Asset Allocation Research for UK Advisers

In this webinar, we are honoured to be joined by Steve Webb, Partner at LCP and former Pensions Minister 2010-15 overseeing "Freedoms & Choice". Steve will discuss his recently co-authored paper for LCP titled ""The Flex First, Fix Later" pension - is this this the future of retirement?" and earlier paper "Is there a right time to buy an annuity?"

Thank you so much to all the UK advisers who voted for us in these upcoming awards!

Elston was one of the early pioneers (back in 2018!) of adviser-defined Custom mandates for DFMs and Advisers, and we are glad the idea has caught on! We aim to continue to deliver, helping adviser to support their clients achieve great investment outcomes at great value for money.

So we are delighted that Elston Portfolio Management - which powers both our ready-made and Custom MPS services - is on the shortlist in each of the 6 categories announced today....

Best Reporting
Best Value for Money
Most Satisfactory Investment Outcome
Best Communication in a Crisis
Most Useful Digital Interface
Best Availability of Sustainable Investment Strategies

After being honoured to win 7 out of 12 categories in 2024, it wd be a statistical stretch to achieve that again in an ever widening, highly competitive field. But here's hoping!
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You can see the full shortlist here.

​The UK’s new Sustainable Disclosure Requirements (SDR) aim to transform sustainable investing by providing clearer fund labelling that obliges greater accountability. Formulated by the FCA, the new regulations have been designed to combat “greenwashing,” ie, marketing investments as sustainable without sufficient evidence. The more clearly-defined standards set out in the SDRs seek to ensure that investors can have greater confidence in ESG funds' sustainability claims. There is a corollary effect, however, which is that meeting the stringent SDR standards requires significant input from a compliance perspective, meaning increased costs for fund managers. This in turn appears to be deterring many of them from seeking SDR certification, thereby reducing product availability for both institutional and retail investors alike.

Key to the successful implementation of SDRs is the government’s Green Taxonomy, an agreed scheme of classification that will underpin the definitions within the regulatory framework. Unfortunately, it has yet to be finalised by the government, leaving businesses vulnerable to misinterpretation when seeking to comply.
Where the UK has SDRs, Europe has the Sustainable Finance Disclosure Regulations (SFDR), which likewise seek to counter greenwashing by promoting transparency. However, where the SDRs set out quite a granular system of categorisation and promote active engagement and results, SFDRs relate to the promotion of sustainable objectives and are relatively less onerous to adhere to. 
The regulatory differential could lead to various outcomes. Potentially, active fund managers in the UK will be afforded greater strategic opportunities because they can boast of higher sustainable standards for their investments. However, the increased cost involved in complying with SDRs vs. SFDRs may push providers to register sustainable products in Europe rather than the UK, leading to an exodus of funds and a diminished pool of sustainable investments to choose from. ​

In this article for Professional Adviser, Hoshang Daroga explores what makes the US stock market exceptional and whether its outperformance is sustainable.

Read the full article

What is Deepseek?
The new Chinese AI tool is the most downloaded app in the US and claims to be able to operate quicker and more cheaply than Chat GPT.  By requiring fewer chips and smaller server farms, DeepSeek can deliver its AI generated results, which incorporates self-corrective learning, at lower cost.  The arrival of DeepSeek in the AI field creates a challenge to Chat GPT and also means more could potentially be done with fewer advanced chips. The DeepSeek app is free, and its code is open source, which means companies in the US can easily create similar copycat versions of it. Its AI model is called R1 which has some 670 billion parameters, making it the largest open-source LLM (large language model) yet. The R1 is unlike traditional models that immediately generate responses. The R1 are trained to think extensively before answering. Its approach is similar to how a human carefully considers a complex problem before answering it. The method is known as test-time compute and requires the model to spend up to minutes working through its chain of thought. The company estimates it has cost $6 million to train the model compared to other AI models which cost over a $100 million each. The app challenges the notion that the only way of building better AI models is by spending large amounts of money buying high powered processing chips.

What happened to NVidia stock?
Lower potential demand for chips has led to a rapid sell-off in NVidia shares, which declined -17% in 1 day on 27th January 2025.  Because of NVidia - and the broader technology sector's high exposure within the S&P 500 this led to a US equity market sell off, dragging down market-cap weighted world equity indices too. Other stocks which suffered similar down moves were Oracle (-13.79%), Cisco (-5.06%), Broadcom (-17.40%). These companies along with Nvidia provide important components in building data centers and digital infrastructure to support training AI models. NVidia released a statement saying "DeepSeek’s work illustrates how new models can be created using that technique, leveraging widely-available models and compute that is fully export control compliant." While President Trump said the breakthrough in technology is a positive for America and that it is a wake-up call for US tech firms to not rest on their laurels.

Elevated concentration risk in the US equity market is well-documented and one of the reasons we recommend advisers we work with to balance traditional S&P500 market-cap weighted exposure (which was down -1.46%) with S&P500 Equal-Weighted exposure (which was up +0.03%), and also for active selections within Sectors and Styles.

How much NVidia is in a portfolio?
For a balanced, well diversified portfolio built with funds, direct exposure to NVidia should not be more than 2% or so.  This reflects the importance of diversifying away from stock-specific "idiosyncratic" risk.

