Extinction Trade Offers Risk Asymmetry for UK Stock Pickers

What I learnt from 2024 and carry into 2025

What Recession?

A year ago, investors began to believe they had missed a US recession. The soft or hard landing debate ebbed away amidst an economy that, despite slowing in Q1, followed through with +3% growth in Q2 and Q3. Inflation, seemingly slain, has recently shown signs of renewed life. Although the Fed's inflation creds no longer look immaculate, they remain sufficient for investors to cling to a no-landing base case helped by a MAGA-inspired belief in American exceptionalism. All of which could yet prove complacent as Trump 2.0 uncertainty looms over markets from later this month.

Stagflationary Europe

2024 was a year of elections, and predictably, the UK got a new government. Less predictable was that it prematurely trashed its economic competency rating, albeit blaming an inherited fiscal black hole. Either way, UK growth trended to zero over the first three quarters, and inflation rose from September's below-target print of 1.7% to 2.6% by November. As the year closed, Europe, including the UK, seemed increasingly threatened by the ghost of stagflation past.

Dollar Direction

Continued uncertainty surrounding the Trump 2.0 policy agenda means that the major world economies and currency blocks look increasingly unsynchronised and unstable. In the afterglow of Trump's re-election, the US dollar (DXY) rose by nearly 8%, short of the destructive 20% spike of 2022. However, unchecked, it could similarly harm risk assets during 2025. Whether Trump 2.0 results in a strong or weak dollar remains critical for risk asset pricing in the year ahead.

China

The dollar's outlook depends on US trade policy, particularly regarding China. Early indications suggest that Trump is more likely to support Musk and Ramaswamy's pragmatic approach than JD Vance and the MAGA hardcore; however, how this plays out remains unclear.

Turning Japanese?

Meanwhile, China is trying to stimulate itself away from a looming debt deflation, the likes of which caused Japan's lost decade (really three decades). There is growing evidence that the CCP is taking more direct control of the economy with its North Star of 5% pa growth. China's ultimate threat is pre-emptively devaluing the yuan. However, it is unlikely that Xi would make such a move before seeing what Trump puts on the table. It is conceivable for Xi to accept Donald's invitation to his inauguration.

Democracy

The picture of central bank policy rates and bond yields reflects heightened economic and fiscal uncertainty, amplified by growing political chaos. (As I write, France, Germany, and South Korea, accounting for about 10% of global GDP, remain without functional government).

Curve Steepening

The most significant bond market trend has been the steepening of curves. As global central banks have lowered policy rates, longer-term bond yields have typically risen. Since September, the Fed Funds rate has been cut by 100 bps, and the US 30-year benchmark yield (upon which mortgage rates depend) has increased by over 100 bps to levels not seen before the GFC. The picture is similar in other Western markets, including the UK.

All Clear?

The bullish interpretation of this yield curve steepening reflects normalisation following a return to economic growth. The previous period of inversion, widely seen as a signal of an impending recession, has proven inapplicable thus far. The red flag has been removed from the beach; it is safe to swim again.

But Wait

However, an alternative interpretation of such steepening reflects increasing expectations for longer-term inflation and increased bond issuance. Investors require higher returns for owning bonds. Whether we are in a bull or a bear market curve steepening cycle remains another critical unknown for the year ahead.

Debasement Trades

Yet the strength of monetary metals prices (gold +30% and silver +27%) and other hard assets, such as Bitcoin (+114%) over the last year, is worth noting. Such moves indicate heightened investor fear of traditional monetary debasement as the only means to settle the sovereign debt dilemma. As we enter 2025, these debasement trades remain underpinned by rising sovereign debt levels and stubbornly high refinancing yields. Until the US DOGE initiative works or Argentina exports the Milei fiscal consolidation playbook, hard assets will remain better risk counterweights for equity portfolios than bonds.

Same Again

De Ja Vu Again

Much like 2023, 2024 saw the UK deliver one of the weaker performances of developed world equity markets. The S&P was up 26%, NASDAQ 31%, its Mag Seven up 33%, and the small-cap Russell 2000 up 15%. Most UK equity indices were up a more modest 6% (FTSE 100, 250 and Small Cap measures alike) except the Budget impacted AIM market, which ended down 5%. 2023's top performer, Japan, managed another +21% (albeit with increased volatility), and even China, widely considered uninvestible, recorded a 14% gain.

Dispersal Halted

At the start of 2024, we asked if the dispersal trade featured in Q4 of 2023 would set the tone for 2024. In short, it didn't. The Trump-induced recovery of American exceptionalism halted the dispersal trade in its tracks. A critical question for this year is whether this is a temporary or permanent feature and what pin might emerge to pop the AI bubble, which has driven NASDAQ's stellar outperformance.

Extinction or Adaptation

UK equities remain the Millwall of equity markets—or, to coin another metaphor, an extinction asset. In his book The Last Ape Standing, Chip Walter depicted man's survival during the ice age 100,000 years ago as a community harbouring in the relatively clement conditions of modern-day South Africa, similar to today's one thousand mountain gorillas stranded in the higher regions of the Virunga volcanoes between Uganda and Rwanda. Such is the nature of complex adaptive systems: a small band of our surviving predecessors migrated and adapted to wildly differing environments to form today's eight billion inhabitants across the globe.

While the UK equity market is unlikely to dominate the world's capital markets again, its recent extended relative decline looks overdone, and some adaptive change is overdue. How quickly this happens remains unclear, but its current path to extinction will likely be interrupted at some stage.

Onward to Assymetry

Last year, my low-risk retirement portfolio made a respectable high-teens return. The most significant contributor to its performance was not its US exposure, which I had reduced to zero long before the Trump Trade kicked in. It was a UK micro-cap investment company called Onward Opportunities (+34%), the portfolio's largest single starting and finishing position.

I sit on Onward's investment committee, helping to identify value among the lower reaches (sub £100m market cap companies) left stranded by the extinction trends of UK-listed equities. Down among the pond life of UK companies lurk good but forgotten value where both time and a functioning price mechanism have forgotten.

Having had a decent year, Onward's largest holding, Israeli AI data company Windward (a 9% position), received an agreed cash offer at a significant premium on Christmas Eve, delivering Onward and its investors an early Christmas present. It remains likely that Onward's portfolio contains other presents for 2025. The Onward strategy epitomises Charlie Munger's first rule of fishing: fish where the fish are, but not where everyone else is fishing. As the price mechanism for smaller listed companies fails, the strategic value of the better-quality survivors becomes more attractive.

The Onward strategy cannot be passive or high-volume. However, if carried out diligently, it can produce excess returns. As its pond of listed assets drains, it reaps outsized returns from private and larger corporate acquirers unless or until the UK equity market makes some adaptive change to grow again. This latter scenario must entail higher valuations, representing the attractive risk asymmetry for astute stock pickers like Onward in a market priced for extinction.

Happy New Year

Jeremy