Investment research company Morningstar notes that investing conditions in the coming year will differ from those in 2024. With inflation easing, many central banks will likely cut interest rates, allowing previously underperforming assets to recover.
Despite the strong market performance last year, Morningstar sees plenty of attractive investment opportunities ahead. AI remains the dominant focus for tech companies, with robust growth set to continue. At the same time, investors seeking stable income have a variety of options to consider.
The company sees some conditions as timeless, such as asset price volatility, the need for investors to look to the horizon instead of focusing on the latest headline, and the importance of creating portfolios that meet investors’ needs rather than simply chasing the highest returns.
US stocks surged over 25% last year, outpacing global markets. The gains were driven mainly by companies benefitting from the AI boom and those poised to benefit from rate cuts. According to the firm’s stock-level valuation models and return estimates, valuations now look stretched after the rally.
Morningstar suggests that investors may achieve better risk-adjusted returns outside the US in 2025. While US markets are expected to see low single-digit returns, regions such as Brazil, China, and Korea are projected to deliver double-digit gains over the next decade (see Chart 1).
From a global valuation perspective, major markets are trading at discounts, with emerging markets in Asia and Latin America particularly attractive. “Outside the US, we see opportunities to diversify portfolios and achieve higher yields via global sovereign bonds,” adds Morningstar (see Chart 2).
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Fixed-income positions
When investing in global bonds, focus on real yields, where nominal yields surpass both current inflation and central bank targets. “Under this framework, we see significant divergence across economies and countries. There are some very attractive real yields available in the emerging markets space, including Brazil, whose five-year bond yield of 13.3% looks compelling against an inflation rate of 4.4%, and Mexico, which is issuing five-year debt with a yield of 10.4% against CPI of 4.6%,” notes Morningstar.
In contrast, bond yields in Europe and Japan offer little headroom above inflation. In Japan, real yields are negative, and if this persists, further interest rate hikes in 2025 are highly likely.
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With inflation easing and global cash rates expected to decline, how should investors adjust the fixed-income portion of their portfolios? Morningstar believes that in a falling interest-rate environment, the exposures of the US Treasury, corporate bonds and non-US bonds can be optimised.
The Federal Reserve (Fed) began cutting interest rates in September 2024, after keeping the federal funds rate at a high 5.25%–5.50% since July 2023 to tackle inflation. With inflation largely under control, the rate is projected to fall to 4.25%–4.50% by the end of 2024, 3%–3.25% by the end of 2025, and 2%–2.25% by the end of 2026, sharply reducing income from bank deposits (see Chart 3).
“While cash deposits have many uses inside a portfolio, we continue to see elevated cash levels ‘on the sidelines’ rather than making a useful contribution to returns. For a long-term investor, holding too much cash has historically led to lower long-term portfolio returns compared with nearly all other fixed-income asset classes,” says Morningstar.
Data from the Investment Company Institute shows US money market (cash) fund assets reached US$6.51 trillion ($8.7 trillion) as of Oct 23, 2024. Despite the post-pandemic recovery, investors continue to hold large cash reserves. If the Fed’s projected rate cuts materialise, longer-term fixed-income bonds offer higher yields. For instance, with the 10-year Treasury yield at 4.3% and assuming a 1% term spread, this implies an average federal funds rate of 3.3% over the next decade. However, Morningstar’s forecasts suggest the rate will average 2.3%, making longer-term government bonds more attractive relative to cash deposits.
In a falling global yield environment, the benefits of cash diminish. Unlike longer-term bonds, cash cannot appreciate when rates decline, leaving income as its sole return source — a factor set to fall as the Fed continues easing. Extending bond duration now requires sacrificing less yield than at any time since 2022. Historical trends show that acting early in easing cycles yields better results, as the yield advantage erodes quickly.
The intermediate segment of the yield curve (five- to seven-year bonds) offers an appealing risk-reward profile. It allows investors to capture price appreciation while reducing the risk of sharp drawdowns that longer-duration bonds, such as 30-year Treasuries, could face if rates rise unexpectedly.
Hidden opportunities
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For investors looking to do more than outpace inflation, Morningstar believes that there are also opportunities within risk assets that are priced to offer a reasonable risk-reward trade-off.
In the latest Morningstar Singapore Fund Industry 2024 Review and 2025 Outlook, senior analyst and manager of research Arvind Subramanian believes that non-rated bonds are significant in the market but have limited current appeal.
Non-rated bonds are prominent in the Asian high-yield market, representing almost 25% of the overall market. Subramanian notes that the higher percentage of non-rated bonds today is due to several reasons. For one, they are predominantly from some markets or regions in Asia that tend to have a higher number of non-rated bonds, and these could be for various local and domestic reasons. The bulk of the non-rated bonds originate from China, the Philippines and Hong Kong.
Morningstar’s analysis reveals that non-rated bonds are highly diverse, with considerable dispersion. They span both the high-yield and lower-end investment-grade sectors. For instance, Singapore Airlines ’ non-rated bonds, due to the company’s perceived strength and high quality, often trade similarly to investment-grade bonds.
Conversely, some property developers in China are non-rated, and investors are less confident about their credit quality. Because of this, those bonds tend to yield much higher yields, reflecting their risks.
Meanwhile, Subramanian has cited research and studies that have demonstrated that fees are a reliable predictor of a fund’s future success. “We examined the cheapest fee quintile (we have bucketed the funds in terms of their feed in quintiles) and noticed a higher success ratio in funds in the cheapest quintile and a lower success ratio in funds in the most expensive quintile,” he says.
While this highlights the importance of low fees for investors, Subramanian notes that fees should not be the sole consideration when evaluating funds. “Qualitative factors such as investment team, investment process, parent organisation, are also very vital in determining a fund’s outperformance potential, but we believe lower-cost funds generally have a greater chance of surviving and outperforming their more expensive peers.”