​Creative disruption requires diversification
As with any paradigm shift, it's hard to identify clear-cut winners in advance.  We welcome the AI revolution as a broader technological innovation theme to consider within portfolios.  But this episode emphasises the value of having a diversified approach.

Cashflow modelling is useful for financial planning at any stage, but essential for decumulation and retirement income advice.
How to make cashflow modelling assumptions
How can advisers make cashflow modelling assumptions that are robust and reliable?
It's important that financial adviser business have robust cashflow modelling assumptions.
We explore the key variables
Growth rates: we propose using SMPI rates from the FRC aligned to the recommended portfolio solution
Inflation rate: we propose using FRC assumptions
Cash rates: we propose using an average cash rate.
Costs and charges: we propose using the total cost and charges figure of the recommended solution.
We will be updating this with additional information shortly.

The global security outlook is challenging.
Join our webinar with Admiral Lord West sharing his views on the state of the world.

I’m here to present a strategic analysis of global security threats. Which is by no means straightforward, given the speed with which events are unfolding at this point in time. We have conflict in Ukraine, Gaza, Lebanon, upheaval in Syria, attacks in Yemen affecting global shipping routes. The first active service I saw was in Aden, so sometimes it feels that things don’t change much. Escalation between Iran and Israel, the humanitarian crisis in Sudan, ongoing fragility in the Horn of Africa and the problem of lawlessness across the whole of the Sahel down into Nigeria. The latter is exacerbated by the withdrawal of the French military and the growing presence of Russia’s Wagner group. Drugs are trafficked from South America to Mauritania and then on up through the Sahara.

Closer to home in Europe, Russia is getting involved to an uncomfortable degree in Bosnia, Kosovo, Montenegro and Georgia and I see this as a problem that will come back to bite us. Putin has never been inclined to accept the collapse of the Soviet Union and believes these places should be in his sphere of influence. The fact that he may feel that he’s gained something in Ukraine will only encourage him elsewhere.

Then there is Afghanistan, now run by the Taliban, who are increasingly getting into bed with terrorist organisations. Our initial aim in going to Afghanistan post 9/11 was because they were training huge numbers of Al Q’aeda terrorists. There were some huge training camps, but we had some success by going in hard and pushing them out of their territory. At that stage, we should have settled and got out, threatening to return only if terrorist training was ramped up again. But we didn’t, and I think that will come to be seen as a huge mistake. Many of the displaced terrorists ended up in Pakistan, which itself is another unstable state.
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Moving further east we have China, making spurious territorial claims in the South China Sea and sabre-rattling over Taiwan, we have North Korea with its unpredictable nuclear status, Russia manoeuvring in the Arctic. All in all, we are in a dangerous world.

I held the position of the UK’s first Cyber minister, and produced our first cyber strategy back in 2008. The concept of cyber attacks and cyber warfare were distant and misunderstood but having a formal strategy (which we produced ahead of the Americans) has made a huge difference as time as gone on. It’s a problem that grows exponentially and could disrupt the flow of money, shipping, transport links. We rely on the relatively weak signals of satellites for much of this, whereas China and Russia have land-based technology that can maintain their signals with greater strength. Attacks on undersea cables are increasing and with Britain being an island, we are also reliant on physical connections to bring us energy such as gas from Norway, and therefore more vulnerable.

Essentially, Russia is already waging a war of sorts with us. Putin has carried out operations on British soil, in France, in Estonia and there is a constant barrage of cyber attacks from Russian state entities.  In spite of signing a treaty in 2002 recognising Ukraine’s borders, he invaded the Crimea in 2014 and because repercussions were minimal, it gave him confidence to move on Kiev. Which proved a major misjudgement. But being unable to accept that he is wrong, he is doubling down and losing huge numbers of soldiers in the process. Notwithstanding, the Russian economy is surviving thanks to trade with India and China. China has been supplying them with equipment and Xi Jin Ping has generally been supportive. I would say that Russia needs to be cautious in that relationship, however. One may note that it has only really ever been successfully invaded from the east.

If Ukraine can hold out in this terrible war of attrition for another year, then Russia will be facing a perfect storm. In terms of manpower, having already turned to North Korea, and half-emptied its prisons, some kind of conscription may well be needed. The supply of weapons from China and Iran is likely to slow down as the financial impact becomes too much for them to maintain. It will be interesting to see whether Trump will keep his promise about ending the war in a day – I suspect he will be instrumental. If he does, it will most likely involve a ceasefire, a peace treaty and the ceding of land to Russia.

The aftermath would be problematic, as NATO membership for Ukraine would be intolerable for Russia, and therefore some kind of American or Western security guarantee would have to be put in place meaning more defence spending for Europe. Russia is on a war-footing, spending 40% of GDP on defence. By contrast Europe is arguing about spending 2.5%.

Putin has threatened nuclear escalation and the country is sitting on approximately 5,000 warheads. But intelligence would suggest that among senior security personnel, not everyone in Russia is on board. And Xi Jin Ping has made it clear that nuclear engagement is to be avoided at all costs. There was a recent report about China building up its nuclear capability fast, but I don’t think the Chinese like the thought of nuclear warfare.

