Asset Allocation Research for UK Advisers

Markets have been on a see-saw as the world digests Trump's tariff policy that risked stalling world trade and triggering a recession.  Yesterday US Treasury Secretary announced a 90 day pause in reciprocal tariffs, possibly triggered by systemic strain in the US Government Bond market. US equities surged +9.5% the largest one-day rally since 2008.  We summarise a tumultuous week in markets. 

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We take a step back at Trump's Trade War, look at lessons from 2018, contrast sector and factor performance.
This public version is a shortened extract from our private call with our Adviser clients, so all data and comments are as at Thu 3 Apr 2025.

Our latest monthly commentary for investing in UK gilts for UK financial advisers. 
Includes:

• Latest gilts UK news
• Update on latest gilt yields
• Changes in Gilt yield curve
• Gilts auction results
• Gilts ETF flows

Shrinking a pot is different to growing a pot. And shrinking it in downmarkets can be dangerous without guardrails.  This is why we designed a “Managed Buckets” based approach for Retirement Portfolios.

Trump is putting reciprocal tariffs on world trade to start negotiations on steps to rebuild US manufacturing. Reciprocal tariffs means putting tariffs on imports from those countries which put tariffs on US imports. What does it mean for markets. What does it mean for the global economy. Will tariffs make America great again?

We explore Reeves Spring Statement 2025 and what it means for UK Growth, Inflation and Rates.

European security architecture has been dismantled and new one needs to take shape.

Trump’s second tariff war has unsettled markets.

The US and UK have kept rates on hold this week.

The “Mar-a-Lago Accord” is a concept, not an event.  Some are advocating a new currency accord and debt restructuring to fix the US balance sheet.

Transatlantic security is going through a reset.  Europe needs to shift to hard power to guarantee its own security.

Gold has continued its surge as a safe haven investment.

Trump’s chaotic tariff policy is destabilising markets and raising concerns around impact on US economic growth and inflation.

Trump's volatile tariff policy is creating uncertainty in global markets.  This could hinder not help the US economic outlook.

Domestic politics is becoming more polarised.
International politics is moving from a unipolar to a multipolar world.
The transatlantic security alliance is under threat.
The weaponisation of tariffs is leading to deglobalisation.
How to make sense of this increasingly fragile world?
We explore some of the key themes of this new world dis-order.

Secondly, Central Bank buying: although the Western world has reduced the amount of gold it holds in Central Banks reserves, Developing Markets - such as China, India and Russia - have been buying physical gold, such that overall, Central Bank gold reserves are on the increase.  This is has been a medium-term trend for BRICs countries to reduce their dependency on the Dollar.  This is a medium-term structural trend.

Finally, a store of value and inflation hedge: as markets worry about debt indigestion - the oversupply of US Government Bonds and the long-term sustainability of Western e.g. US/UK debt levels, Gold is a "real asset" that preserves value should there be any risk of devaluation of debt securities.  Gold is a "real" store of value because it also acts as an inflation hedge: whereas nominal Bonds cannot hold their real value when inflation rises, Gold tends to hold its value in real terms and has withstood inflation shocks through revolutions, wars and even back in Biblical times!  This is a long-term structural trend.

​After being slow to respond to the inflation shock in 2022, it now looks as though the Bank of England may have overtightened relative to growth and is now exposed to "stagflation risk".  Stagflation is when the economy is caught in a lower growth and higher inflation trap.  This will be a challenge for policymakers to navigate.

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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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.

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• 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.