Multi asset: will fiscal policy catch investors off guard?

As we enter the new year, this Q1 issue of Simply put looks at whether bullish consensus forecasts for 2025 fully incorporate factors such as fiscal consolidation, which could lead to increased market volatility and further reinforces the case for strong diversification.

The CIO’s perspective: Growth recovery vs fiscal recovery?

2024 was a year that tested the resilience of our systematic investment process – notably, due to the extreme concentration of performance both between and within asset classes. The dominance of US assets (especially equities) has been almost impossible to beat, particularly for our strategy, which eschews over-concentration in favour of diversification. That said, our risk-based approach has still proven beneficial, enabling us to remain close to our performance targets.

For 2025, we are mindful that two significant macroeconomic shifts could profoundly impact markets and challenge market concentration. Firstly, after two years of subdued global growth punctuated by US exceptionalism, a nominal recovery could invigorate the global economy, suggesting a more balanced performance across assets and regions. Secondly, the potential for fiscal consolidation across North America and several European countries could catch investors off guard, necessitating a thorough analysis of potential repercussions, particularly in terms of how different asset classes might react. These emerging trends could have divergent effects on market returns.
 

FIG 1. Percentage of countries in the world experiencing an improvement in growth conditions¹

Read also: Upbeat macro, moody market

The challenge for 2025 will be determining which factors might prevail between more balanced global growth prospects and the potential onset of fiscal consolidation. True to our investment philosophy, we choose not to favour one scenario over the other; instead, we maintain a balanced approach by combining developed and emerging market equities with bonds and trend strategy allocations. This aligns with our core investment principles and allows us to navigate through uncertain fiscal and economic landscapes effectively.

Our initial takeaway from the interplay between more balanced growth momentum and fiscal consolidation in 2025 is that market concentration should fade, potentially leading to a broader range of investment opportunities.

Portfolio positioning: Keeping an eye on diversification

There hasn't been much change in the composition of our strategies over the past quarter. Broadly speaking, our allocation remains skewed towards protection assets. Yet amid the cross-cutting theme of fiscal consolidation and its macroeconomic consequences, the pursuit of improved diversification reflects a rebalancing between risks and opportunities across markets for our investment strategy.

After bond risk spiked in 2022, our bond allocation remains somewhat lower than the historical norm². This assessment stems from two primary factors: a return issue and a risk issue. From a return perspective, while long-term yields remained below short-term rates, investors have not been adequately compensated for holding duration risk. Secondly, with persistently high inflation in developed markets (DM), interest rate volatility has remained elevated for an extended period. However, both factors have now begun to show signs of improvement: central banks have initiated rate cuts, aiding the regeneration of the term premium.

A potential resurgence in the appetite for bonds could be triggered by an increase in risk aversion, prompting investors to rebalance their portfolios towards safer assets. While there are signs to support this narrative, signals remain mixed and we are not compelled to increase our bond holdings significantly at the moment, although this could change during the first quarter.

FIG 2. LOIM Global Risk Appetite and components³

Overall, when integrating all the components of our investment process, we are starting the new year with an increase in global market exposure and a marginally altered allocation, favouring cyclical investments, but with a broader trend of normalising our protective asset allocation.

Macro: The mechanics of fiscal consolidation

With growth forces gaining momentum, the critical question for 2025 concerns the direction of fiscal policy. Should we anticipate a significant tightening of fiscal policy in 2025 and, if so, in which regions?

According to the IMF’s World Economic Outlook, the global average primary deficit to GDP ratio stood at 2.9% in 2024, while a decrease to 2.4% is expected in 2025. This reduction represents a less stimulative fiscal policy of 0.5% of GDP globally (for DM economies), which is not insignificant.
Yet, in specific countries, government plans could lead to even more substantial deficit reductions: 1.4% in Italy, 3.4% in Japan and 0.9% in the UK (IMF projections).