If we turn to focus on the Middle East, I don't think a war between Israel and Iran is imminent. Albeit that it would suit Netanyahu because then the US would have to get involved. But having studied Iran for many years in my defence intelligence role, regime survival is the most important thing to them and a war would almost certainly bring about the regime’s defeat. I don’t think Iran knew much of the Hamas attack of 7th October. They have the capability to produce a nuclear weapon in the time-frame of a couple of months but at present are not opting to do so. The war between Israel and Palestine however will most likely continue in some form or other as it has done since 1948 and that is a terrible shame.

As to whether China will ever invade Taiwan, I would think it unlikely unless something dramatic changes in Taiwan politically, and an overt drive for independence is asserted. An invasion of Taiwan would be a risky military endeavour, and China doesn’t like war because it is unpredictable. Putin’s failure to achieve a swift victory in Ukraine is but further evidence of this. Taiwan is also a manufacturer of chips in huge volumes, and with the economic woes currently besetting China, disrupting this could be harmful. The Belt and Road initiative is more instructive of the way that China likes to operate. Infrastructure is built in countries all round the world, leaving them owing China a huge amount of money which then prompts the yielding of land and strategic bases by way of exchange. This tactic is currently in the spotlight in the Chagos islands, and China’s involvement in Mauritius.

China has tried to dominate the global supply of rare minerals and raw materials, something we need to guard against when we think of who we source from, and it is also trying to control the £7.5m worth of trade that passes through the South China Sea each year. Sending a carrier to the region is the right things to do, not least because it is a show of support for the Americans.

​It cannot always be a one-way street. Post-war, the US has supported us in Europe and Trump has the grounds to put it to us that if we don’t pay enough money, we cannot look to them to look after us. Spending on our own defence is an imperative. The coalition government of 2010 cut our military by a third. When I joined the Navy there were about 139 destroyers and escorts. By the time we fought in Falklands there were 75 and we lost 8 of them. We now have 15. If we were to lose another 8 in combat today, we would have 7 left. The military has been hollowed out. Along with many other European nations, it is clear that not enough money has been spent, and learning lessons from the war in Ukraine, it is vital that defence is taken seriously now.  ​

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[5 min read, open as pdf]

• Refreshed rates were overdue
• Linkage to volatility is welcome
• Robust assumptions for cashflow modelling

What are SMPI rates and how are they used?
Pension providers use Statutory Money Purchase Illustration (SMPI) rates to illustrate the potential return on a pension portfolio. Mandated by the Financial Conduct Authority (FCA), the methodology behind SMPI is overseen by the Financial Reporting Council (FRC). While the rates theoretically derive from capital market assumptions, after extensive consultation in 2023, the FRC evolved the approach.   The key changes are 1) there are now four growth rates defined, rather than three, and 2) the growth rates are linked to volatility.
What are the implications for advisers?
Financial advisers have to use an assumed growth rate when undertaking any kind of cash-flow planning.  Whilst financial advisers are not obliged to use the same rates as a pension provider, we consider it good practice to use them in cashflow modelling assumptions so that growth rates are 1) reasonable, 2) consistent with regulatory guidance for pension providers and 3) evidence-based.
Whilst growth rate assumptions are never certain and assumptions are open to challenge, the fact that there are now volatility bands for each SMPI rate means advisers can apply rates that map to an asset allocation framework, thereby de-risking their growth rate assumptions by relying on the FRC approach.
SMPI rate history 
Since April 2024, the SMPI rates are 2%, 4%, 6% and 7% for volatility Groups 1,2,3 and 4 respectively.  This was a change from 1%, 4%, 5% and 7% from October 2023.  For the decade prior to then, the SMPI rates were 2%, 5%, and 8% for the Lower, Intermediate and Higher Rate.
The evolution of regulatory SMPI is summarised in the chart.  As the methodology considers capital market returns and risk premia, the reduction in rates was linked to compressed yield following the financial crisis (plotted with spot gilt yields and rolling 10-year gilt yields for reference).
What is the methodology to setting the rates
A huge amount of asset class performance analysis around long-run gilts returns and risk premia was conducted by PWC in March 2012 to assist the FCA and the FRC in their review of statutory projection rates. From 2003 to 2012, these rates were 5%, 7% and 9% for the lower, intermediate and higher growth rates.  Broadly speaking this inherently represented a “risk free” bond portfolio of 5%, an all-equity portfolio of 9% (assuming 4% equity risk premium), and a balanced multi-asset portfolio in the middle of 7%.  The PWC study of 2012 (when gilt yields were suppressed following the financial crisis) supported the FCA decision to reduce the rates to 2%, 5% and 8%.
What does the new methodology look like and how has it been calculated?
In addition to creating a new low fourth rate, and tweaking the other rates, the SMPI rates are now also been defined by 5-year volatility bands (across 4 bands), which is a similar (and more pragmatic) methodology to ESMA SRRI definitions (7 bands).  Both the FRC and ESMA methodologies face the challenge of using static volatility bands (when volatility is itself dynamic), but introducing the linkage between risk and return is good progress and consistent with theory and practice.  The volatility bands used by the FRC to create the groups are:
Group 1: 0-5% volatility
Group 2: 5-10% volatility
Group 3: 10-15% volatility
Group 4: >15% volatility
Based on the FRC’s technical analysis[1] (looking at the median volatility of 1,075 pension funds over rolling 5-year periods), Group 1 volatility (0-5%) would capture money market funds, Group 2 volatility would capture bond funds, Group 3 would capture multi-asset funds, and Group 4 would capture equity funds (based on an analysis of pension funds).
By looking at the mid-point of those volatility bands, it is now possible to link SMPI returns with volatility assumptions to create a traditional capital markets framework.  The SMPI risk-return is summarised below.

