credit selection, not risk-free rates, will drive returns in public and private debt markets.
   
   Given our expectation for modest U.S. rate cuts and a broadly range bound Treasury market, we think investors should focus less on timing duration positioning and more on generating alpha by emphasizing relative spreads and exercising selectivity among credit sectors, which look particularly attractive (Figure 2). For example, senior loans have posted positive monthly returns since November 2023 and offer yields north of 8% with minimal interest rate risk and credit upgrades outpacing downgrades.
   
   So far, these views have mostly paid off. While credit spreads have widened, interest rates have declined, supporting global bond markets. We maintain our view that a diversified bond portfolio balancing rate and credit sensitivity will be resilient in a higher-for-longer rate environment. But selectivity is critical. For example, we are bullish on U.S. corporate credit (high yield and loans) but prefer relatively higher quality issuers. In the securitized space, we like off-benchmark issues such as data center asset-backed and non-agency commercial mortgage-backed securities that offer compelling risk-adjusted spreads. And we favor private credit in the middle market, particularly more conservative structures with lower leverage and stronger covenants.
2. Municipals are still the borrower of choice for investors in it for the duration.
   
   Following on from our first theme, individual investors should consider bar belling their shorter-to-intermediate duration positioning in taxable sectors with longer duration municipals. Since the municipal yield curve is steeper than the Treasury curve and muni credit fundamentals remain solid, we think longer-duration municipal investors are well compensated for taking on greater rate sensitivity.
   
   Municipal bonds have enjoyed a solid start to the year, and we believe municipal borrowing remains more compelling than U.S. government options. Municipalities enjoy strong credit health, and we anticipate growing demand for muni bonds as non-U.S. and institutional crossover investors add allocations. Sectors such as transportation (which is benefiting from massive spending on airport terminal expansion and modernization) and water/sewer utilities (which have healthy cash flows and ample capacity for increased debt) look particularly attractive.
3. Real estate reality: it’s at a turning point.
   
   Real estate is (finally) beginning a rebound, with investor demand rising as prices stabilize and both fundamentals and liquidity improve. Real estate performance turned positive in the most recent two quarters, a trend historically associated with longer-term positive turnarounds. While many headlines focus on high office vacancy rates (we agree the office sector will remain under pressure), we see ample opportunities across other segments, such as industrial and alternative. We also see value in publicly listed REITs, which offer good fundamentals and earnings growth.
   
   With our positive view toward real estate, we also see opportunities in related asset classes. Mortgage- and commercial-mortgage-backed securities should be lifted by rising real estate markets. And we see growing opportunities in investments that fund energy upgrades through mechanisms such as Commercial Property Assessed Clean Energy (C-PACE) financing.
4. Energy demand charges ahead of capacity, creating opportunities amid political changes.
   
   A new energy boom is being powered by the rise of AI, growing capital expenditures for power generation and increased spending on energy transmission. Power-related infrastructure investments should benefit from these trends across public and private markets (perhaps more than pure-AI related plays).
   
   Regulatory and political shifts under the Trump administration in the U.S. are causing a reevaluation of the energy “winners and losers” in the years ahead. Overall, we expect the green energy transition to persist around the world (especially in Europe), but we think investments such as natural gas, pipelines and traditional energy will benefit from Trump administration policies. And with power demand outstripping current supply capacity from traditional sources, we could also see a boost to nuclear and geothermal energy generation. In contrast, areas such as U.S. wind power and electric vehicle charging infrastructure should look more challenged.
5. Small caps are suiting up for the big leagues.
   
   This is our only theme that is off track, as small caps have been underperforming. Nevertheless, we hope that a combination of attractive relative valuations and the shifting U.S. political backdrop will support small caps. We expect President Trump and the Republican Congress will usher in an environment of lower corporate tax rates, less regulation and more protectionist trade policies. These trends should promote new capital investment cycles, which could create small-cap tailwinds.
   
   Elsewhere in global equities, we are growing more positive toward non-U.S. developed markets. We remain bullish on Japan given rising earnings and pro-growth policies. Many observers (ourselves included) were probably too negative toward European markets earlier in the year. Attractive valuations, Germany’s massive fiscal stimulus plan and improving relative growth are causing us to move non-U.S. equities up a notch in our heat map.