Understanding market uncertainty in 2025 as interest rates, inflation and trade tensions create new risks for investors.
As we move through the early stages of 2025, I want to highlight a couple of broad themes I think will influence markets through the year. No table thumping, frothing at the mouth predictions per se, but rather the core influences driving the narrative, and in turn themes investors need to consider when allocating their capital across various asset classes. At the very top of matters for consideration is the degree of uncertainty over the year ahead.
Before heading into the two core themes, it’s worth pausing to take stock of where we’re starting the year from. Stocks valuations are elevated, priced to perfection almost, with core indices near historical highs. Bond yields are within the top quartile of recent trading ranges, and well above post GFC averages, arguably back toward ‘normal’ long run averages. Credit spreads on the other hand are in the neutral zone, neither historically cheap nor expensive.
On the data front, domestic growth is anemic, at its slowest pace since the early 1990’s (excluding the pandemic) and only propped up by government spending and population growth. Domestic inflation is trending in the right direction, but there are potential obstacles ahead that could disrupt the trend. The jobs market remains resilient, which is making the case for rate cuts a challenge to argue. The under-pressure A$ is certainly not helping the cause – a weaker A$ is inflationary, all other things being equal.
I’ve listed the themes in order of importance, as I see them here and now. As the year progresses though, influences will wax and wane as data is released, policies are formulated, events unfold, markets grow or shrink, and politicians speak. The focus here is on Mutual Limited’s sandpit, bonds and credit, but I’ll touch on stocks for what it’s worth.
Number One: Monetary Policy Normalisation
Probably the theme closest to many households’ hearts, monetary policy normalization. In laymen’s terms, when will the RBA cut rates, and by how much? The RBA has hiked rates by +425 bps since the first half of 2022 in a bid to combat inflation, which remains a work in progress. While peer central banks around the world have cut rates by anywhere between 100 bps and 135 bps over the past six-months or so, the RBA has been resolute in leaving the cash rate unchanged.
The RBA next meets on February 18th, which at this stage is considered a ‘live’ meeting, meaning there is a decent chance of a change in policy. Following the most recent CPI data (Q4 2024) market pricing indicates a 92% probability of a 25 bp rate cut, taking the cash rate down to 4.10%. Consensus among market pundits is leaning in the same way regarding the timing of the first cut, although there are a few stalwarts still thinking an April or May cut more likely.
I’m being a bit of a stick in the mud, I think the RBA won’t cut at the February meeting. I accept that this is a somewhat risky call in the face of consensus views. While inflation data supports a rate cut, labour data doesn’t. Also contributing to my stance in the mud, is the risk to global inflation from US-instigated trade wars. Closer to home, we have a Federal Election by mid-May (yet to be called), which will likely to be fought on cost-of-living grounds, i.e. I expect more government spending than less. Government spending is already elevated by historical averages, representing a challenge to the RBA’s inflation fighting agenda. And lastly, there is the weaker AUD, which is inflationary all other things being equal. Having said all that, I am emotionally prepared to be proven wrong.
Looking ahead, whether or not the RBA cuts in February, markets are pricing a cash rate of 3.60 % by year-end, suggesting three cuts. The consensus median is a touch lower at 3.60%. While much will depend on upcoming data and potential events already discussed, I’d say we’ll see one cut at worst, with two at best, taking the cash rate to around 3.85%-4.10% by year end. Beyond that is pure guesswork.
Number Two: Fiscal Policies, Deficits, and Threats to Inflation
The second theme is pretty broad—namely fiscal policy and its implications for inflation and bond yields. Arguably, themes one and two are akin to the chicken-and-egg argument, but for now, the order I’ve presented feels right. We’ve seen the impact of government spending on inflation across the domestic economy, which is a contributing factor to why the RBA has lagged their global central bank brethren in cutting rates. Government spending in Australia as a percentage of GDP sits around 28%, well up from historical averages of 22%. The RBA has spoken of the relatively rapid growth of public final demand (government spending) as a contributor to excessive aggregate demand, which, in turn, impacts inflation.
Another implication of higher government spending—particularly when there is no corresponding increase in government revenues, is the need to fund it. If spending exceeds revenues, deficits arise, requiring funding through increased government borrowing. Rising deficits place upward pressure on bond yields, which in turn increases cost of borrowing for businesses and households. The Australian fiscal deficit is currently manageable at 2.1% of GDP. Where it’s more a problem is in the US, where the deficit is ~6% of GDP, with expectations it’ll get worse under the Trump administration given stated policies. Local bond yields and their direction are closely aligned to US Treasury yields, as displayed in the following chart.
In addition to the likely growing US government debt burden and associated pressure on yields, we also have the prospect of old-fashioned tariffs on the US’s core trading partners: Canada, Mexico and China, among others. China is closest to our economic hearts as our largest trading partner (29% of exports). Any threat to China’s growth prospects will weigh on our own growth hopes to some degree. Commodity prices would likely suffer, which could trigger further weakness in the AUD. This would cushion local exporters, but at the same time be inflationary for consumers and households. China may counter US tariffs with stimulus packages or imposing their own tariffs on US goods, but at this stage it’s all an unknown, and that is the risk in itself.
Outlook: What Are the Risks?
Bonds
Much depends on what the RBA does this year, but the outlook for rates and yields is lower, but not as low as the prior cycle. Given inflationary risks, the easing cycle is expected to be relatively short and shallow, possibly two cuts bottoming out around 3.50% vs 0.10% through the prior ‘extraordinary’ cycle. Bond yields will likely end the year lower than they are now, with three-year yields to trend toward 3.60% - 3.80% vs 3.82% now (January 31st), while ten-year yields will fall to a range of 4.00% - 4.20% vs 4.40% now. Risks to the downside would be triggered by a material drop in growth and softening labour markets, while risks to the upside could come from resurging inflation following Trump’s tariff plans.
Credit
Credit spreads entered the new year at neutral levels, within striking range of long run averages, but still above pre-COVID levels. Investor sentiment remains constructive. The A$ credit market—the traded market at least—is very much an investment grade market, with strong underlying fundamentals. The ‘private credit’ market, which has attracted some negative press of late, is down the riskier end of the spectrum, again as evidenced by some recent events. The main threat to credit spreads – i.e., a material widening, would be a systemic event akin to the pandemic, GFC, or something of equal significance. A low probability event, but one that brings high impact consequences. Elevated issuance could also impact spreads, but with lending growth running at just above average, any new issuance should be comfortably absorbed without any undue stress in spreads. We expect spreads to remain range bound.
Stocks
Not my wheelhouse per se. I have no street cred when it comes to stocks, so take my views with a grain of salt. For me, stock valuations are on the frothy side, and indices are close to historical highs despite the recent aggressive run up and known unknowns ahead. Sure there are some single name nuggets of gold, but market wide, I see more reason for markets to disappoint than not. We would need to see some aggressive earnings growth to justify current valuations and it is hard for me to gain confidence we’ll see such growth. If I were handed $1m today to invest, I’d put only a token amount in stocks. Buyer beware.