What could FRC do to improve the methodology?
Use index, not fund data
The current volatility bands are based on pension fund performance aggregates for different asset classes.  This requires data aggregation and inherently captures how those funds are managed, not just their asset classes.  We think a potential improvement would be to use index data for each asset class and derive SMPI rates that are expressly linked to asset allocations, rather than samples of funds.  This would enable consultants and scheme providers to model the SMPI rate of different asset allocation strategies and be a more useful assumption for cashflow modelling tools.
Relative, not absolute, volatility bands
The other drawback, in our view, is using absolute volatility bands. Because market volatility is itself volatile, a “balanced” 60/40 mandate could be >10% for one 5-year period and <10% for another 5-year period. The risk classification of KIID documentation has the same problem. 
We think “relative risk” is more useful. This is where a portfolio can be defined as having x% of Global Equity volatility. Relative risk is relatively stable as it captures fluctuations in the level of volatility over any 5-year period. By contrast absolute risk cannot.
Conclusion
Growth rates in pensions illustrations are highly governed by the FCA and FRC.
By contrast there are no constraints on what financial advisers use as illustration rates in cashflow models.
We think it prudent that advisers use the FRC growth rates in their cashflow planning tools.

[1] https://media.frc.org.uk/documents/AS_TM1_-_Accumulation_Rate_Assumptions.pdf

• Persistent discounts have attracted a US activist hedge fund
• Their criticisms are valid, their cure is self-interested
• A wake-up call for Investment Trust boards

​The Investment Trust sector has been under pressure for the last few years.  Investment Trusts that invest in liquid public overseas equities are compared to lower cost index fund and ETFs.  Investment Trusts that invest in liquid public UK equities – likewise, but with the additional challenge of a general deallocation from UK equities impacting flows.  Finally, Investment Trusts that invest in property and other real assets such as wind farms and infrastructure have been pressured by rising borrowing costs that also impact valuations.
Throw into the mix an extensive debate around cost disclosures[1], a public boardroom bust up at Scottish Mortgage[2] and accusations that the industry is too “cosy” with independent boards being independent in name only but in reality very rarely challenging or replacing sponsoring investment managers.
This has created a perfect storm for Investment Trusts where the lack of demand has led to persistent discounts.

Vulnerable to an attack
As the sector has not got its house in order pre-emptively, sharks are now circling in the shape of an activist US hedge fund, Saba Capital, that has built up stakes in 7 investment trusts.  They are now requisitioning shareholder meetings to oust each Trust board and install their own candidates as board members and transfer the investment management contracts to Saba.
If they are successful it’s a neat way of getting hold of almost £4bn of UK retail assets and collecting management fees on the same.  In this respect, their strategy (however presented) is not without self interest.

Who are Saba Capital Management?
Saba Capital Management is a US based hedge fund specialising in arbitrage.  It also manages US-based investment trusts.

We agree with the diagnosis
We agree with Saba’s diagnosis of the failings of some of the Investment Trusts.
We also agree with the key tenets of how boards should act to deliver value to shareholder.  Based on Saba’s own proposal[3], this would be to:

1. Offer liquidity events to address NAV discounts
2. Reviewing Trust’s managers including performance and fees and evaluating the termination of existing management arrangements
3. Refocus the Trusts’ investment mandates to realise scale benefits and synergies (for example consolidation).

In our views, these should be “good housekeeping” points for any trust board.

We disagree with the cure
However we disagree with Saba’s self-interested proposal to take over these Trusts with just two of its own appointees to each board.  From the outside, this looks like an asset grab in a sector that has done too little to address its own problems.
It would be preferable for Investment Trust boards to wake up and force change themselves, rather than wait to have it forced on them by self-interested third party.
Ironically, it may take this abrasive battle to stimulate change in the sector.

What happens next?
In the end it will be up to retail investors to vote their shares.  The risk is that investor apathy and or the technological barrier to exercising a vote via retail platforms (another area of unfinished business that has been neglected too long) means that Saba
If Saba do win, it will vindicate their activist approach and a sorry indictment that the Investment Trust sector didn’t get its house in order earlier.  So either way it’s hopefully it’s catalyst for reform and increased discipline, transparency and true independence in the Investment Trust sector.

Why do investement trusts trade at a discount
The share price of an investment trust can be at a wide premium or wide discount to their NAV, for the following reasons:
1) because there is low or shrinking demand for the shares. As investment trusts are closed-ended funds, the premium or discount reflects the direction of supply and demand of shares.  For an investment trust, the premium or discount to NAV is primarily a function of demand.  When demand is very high, the share price can be at a premium.  When demand is very low, the share price can be at a discount.  
2) because the fund holds some hard-to-value or periodically valued investments.  Assets such as physical property or infrastructure projects, a discount to NAV can reflect a lack of confidence in the NAV attributed to those assets.  For example, when interest rates rose dramatically which would force a reduction in the value of a property portfolio, the market may have applied a greater discount to NAV more quickly, than the NAV would be reviewed. 
3) because there is no catalyst to drive a re-rating.  With no catalyst or a valuation re-rating such as a capital event (capital distribution, share buyback, change in dividend policy), discounts can persist.

