Swing state: investment themes and opportunities in 2025 and beyond 

Since 2020, a series of significant shocks to the global economy – the Covid-19 pandemic, escalation of the conflicts in Ukraine and  the Middle East, resultant inflation, and the vertical adoption curve of generative AI that has driven US exceptionalism – have dominated investor focus. The knock-on effects of this series of events continue to reshape our world and have challenged conventional portfolio thinking, in particular the potential benefits  of diversification. These impacts warrant in-depth analysis and consideration as the slower-burning repercussions are felt across portfolios. Equally, as the ‘acute’ and reactive phase of these events ends, we believe it is time for investors to lengthen their perspective to consider other longer-term risks and opportunities. 

The theme of this year’s report, “Swing State”, reflects look-forward views from an investment environment characterized by several potential swing dynamics:

• Market concentration levels have swung to a secular high.
  
  
• Rates have begun a downswing as inflation appears to have been brought under control.
  
  
• Government debt burdens in developed economies are at strained levels. A new administration in the White House, won on a pledge of tax cuts, raises questions about whether debt will continue to swing higher.
  
  
• Emissions continue to rise despite progress in cleaner technologies, due in part to increased energy demand.

While some of these swing dynamics remain in full flow, it is prudent to consider common-sense laws of financial gravity – what swings up must eventually swing down. The ‘tiger’ or ‘miracle’ sector in any time period eventually rotates into another, inflation responses eventually work (and have largely already done so), and serious environmental problems are eventually regulated.

Through the course of this paper, we outline some of the key themes and opportunities we see over the next five years and beyond. To make sense of this evolving landscape, we categorize our themes as follows:

• Regime changes — One-off, enduring shifts in conditions.
  
  
• Super-cycles — Current position in classic economic super-cycles (debt and commodity cycles) and the super-cycle of socioeconomic paradigms (Kondratieff waves or Strauss-Howe saecula).
  
  
• Megatrends — Multi-decade transitions gradually reshaping the world.

In recent times equity market returns and market capitalization have become increasingly concentrated in a few large stocks which have disproportionately influenced overall market movements. Large swings in single stock valuations can lead to material portfolio losses, exemplified in the stock market turmoil seen in September 2024.  

Our view is that portfolios should remain diversified with strategic allocation to areas that have underperformed in recent years, for instance developed ex-US equities, value, or emerging markets. 

In the context of a divergent multi-polar world, emerging market equity indices exhibit stronger exposure to revenues coming from some of the fastest-growing market economies in the world, and therefore warrant maintaining a strategic allocation at around market cap weighting. Investors should be aware of the return erosion that can come from “selling low”. 

In a deconcentration phase of the market active management is favored, further supporting an allocation towards alpha-seeking strategies, in particular diversified hedge funds. 

The effects of rising interest rates can take time to play out across the real economy, and we are only beginning to experience the full impact of the recent increases. While rates are expected to decline in the near term, they are unlikely to revert to the ultra-low levels seen in the decade following the global financial crisis.

In a higher interest rate environment, investors can employ flexible strategies that capitalize on potential opportunities  from across the risk spectrum, for instance investing in high-quality, government securities, while also strategically allocating a portion to high-yield and private debt. By focusing on these two ends of the ratings spectrum, investors can potentially enhance returns and manage risk more effectively, while avoiding the less favorable medium-risk assets that may not offer adequate compensation.

Despite the increased attraction of core fixed income assets, private debt remains an attractive asset class, though we believe that investors should be cautious of crowded areas where valuations may be overstretched. Instead, the focus should be on sectors with potential inherent  structural advantages, including asset-backed and structured strategies, where we continue to see strong opportunities.

In recent years, private markets have increased in size and become a mainstay of portfolio construction. Private market programs that adopt a holistic (de-siloed) approach may more effectively capture the full breadth of available opportunities. Lines between asset classes are increasingly blurred, particularly in areas such as data centers, energy transition, and areas such as waste management, wastewater, and services. 

The challenging exit environment in private markets, particularly in private equity, has spurred innovative fund structures while existing vehicles that provide limited partners with liquidity have gained popularity. The rise of semi-liquid funds, secondaries, and continuation vehicles reflects investor demand for liquidity solutions.

