Welcome to 2025

As always, the January Absolute Return Letter is about issues that are at the forefront of our minds – issues (risks) that keep us awake at night because they could have a profound impact on equity returns, should they come to fruition.

And, as always, I shall be the first to admit that the true sledgehammer – the bombshell which could wipe out vast amounts of wealth – is likely to come out of the blue. Did anyone really plan for the pandemic? Maybe when the reality started to sink in, and large amounts of wealth had already been lost – but beforehand? Get my point? The true mega-risks are almost always those we don’t even think about.

With that in mind, today, I will list a few risks that dominate the mindsets of the staff at Absolute Return Partners as we have just entered a New Year. A few weeks ago, I sent an email to my colleagues, asking them to list the issues they worry most about, and today’s Absolute Return Letter is a small collection of the worries that dominated those lists. With those comments, let’s begin.

What to worry most about as we enter 2025

I. The absurd valuation of US megacap stocks

In 1986, I landed a job in London, selling US equities to Scandinavian institutional investors, and, for the next four years, I had to listen to clients who kept arguing why Japanese equities were so much better than US equities, and why they were not at all overvalued which they appeared to be (to me).

As you may remember, the Nikkei 225 Index peaked in August 1990 before the bubble burst, a downturn which led to losses of about 80% over the next 19 years. In the years after the GFC, the Nikkei 225 began to recover; however, the old peak of August 1990 was only surpassed in May 2023, almost 33 years later. In other words, it took almost half a lifetime to fully recover from the large losses caused by the burst of the Japanese wealth bubble.

Now, replace Japan anno 1990 with the US anno 2025. I am already looking forward to the dozens of emails I will receive, mostly from US investors who will tell me that you cannot compare Japan 35 years ago with the US today. They will argue that US equities are on much firmer ground today than Japanese equities ever were, and I will (quietly) conclude that this aura of supremacy is precisely why the current feast will end in tears.

Take a look at Exhibit 1. As you can see, since we came out of the GFC in early 2009, US equities have performed dramatically better than European equities, and one is entitled to wonder why one should invest in anything but US equities.

The extraordinary returns on (certain) US stocks have led to a huge appetite for equities amongst US retail investors, and nowhere is that more visible than when you look at flows into US equity ETFs which, for the first time ever, surpassed $1 trillion last year (Exhibit 2). Needless to say, record inflows aren’t necessarily all new money but, when you combine Exhibits 1 and 2, I would argue that a fair amount of it is.

Sophisticated investors may have begun to realise that Trump’s policy programme (more on that later) will, if implemented as announced, come at a huge price; however, around the speculative fringes, the risk-talking is getting bigger by the day. Single stock ETFs, which are almost exclusively bought by retail investors, are more popular than ever. According to Bloomberg, leveraged, single-stock ETFs have been particularly popular in 2024. I suggest you take a quick look at Exhibit 3 below, which depicts the flows into an ETF which invests exclusively in Nvidia common stock on a leveraged basis. As you can see AuM have risen from a few hundred million dollars to well over $5 billion over the last 12 months.

II. The Yen carry trade

Closely linked to our worry that the US equity bubble may be coming to the end of its runway, are our concerns related to the Yen carry trade. For those of you who don’t know what the Yen carry trade is, here is how it works. Essentially, you borrow in Japanese yen (JPY), where interest rates are low, and invest the proceeds in currencies that offer higher returns such as US dollars (USD). If you can borrow JPY at 0-1%, invest in USD government bonds yielding 4-5%, and at least partially hedge the currency risk as many sophisticated investors have done in recent years, it appears to be not only a very rewarding trade but also a fairly safe one. And I should stress that the yen carry trade is not only used when investing in bonds. It also explains much of the equity rally in 2024.

Now, let’s look at the implications. If JPY weakens, global liquidity increases, the reason being that investors tend to borrow more, the cheaper the currency is, leading to more capital flowing into financial markets all over the world. The side effect of this dynamic is asset price inflation, as more capital chases the same pool of investments, hence why the end-result may be a bubble.

On the other hand, if JPY strengthens, global liquidity decreases. The carry trade is now less attractive, and investors typically begin to liquidate their higher-yielding investments to pay back their JPY loans, which leads to a withdrawal of capital from financial markets, effectively reducing global liquidity. The impact? Declining risk asset prices.

The bottom line is that JPY movements act like a global liquidity tap, and JPY fluctuations will typically affect all risk assets – not just bonds. In July 2024, BoJ raised Japanese interest rates for the first time in 17 years (from 0.00% to 0.25%), and JPY began to rally, which affected financial markets worldwide. Remember the mayhem in early August of last year? Our concern now is that BoJ has a long way to go with respect to its hiking plans, and that Japanese interest rates will be raised a number of times in 2025 to the detriment of risk assets worldwide.

III. The impact of Trump’s policy programme

US Election Day turned out to be a sweep for the Republican Party, i.e., at least for the next two years, Trump will benefit from a control of Congress. As a consequence, he will enjoy sufficient powers to act on most of the promises he made when campaigning recently. That said, one thing is what he says he’ll do. Another thing is what he actually ends up doing. You never quite know with Trump.

The most likely near-term changes are those that can be executed under the Executive Order mandate and, in that category, tariffs and deportation of illegal immigrants stand out. Trump is clearly intent on using tariffs as a weapon against trading counterparties, and you should expect him to act quickly. He is keen to demonstrate that he meant it seriously when he talked about raising them, and it won’t require months of preparatory work in Congress. Precisely by how much and vis-à-vis whom is difficult to say, though. When it comes to Trump, I have learned that what he does is not necessarily predicated on what he says he will do. And he obviously uses the threat of tariffs as a negotiation tactic.

Let’s assume Trump goes for the Full Monty – the High Scenario in Exhibit 4 below. As you can see, the impact on US inflation will be dramatic. Even a much softer version, where tariffs are increased less dramatically and fewer illegal immigrants deported (the Low Scenario in Exhibit 4), will have a significant impact on US inflation.

2025 is therefore likely to end up in a power struggle between hardcore MAGA supporters and more pragmatic Republicans in Congress who realise that, if fully implemented, Trump’s policy programme will lead to misery. If the MAGA movement win that battle, the Fed will almost certainly raise interest rates, and that will be costly. Mortgage holders will suffer, and so will US equity markets. Under those conditions, 2025 could turn out to be a rather dubious experience.

Final few words

Today, I have only started to scratch the surface on this topic. My colleagues provided me with many more concerns of theirs, many of which I will cover over the next few months. To me, the first concern raised in today’s letter – are we coming to the end of the great equity bull market, which started in earnest in early 2009? – is the most important one. I learnt a very serious lesson in connection with the collapse of the Japanese bubble in the early 1990s. When bubbles burst, the implications are far more dramatic than when we ‘just’ go from bull market to bear market conditions. Therefore, a ‘so what?’ attitude could be very costly.

Having said that, I also learnt that timing the end of bubbles correctly is almost impossible; there are so many dynamics pulling in either direction. Therefore, a hedging strategy may make more sense than a vanilla exit strategy which could prove terribly expensive, if your concerns turn out to be premature.

Niels

2 January 2025‍