Why do investment trust discounts  narrow?
Discounts can narrow for three reasons:
Firstly, if there is high or growing demand for the shares.
Secondly, where there is potential for a capital event.
Finally, assuming markets are efficient, when there is a change in the outlook for net returns over time.
Furthermore, where an investment trust invests entirely in liquid publicly traded securities, this means the NAV can be clearly evaluated, creates scope for “arbitrages” – buying or selling the Investment Trust relative to its underlying holdings.  This helps keeps premiums/discounts narrow. 

Why do investment management fees matter
The investment management fee is typically applied to the NAV (a few trusts are moving to management fee being applied to share price to align interests better with shareholders).
Investment trust fees matter as they consume a portion of the trust's NAV. 
For two investment trusts with an identical basket of underlying assets, an investment trust with high fees as a % of NAV will underperform an investment trust with low fees as % of NAV, other things being equal.

What is the difference between a fund, an ETF and an Investment Trust?

• Funds (OEICs and AUTs) are not listed on an exchange, and their units can be bought or sold each day at their NAV.  The investment management fee is applied to the NAV.
• Exchange Traded Funds (ETFs) are public limited companies (plc) listed on an exchange and their units can be bought or sold anytime during market hours, and their share price can be at a negligible premium or negligible discount to their NAV, 1) because the fund holds easy-to-value publicly listed securities and 2) because the funds are open-ended there is an active primary and market for fund units that can absorb supply and demand.  The investment management fee is applied to the NAV.
• Investment Trusts are public limited companies (plc) listed on an exchange and their units can be bought or sold anytime during market hours

Conclusion
The investment trust sector needs reform.  We would prefer the sector to reform itself.

[1] some want Investment Trusts to be treated as operating companies and have their running costs excluded from fund-of-fund OCFs. Other wanting Investment Trusts to continue to be treated as other publicly listed retail funds (ETFs), and ensure their running costs continue to be included in fund-of-fund OCFs to maintain a level playing field. We are in the latter camp. To bring nuance to the debate, we think there should be differentiated treatment between Investment Trusts that invest predominantly in publicly listed securities, and those that invest predominantly in real assets (property, infrastructure etc).

[2] https://www.ft.com/content/84c6442c-4108-4094-b94d-8585517da00a

[3] https://www.mindthegap-uktrusts.com/

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[5 min read, open as pdf]
Macro factors: growth, inflation and rates

• Macro factors affect all asset classes
• Growth, Inflation and Rates are key macro drivers
• Asset allocation should adapt to changing macro factors

The main macroeconomic factors (rewarded risks) inform portfolio construction and can affect all asset classes.
The three key macro drivers that impact markets are Growth (“G”), Inflation (“I”), and interest Rates (“R”) the policy rates set by the Central Bank.  Every economic data release is relevant in as much as what it means for the direction of these three key macro drivers.
Monitoring these macro factors
The chart shows the recent evolution of these three macro factors for the UK.
What about other macro factors?
Other key macro factors that impact markets include Sovereign Risk (e.g. higher risk premia for Emerging Markets), Credit Risk (higher risk premia for lower quality debt) and Liquidity Risk (higher rewarded return for less liquid investments).
Macro factors affect all asset classes
Macro factors impact equities and bonds alike.  Macro factors impact the risk premia (and hence return expectations) on different asset classes.  As these premia shift, so do expected returns.
For example, corporate bonds are impacted by interest rates premium, inflation risk premium and credit premium. Small cap equities are impacted by interest rate premium, inflation risk premium, growth premium and liquidity premium.
Macro factors are inter-related
Macro factors are inter-related.  In the text books, when economic growth is strong inflation pressure builds.  Interest rates are raised to contain inflation.  When interest rates fall, that can stimulate growth.  In reality, it can be more complicated (and has been).  The relationship between macro factors is key, as a read of the Bank of England’s Monetary Policy Committee minutes will show.
Why we believe in an adaptive approach
A static-allocation “cruise-control” portfolio had worked well until the bond market dislocation of 2022 driven by the inflation and rate-hike shock.  But as markets don’t stand still, nor should portfolios, in our view.  We believe in an adaptive approach adaptive approach to navigate market risks, rather than leaving portfolios in cruise-control.  This categorically does not mean trying to time the markets.  What it does mean is trying to steer away from potential hazards along the way.
Conclusion
Keeping an eye on the key macro drivers is therefore key to asset allocation decision-making.

Henry Cobbe, Head of Research at Elston Consulting, shares his insights in an interview with Institutional Asset Manager following our recent IAM Award win.

Read full article here​

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[5 min read, open as pdf]

• Debt indigestion is a problem
• And a bout of it hit this week
• Reeves era and Truss moments are different but that doesn't help

One of the key themes in our 2025 Outlook is Bond (in)digestion. It looks like there's a bout of it this week. Concerns on Trump tariff policies, US debt issuance and zombie-like inflation is rattling the bond market - particular at the longer-dated end. BoE (and hence GBP) is exposed because it is stuck between an inflation rock and a low growth hard place.

With rate cuts less likely, and zombie-inflation proving sticky, there are dual pressures on long-dated gilts.