Global secondary transaction volumes, in particular, have grown significantly as the market has matured, increased more than 10% per year over the past decade. Secondaries can offer  unique benefits such as accelerated capital deployment – potentially avoiding the dip in the J-curve and allow for tailored investment solutions that seek to enhance portfolio diversification.

For sophisticated investors, co-investing in prime private market assets with quality general partners presents an opportunity. These investments carry more risk, and but provide significant benefits: experienced limited partners with strong general partner networks can capitalize on selectivity and favorable terms; lower fees; accelerated capital deployment to mitigate J-curve effects; opportunities from current market dislocations.

Real estate has struggled in recent periods, but it is approaching the tail of its most recent correction. This provides historically attractive entry pricing for most assets. Given the heterogeneous characteristics and imperfect information of the asset class – different regions offer highly differentiated opportunity sets – global real estate offers many compelling opportunities with strong absolute return prospects. Sector allocation and stock selection are the most important factors determining outperformance. For investors with a higher risk appetite, there is potential to achieve outsized returns from market dislocations. 

Geopolitical tensions can have profound and far-reaching consequences for the global economy and financial markets. Recent events have intensified focus on all aspects of security: energy; resources; supply chain fragility; supply-side inflation shocks; cyber-risk; and the potential of debt weaponization.

The systemic impacts of energy shocks and supply chain disruptions triggered by the pandemic and then exacerbated by Russia’s invasion of Ukraine – causing countries to re-evaluate their commodity sourcing – serves as an example of the amplifying effect that geopolitical tensions can have on already complex risks. At the same time, rapidly expanding renewable energy programs increase the proportion of ‘homegrown’ power for most countries, therefore increase energy security provided that power generation is matched with storage capacity and grid buildout.

Elsewhere, competition between the US and China is leading to trade tensions, particularly around dual-use technologies. While we do not believe that the world is deglobalizing, we do believe that it is fracturing into blocs.  In an increasingly multi-polar world, emerging market strategies provide diversification via more direct exposure to emerging market revenues.  Active management is preferred to capitalize on alpha opportunities, and for reasons of risk mitigation. Dynamism is needed to respond quickly to developing sovereign risk, noting that country risk is a much larger factor in emerging markets than it is in developed markets.

In an increasingly factionalized world, currency movements can have a material impact on investment returns. Whether this is beneficial or detrimental to risk-adjusted returns depends on the market conditions, investor’s circumstances and, critically, their domicile. Investors with a globally diversified portfolio understand that a decision not to hedge currency exposure is not a passive decision.

While Wall Street can take some comfort in inflation deceleration, it is cold comfort for people on the High Street who are left with permanent cost of living increases. Overall economic growth remains robust, but it has come with distributional problems, creating a disconnect between economic indicators and the realities of everyday living conditions. This disparity is contributing to growing public distrust in institutions. In advanced economies a key feature of the social contract has disappeared, that each generation is likely to earn more than their parents.  Wealth accumulation also presents a challenge as an unprecedented intergenerational wealth transfer from the Baby Boomer generation is expected to buttress unequal outcomes for the next generation.

The gap between economic growth and social well-being presents a unique opportunity for targeted investment. Strategic investments that focus on addressing social progress, such as affordable housing, healthcare infrastructure, food transition and cost-of-living solutions, offer the opportunity to make a significant impact and have the potential to provide attractive financial returns.

The government debt cycle in developed countries, particularly the US has contributed to the build-up of imbalance and tension, with concerns that the annual burden of debt, now roughly equivalent to defense spending, will slow growth in the US economy. Debt levels may increase further from here under populist control.

As public debt levels scale new heights in the US, it is worth considering the position of the natural purchasers of US government debt. Japan remains a natural purchaser due to a significant yield pickup over domestic issuance and fears of yen weakness. It is worth noting that while China’s Treasury holdings have fallen off, its purchases of agency mortgages have increased, indicating that the US’s deep public markets remain a natural home for China’s vast foreign reserves.