However, as the sell-off has deepened, it appears that expectations are now "catching down" with meaningful cuts to US growth becoming widespread. Normally a market decline of this magnitude would reflect a risk–off rotation (from cyclicals to defensives). However, has not been the case with price performance reflecting a multiple of cross currents including the willingness to take profits in expensive stocks, the willingness to rotate out of yesterdays winners and into tomorrows winners (particularly in cyclical and interest rate entice areas), as well as some broad de-risking of over owned and overhyped exposures (such as US technology).
The factors that contributed to the downturn may continue to impact markets as we head further into 2025, and it’s crucial for investors to avoid getting caught up in short-term fears or the desire to avoid missing out.
Four key developments in markets to keep an eye on
Firstly, President Trump’s unpredictable policies. Policies regarding tariffs, immigration, and the DOGE is creating more uncertainty in markets. These policies have raised concerns about the stability of the US economy, with signs suggesting it might not be as resilient to global challenges as expected.
Secondly, low-cost AI innovation. DeepSeek, a new player in the artificial intelligence (AI) market, changed the outlook for technology. DeepSeek's innovations pointed to a “low-cost” AI market, which could reduce the growth potential of major tech companies. This led to a reassessment of tech valuations, which had become overinflated.
Thirdly, political shifts in Europe and the potential end of the Ukraine-Russian conflict. This has improved the region’s economic outlook. Lower energy prices and expanded government spending boosted European markets, leading investors to move from high-growth US stocks to cheaper, more economically sensitive European stocks.
Finally, Australia’s reporting season showed signs that the earnings cycle might be turning upward. This encouraged investors to shift from high-quality stocks to those that had been underperforming but now offer better value at lower prices.
What does the road ahead for the equity market look like?
Despite the downturn in February, we think several developments are positive for the equity market outlook and will help rather than hinder its resilience.
A positive sign was that investors were moving out of expensive stocks and into cheaper stocks (valuation convergence) as stronger breadth makes the rally more durable. Similarly, we saw non-US tech perform, such as those in China, as well as European equities outperform US equities.
Another positive was that US long bonds yields fell dramatically (against fears that inflation would keep them elevated) while at the same time credit spreads remained extremely well behaved, meaning financial conditions have stayed easy.
Locally, we saw signs of a trough in Australian corporate earnings because a stronger profit outlook is supportive of more broad-based equity performance. And lastly, it’s positive that the RBA has started cutting policy rates as this provides a tailwind for rate sensitive sectors and deep cyclicals which have been hamstrung by consumer confidence languishing at recessionary levels.
However, the road ahead for investors in 2025 will be volatile. Markets are wedged between rising trade uncertainty and a deteriorating US economic backdrop with elevated valuations and heavy positioning exacerbating price volatility.
For the market to stabilise and continue its upward trend, there needs to be clarity around Trump’s trade and tariff policies. While tariffs have only a modest direct effect on the economy, its impact on investor confidence is significant. Resolving these issues is essential for restoring market confidence.
On the economic front, although recent data has been disappointing, the US economy remains on solid footing. At this stage, we still think the US is entering a soft patch and that the economy remains on a reasonably solid footing with the Fed in the background should conditions deteriorate faster than expected.
More broadly, cyclical tailwinds are getting stronger across Europe and the drag from China is abating. In addition, further rates cuts are on the cards across most major developed economies. The valuation expansion that was driven by falling inflation (and risk premia) was clearly last year’s story. This year’s story will be stronger and more broad-based growth (reflation) and steady(ish) inflation – or at best modest improvements.
If all these uncertainties ease and US data stabilises, the bull market is likely to continue, though at a slower pace.
Stay disciplined
In this environment, it’s crucial for investors to stay disciplined. Avoid getting caught up in short-term fears or the desire to avoid missing out. Focus on long-term fundamentals, take advantage of the opportunities that volatility provides, and be patient as the market adjusts.
It’s easy to get caught up in the optimism of a market rally, but even strong markets can face setbacks, especially when too many investors are positioned the same way. This creates the potential for a reversal when the market turns.
We doubt the drivers behind the current sell-off and rotation signals the end of the bull market, just a stumble. Broader equity performance alongside outperformance of catch-up trades strengthens the resilience of the equity outlook. However, before a new trend can be established, clarity around trade and growth risks is needed. Until then the churning will continue.
Jason Todd, founder and CIO, Ten Cap
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