​Whilst for some it might be satisfying to blame higher UK bond yields on Rachel Reeves, comparisons to the "Truss moment" are not entirely fair. There is a difference in my view. Here's why: Truss yield spike: fear that UK books not balancing, disregarding OBR, not showing workings - only UK yields affected. Idiosyncratic UK bond market risk. Conclusion? Politicians ignoring how markets work.

Reeves yield spike: fear that US and UK books not balancing PLUS US/UK debt issuance indigestion. US & UK yields simultaneously affected. Idiosyncratic UK AND Systematic US/UK bond market risk. Conclusion? Markets ignoring what polticians say.

The Reeves era of yield pressure is different from the Truss/ moment of her 2022 budget.  But that doesn't help.

A review of bond duration and how to mitigate the risk of zombie inflation is required to cope with bond indigestion.

​Find out more about the Elston Smart-Beta UK Dividend Index (ticker: ELSUKI)
For latest UK Equity Income index factsheet click here
​ 
UK Equity Income: monthly index commentary for December 2024
by Rob Davies, UK Equity Income Index Specialist at Elston Consulting
 
UK equities delivered a strong return over 2024 only just failing to deliver double digit gains. That said, December gave a negative performance with every sector bar two showing declines. The worst performing sector was Real Estate closely followed by Materials, Consumer Discretionary and Industrials. Financials and Not Classified were the only two to gain over the month. It is not hard to discern the perceived effect of interest rates on the relative performance between sectors. Bank rate was left unchanged in December.
 
Over the year Financials were the stand-out winners rising in value by over a quarter. Industrials, Consumer Staples and Communication Services also posted double-digit gains while Real Estate was down by a similar figure. Partly driven by out of favour financials at the start of the year a Value style delivered superior returns.
 
External influences were modest in December although the slight strengthening of sterling against the dollar was probably a small negative factor. Despite that the forecast for dividends to be paid out next year edged up slightly.

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Watch our 2025 Outlook in full
What do we mean by "Zombie Inflation"?
“Zombie” inflation means it is down but not dead.  Inflation is past its peak and settling at or above the 2% target which is now a “floor,” not a “cap”.  Wage growth pressure, trade friction and energy market volatility means that inflation is down but not dead.
Inflation is past the peak but has not gone away
Inflation has moderated from its peaks, but we believe it remains a very real risk. The 2% inflation target increasingly functions as a floor rather than a ceiling. Wage growth, energy volatility and geopolitical tensions could drive renewed inflationary pressures.
Looking at rolling inflation for historic performance hurdles
We look at rolling 5 year inflation (UK CPI) as smoothed measure to set hurdle rates for portfolios for past performance evaluation.  The rolling 5 year data has not peaked yet (see chart) - it will take time for the inflation shock to wash out.
Looking at breakeven inflation rates for expected return hurdles
We look at 5 year breakeven inflation rates (UK BEIR) to set hurdle for target returns for UK investors.  The long-term average for 5 year BEIRs is approximately 3%.  In this respect forward-looking inflation expectations are also down from their peak >4%, but still high at 3.6%.
How can advisers build in inflation resilience to portfolios
To address this risk, portfolios should incorporate inflation-resilient asset classes, such as a tilt to yield within equities, and moderate exposure to liquid real assets, as well as short- to medium-term inflation-linked bonds.
How can advisers find out more about investing in inflationary times?
To find out more see all our Insights on inflation investing
https://www.elstonsolutions.co.uk/insights/category/inflation

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Watch our 2025 Outlook in full
America First means continued exceptionalism
The Trump administration's "America First" policy could help underpin US economic, earnings and market exceptionalism.  US economic growth is outpacing the UK and EU.  It benefits from higher energy prices and defence spending.  American dominance of technology sector means its corporate earnings in aggregate have been more resilient, relative to the rest of world and the UK.  Higher earnings growth has been rewarded with higher valuation multiples.  Given the levels of market concentration, selectivity and balance within US equities remains key.
Outlook for US economic growth remains robust
US political and economic policy, and the performance of both its economy and its markets continue to define the global landscape. The newly-elected Republican government brings with it a strong mandate, emphasizing economic nationalism and trade protectionism. With a renewed "America First" policy framework, the outlook for US economic growth, corporate earnings and equity markets remain robust.
The U.S. economy is expected to perform well in 2025, bolstered by domestic-focused policies and the competitive advantage it is afforded by an international trade environment that will be increasingly contested with Trump’s threatened tariff policy. The divergence between US and UK/European economic trajectories underscores this exceptionalism, with US economic and earnings growth accelerating while UK/European growth lags.
Remapping of European energy landscape boosts US LNG
Whilst the Russia-Ukraine war and related sanctions is bolstering the US Energy and Defence sectors, the remapping of European energy supply chains from piped Russian gas to shipped US LNG is an important shift from an energy security perspective, but the resulting inflation for manufacturers is hollowing out European industry - impacting the UK and Germany in particular.
UK equity market valuations gap remains
The much-debated focus around lower UK equity market valuations is a function of lower UK corporate earnings growth, in our view.  This has been the case both over the past decade, and looking forward.  Without an accelerating growth trajectory or reason for a valuation re-rating, there is a risk that the relatively lower valuations for UK equities persists.  We nonetheless recommend a low-moderate UK allocation as a useful diversifier, given the UK’s declining correlation with global markets.
US ecoomic growth, earnings growth, and valuation multiples have driven market growth
Dominance in technology has underpinned healthy corporate earnings in the US, relative to other regions. This earnings strength has supported higher valuation multiples for US equities.  Combined with favourable interest rate dynamics, this has propelled market outperformance.
US continues to set the pace for global equities
Over the past decade, cumulative returns for US equities have materially outpaced global and UK markets, a trend likely to persist.  We have to remain alert to anything that dislocate a richly-valued US equity market: agility from a sector and factor positioning perspective can be helpful in this respect.