This is commonly referred to as ‘fiscal consolidation’ and warrants caution due to its potential impact on global GDP and corporate profits. How a country manages fiscal consolidation or expansion hinges on two factors: a controllable element and a combination of structural factors and chance. The controllable element is the primary deficit, which is the difference between fiscal revenues and expenditures, excluding borrowing costs. The structural element is the differential between nominal interest rates and economic growth rates. This information is useful in analysing which countries are on a sustainable fiscal path, where the debt-to-GDP ratio does not consistently rise.

FIG 3. Debt-to-GDP expected deterioration in 10 years vs real rates⁴

Countries with a poorer control over their fiscal circumstances, which currently include the US, UK and France, need to try to steer their debt levels onto a sustainable trajectory. In our view, this long process of fiscal consolidation will be one of the key challenges of 2025 and the years ahead.

Special focus: Avoid those worst days!

A central theme for our investment process has been that risk management is not solely about mitigating risks; it can also be a significant source of performance. Our approach has involved eschewing a singular market perspective in favour of seeking diversification and prioritising signal-driven strategies over narrative-driven ones. These principles have consistently enhanced our strategies. In addition, our ability to moderate extreme returns has made a distinct contribution that we anticipate will continue to serve us well in 2025.

While the outlook for 2025 is optimistic, potential fiscal consolidation and political risks could precipitate ‘tail events’. The occurrence of large negative returns, which can trigger significant market declines, underscores the importance of dynamic drawdown management.

Read also: Higher US tariffs: winners and losers

Risk management – exercising caution while invested – can add value and enhance the profile of a long-only investment situation by cutting off the tails of the return distribution and improving risk-adjusted returns. If it also yields an uptick in performance, even better!

Our dynamic drawdown management has matured over the past 12 years, providing us with invaluable experience, and a growing and meaningful sample to look at. Figure 4 shows our dynamic risk management has significantly reduced the left tail while capturing a substantial portion of the right tail, thereby enhancing performance – on a risk-adjusted basis and also on an outright performance basis. This approach could be very relevant over the next year as, in our view, the prevailing growth consensus driving the market could yield unexpected setbacks.

Simply put, while the consensus points to another bullish year in 2025, keeping a firm grip on tail risk will be essential.

FIG 4. Distribution of returns for the 40/60 portfolio in USD and the All Roads strategy rescaled to match the 40/60 volatility (top) and zoom on both tails (below)⁵

New research: Diversification everywhere

In everything we do, managing risk is ever present. This can pertain to market risk, execution risk or even a more challenging type of risk: model risk. Our preference for systematic investing stems primarily from its ability to avoid cognitive biases, which are numerous and well-documented in the rich field of behavioural finance. However, blindly following a flawed rule does not equate to intelligence.

‘Model risk’ essentially involves addressing the issue that the signal used to inform asset allocation might produce a biased representation of what it is supposed to measure – in statistical terms, we aim for ‘consistent’ models. This is easier said than done since we cannot measure reality with certainty, a problem that science has wrestled with for centuries.

Our approach is straightforward: we diversify our signals measuring the same thing. By doing so, it reduces the probability of relying on a false signal by blending it with a multitude of others.

For example, we have found that pursuing model diversification within our trend-following overlay can yield attractive improvements in terms of investment performance.

FIG 5. Sharpe and Calmar ratio per trend following signal and aggregation (2006-2024)⁶

Reading note: 3MM stands for 3-month moving average; breakout is a strategy buying new highs and shorting/selling on fresh lows; DEMA is Double Exponential Moving Average with either half reversal (neutralising allocation when long/short signal surpasses a threshold) or full reversal (longs become short and shorts become longs when the signal surpasses a certain threshold); binary looks at the sign of the average return-to-risk ratio over a given period; counting uses the signal of the sum of the signs of returns over a lookback window.

In short, multiplying signals is essential to improving our understanding of market and macro dynamics – an essential approach for systematic investors.

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Simply put quarterly edition: Will fiscal policy catch investors off guard?

 

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