In our 2025 outlook, we explore our key themes for the year ahead

• America First: why we expect the US to continue to dominate the economy and the stock market
• Debt (in)digestion: government borrowing in the US and UK is reaching new highs.  It looks sustainable, but is in fine balance.
• Zombie inflation: inflation is down, but not dead.  What are the drivers that could keep it above target weight.

Please join Henry Cobbe and Hoshang Daroga from Elston for this Outlook webinar or read the summary version below.
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[5 min, read as pdf]

Our 2024 Investment Review covers how the 2024 turned out relative to our Outlook.
In our 2025 Investment Outlook we do not attempt to set target levels for market indices: level-specific forecasts are unhelpful and impossible to predict with certainty.  Instead, we focus on the key themes that could characterise investment trends within and across asset classes and hence inform the decision-making for advisers’ investment committees we serve.

The summary of our key themes for 2025 is set out below.

America First: US exceptionalism to continue
America First policy making will underpin US economic, earnings and market exceptionalism.  US economic growth is outpacing the UK and EU.  It benefits from higher energy prices and defence spending.  American dominance of technology sector means its corporate earnings in aggregate have been more resilient, relative to the rest of world and the UK.  Higher earnings growth has been rewarded with higher valuation multiples.  Given the levels of market concentration, selectivity and balance within US equities remains key.

US political and economic policy, and the performance of both its economy and its markets continue to define the global landscape. The newly-elected Republican government brings with it a strong mandate, emphasizing economic nationalism and trade protectionism. With a renewed "America First" policy framework, the outlook for US economic growth, corporate earnings and equity markets remain robust.
The U.S. economy is expected to perform well in 2025, bolstered by domestic-focused policies and the competitive advantage it is afforded by an international trade environment that will be increasingly contested with Trump’s threatened tariff policy. The divergence between US and UK/European economic trajectories underscores this exceptionalism, with US economic and earnings growth accelerating while UK/European growth lags.
Whilst the Russia-Ukraine war and related sanctions is bolstering the US Energy and Defence sectors, the remapping of European energy supply chains and resulting inflation for manufacturers is hollowing out European industry.
The much-debated focus around lower UK equity market valuations is a function of lower UK corporate earnings growth, in our view.  This has been the case both over the past decade, and looking forward.  Without an accelerating growth trajectory or reason for a valuation re-rating, there is a risk that the relatively lower valuations for UK equities persists.  We nonetheless recommend a low-moderate UK allocation as a useful diversifier, given the UK’s declining correlation with global markets.
Dominance in technology has underpinned healthy corporate earnings in the US, relative to other regions. This earnings strength has supported higher valuation multiples for US equities.  Combined with favourable interest rate dynamics, this has propelled market outperformance. Over the past decade, cumulative returns for US equities have materially outpaced global and UK markets, a trend likely to persist.  We have to remain alert to anything that dislocate a richly-valued US equity market: agility from a sector and factor positioning perspective can be helpful in this respect.

Debt indigestion: government debt is in fine balance
Government debt is spiralling in the US and the UK.  But with projected economic growth, aggregate debt levels remain (just) digestible.  But any upgrade to borrowing or downgrade to growth could destabilise this fine balance and rattle the bonds market.  Lower bond yields (higher bond values) mean more confidence in the bond market.  Higher bond yields (lower bond values) mean less confidence in the bond market.

The sustainability of government debt levels poses a significant challenge for both the US and UK.  This combined, with new Governments and spending priorities increasing uncertainties.  Rising interest rates have meant increased borrowing costs, putting pressure on fiscal balances. In both the UK and the US debt levels appear high in absolute times, but just manageable relative to GDP.  However, any weakening in economic growth or fiscal indiscipline could destabilise this fine balance. These concerns have supported demand for gold and precious metals as Emerging Market Central Banks reduce exposure to the Dollar/US Treasury holdings.
We will be monitoring new debt issuance carefully to see if the amount of government debt remains digestible without dislocating yields.

Inflation: down but not dead
“Zombie” inflation means it is down but not dead.  Inflation is past its peak and settling at or above the 2% target which is now a “floor,” not a “cap”.  Wage growth pressure, trade friction and energy market volatility means that inflation is down but not dead.

Inflation has moderated from its peaks, but we believe it remains a very real risk. The 2% inflation target increasingly functions as a floor rather than a ceiling. Wage growth, energy volatility and geopolitical tensions could drive renewed inflationary pressures.
To address this risk, portfolios should incorporate inflation-resilient asset classes, such as a tilt to yield within equities, and moderate exposure to liquid real assets, as well as short- to medium-term inflation-linked bonds.

Asset Class Perspectives for 2025

• Equities: U.S. equities are poised to continue to perform, supported by strong economic and earnings growth. Growth sectors, particularly technology, remain key drivers.  But we should remain alert to potential dislocations – so diversification and volatility control are key.  Within the US, we recommend broadening exposure to balance, not remove, concentration risk.  For the UK, we recommend being underweight on low growth outlook, a position nonetheless makes sense as a diversification function.
• Bonds: Duration positioning will depend on the expected path for inflation and interest rates. We start the year remaining neutral duration as a balance between rate cuts and inflation.  We are recommending to tilt away from GBP as “gap” in relative rates has closed, with no change to strategic allocations.
• Alternatives: Gold has had strong run.  Consider broadening with diversified alternatives.  We focus on risk-based diversification (low correlations to equities and bonds).  Whilst we hope that geopolitical risk could potentially improve (post-inauguration), trade friction could increase, creating another set of risks for equities and currency.

Conclusion
The three themes outlined above illustrate the forces shaping the investment landscape and asset class trends in 2025. As always, our approach emphasises an adaptive approach to navigate market risks.  This does categorically mean trying to time the markets.  But it does mean trying to avoid foreseeable harms along the way.  Our granular asset-class recommendations are available to our clients. 
Henry Cobbe, CFA
Head of Research, Elston Consulting

For historical data, we use our own research and Bloomberg data.
For forward looking estimates used in strategic asset allocations, we use BlackRock Capital Market Assumptions for GBP investors, which we consider to be highly robust.
For live market earnings, momentum, valuation, volatility, correlation and flows data to inform tactical asset allocation recommendations, we use proprietary research and Bloomberg data.

[5 min read, read as pdf]
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• The US economy outperformed expectations
• The long-awaited pivot came through
• Portfolio resilience proved key

As we look forward to 2025, it is worth revisiting the themes and predictions of our 2024 outlook “turning the corner” to get a sense of what we anticipated at the time, how this informed our recommendations to UK adviser firms’ investment committees.  Asset class performance for 2024 is summarised in the chart above.  Our 2025 outlook is published separately.
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Steady as she slows
In 2024, we anticipated a gradual deceleration in the U.S. economy, with markets pricing in the likelihood of a slight recession. In the event, the U.S. economy surprised on the upside. Growth forecasts were upgraded from 1.15% at the start of the year to an impressive 2.6% by year-end. This revision supported robust equity market returns and served as a reminder of the resilience of U.S. economic fundamentals.  In summary, a resilient US economy defied expectations.
What did we recommend to our clients at the outset and during the year? We took a balanced view between accepting concentration risk (traditional S&P 500) and diversified (active, sector exposures).  We also recommended clients lean in to broader US equity corporate landscape via 1) Equal Weight and 2) US Small Caps exposures.
By contrast, the UK had that shrinking feeling as regards economic growth, and although out of a technical recession, we are not confident of its prospects relative to the US.

Pause before pivot
At the close of 2023, we were focused on the Federal Reserve’s pause in interest rate hikes, noting that a rate cut was a question of when, not if. While the consensus view was that the first cut would be announced by mid-2024, we anticipated that the timing would hinge on the performance and strength of the U.S. economy. Indeed, the economy’s resilience delayed the start of what we anticipate to be a rate-cutting cycle to September 2024, when the Federal Reserve finally delivered a significant 50-basis-point cut.
In fact, the eventual BoE Fed pivot came a month or two later than we had estimated at the start of the year, but we recommended our clients remain dynamic with regards to duration management.  We recommended clients go strongly overweight duration in June as a good time to extend duration ahead of BoE cuts, with Fed following suit, and we saw the additional duration deliver returns on the bond side of the portfolio before attention shifted to debt supply and the UK budget later in the year, which led us to recommending to move back to neutral.

The importance of portfolio resilience
Our focus on resilience proved vital when it came to navigating the key macro factors in 2024: Growth, Inflation and Interest Rates.
For Growth, anticipating a soft landing for the US economy, we highlighted the potential outperformance of cyclical sectors, and momentum, yield and size factors. In the event, momentum emerged as the best-performing factor, with yield and size also delivering strong returns. For Rates, we adjusted duration exposure mid-year to capture the effect of falling policy rates, aligning portfolios with a changing interest rate environment. For Inflation, which remained above target, the inclusion of liquid real assets (but to a lesser extent than in 2022) and shorter duration inflation-linked bonds, ensured continued portfolio resilience.  We continue to emphasise the importance of a diversified alternatives exposure from a correlation perspective, not just in name.
Our recommendation to consider Private Market Managers and Gold & Precious Metals paid off during the year – as these were the best performing asset classes for the year, outperforming world and US equities.

Political and Geopolitical risks
In a year of elections, we saw a change in government in the UK and in the US following Trump’s Presidential win.  Both have a greater impact on bond yields and currency dynamics than equity markets, in our view.
Geopolitical risks remain elevated with the Russia-Ukraine war continuing to grind, escalating conflict and contagion in the Middle East – all at tragic human cost.

Conclusion
Markets did indeed turn a corner in 2024, with economic growth, earnings and equity market returns outperforming expectations.  With 2024 in the rear-view mirror, it’s time to look ahead to 2025.  Our 2025 outlook is published separately.

Henry Cobbe, CFA
Head of Research, Elston Consulting