Investing in 2025: Compound Your Way to Happiness

Key Takeaways

• Compounding Returns: Harness the power of compounding to accelerate portfolio growth, with a focus on income-oriented fixed income and growth equities.
• Economic Resilience: The U.S. economy’s stability, driven by services and infrastructure investments, supports a durable growth outlook.
• Strategic Fixed Income: Current market conditions offer opportunities to compound returns with low volatility through high-quality fixed income assets.
• Growth Equity Leadership: Tech leaders, including the "Magnificent Seven," continue to drive market performance and offer compelling growth potential.
• Navigating Uncertainty: Managing around inflation, policy shifts, and geopolitical factors requires balancing quality income with high-growth assets.
• Portfolio Optimization: A mix of fixed income, growth equities, and alternative investments can provide diversification and upside.

While we wouldn’t dream of suggesting revisions to Einstein’s theories, we might revise this quote just slightly to include compounded growth alongside of interest. Of course, Einstein was no stranger to revisions, he famously added and subsequently removed the cosmological constant from his theories of general relativity, only for it to be added back by physicists 70 years later.

Investing alongside major change going into 2025 with little visibility into how that change will play out can feel highly uncomfortable. In this insight, we take a leaf out of the physics community’s book by re-evaluating our economic constants and variables, while finding comfort in the wonders of compounded returns.

Our constants – what can we rely on?

As investors, we are constantly trying to identify what we know. The good news is that even during this especially uncertain period, there are several economic engines that continue to power the United States ahead. We’ve covered the services-oriented nature of the modern U.S. economy at length previously, so won’t go into great detail here. The bottom line is that services-related activity makes up 70% of overall economic activity and is nearly 3x less variable than goods-related activity. This stable foundation has played a major role in the U.S.’ sustained outperformance in the post-pandemic period. Being a relatively insulated, technologically advanced, asset-light economy comes with a versatility that means it now takes a disruption on the scale of COVID or the financial crisis to shock it into a recession.

This story has been clear to see in the employment data. The services industry has hired nine out of every ten jobs added since the height of the pandemic. By most measures, the labor market has now returned to a normal equilibrium from the inflationary, overheating state reached during the reopening. A major question mark hanging over this cycle was whether this would be achievable without creating a spike in unemployment, which looks to have been answered. Though it certainly hasn’t disappeared as a variable, it will hold a smaller weight in the conscience of the market going forward. Unemployment holding firm near all-time lows is just one of four indicators of the financial health of households that give us confidence in the durability of growth. Average incomes, even after adjusting for inflation, are securely back on the healthy upward trend set in the 2010s. Households are the wealthiest they have ever been, with the lowest levels of debt attached to that wealth in seven decades. The aggregate picture across employment, income, wealth, and debt is the best it has been since the post-war boom in the early 1950s. The repeated calls for a hard landing have largely gone mute and the undeterred U.S. consumer looks set to keep it that way for some time.

The obsession with labeling this cycle as a hard or soft landing is detached from the data that defines it. The data indicates we are heading for a ‘no landing’ scenario in which both growth and inflation run at a higher pace than the secular stagnation of the preceding decade. A robust consumer is driving this on one hand, while an unprecedented public and private sector drive to build out infrastructure mega projects is on the other. We live in a new era of pro-cyclical fiscal policy with bipartisan support for onshoring strategic industries. This has coincided with a once-in-a-generation rush to develop the ecosystem for a productivity enhancing technology. Hundreds of billions of dollars in investment have been committed by both government and private enterprise, and the benefits this will create have only just begun to be realized. Consumption and infrastructure investment are two pillars of economic growth that can continue to power American exceptionalism well into the future.

While the specifics of how strategic decoupling and artificial intelligence will manifest are up for debate, the residual effects of the pandemic era fiscal stimulus are easier to pinpoint. There is still an unprecedented level of cash coursing through the system. Assets in money market funds stand at just under $10 trillion, double where they were in 2019, except now they are compounding at around 4%. The annual income from U.S. fixed income assets exceeds $2 trillion, more than double the net annual supply of these assets excluding treasuries. All this cash is dry powder that will have to be invested. The technical support this creates for asset markets, alongside the fundamentally sound growth outlook is a powerful tailwind, especially for equities. This is all before considering that the well-paid consumer detailed in the previous section is due to invest nearly $1 trillion of salary annually at the current savings rate. In the simplest terms, demand for assets is outstripping supply by the largest margin in a long time. A corollary of this favorable technical and fundamental setup is that its allowed valuations to reach somewhat uncomfortable levels, though this may not be as large of a concern as a historical comparison would suggest - more on this later.

Our Variables – What do we need to manage around?

There aren’t many comparisons to be drawn between investing and quantum physics, but the policy cocktail in store for 2025 is one of them. There are three states of the world we could legitimately find ourselves in once the new administration’s economic agenda takes hold, and the only way of knowing with certainty which one we end up in is through observation. In the short-term, the constants laid out in the previous section are likely to keep baseline growth healthy.

1. The initial phase of decoupling and the infrastructure boom creates a demand shock that keeps inflation above target in an inflationary boom. In this environment it makes sense to own growth equities and real assets to capture upside and hedge against the erosion of value from higher inflation.

2. The optimal long-term outcome that this could transition to is a deflationary boom. This hinges on the productivity boost from AI materializing in a way that supplements labor and effectively lowers input costs. The range of estimates on the size of this boost is currently so wide that there is little to be gained by speculation until we see it in practice. Virtually all assets have the potential to perform well in this end state.

3. The risk scenario is that overly restrictive tariffs and a longer-than-expected timeline for AI to realize its potential create a stagflationary environment in which few assets can offer an attractive risk/return profile. With most of the risks being to higher inflation, and a strong foundation for growth, we believe we can take a deflationary bust outcome off the table.

Policy pronouncements since the election have skewed extreme, their actual implementation will likely take a more moderate shape. Take the 25% tariff proposal on Mexico and Canada as an example. Bilateral trade between the U.S. and Canada looks surprisingly symmetric for the largest categories of goods that flow across the border. 6.2% of the U.S.’ imports from Canada are cars, 5.5% of Canada’s imports from the U.S. are also cars. This isn’t a coincidence, U.S. automakers built cross-border supply chains under NAFTA. The parts and assembly process for a single car will cross the border multiple times. It follows that a blanket tariff on this flow would exceed the profit margin of U.S. automakers and almost certainly necessitate price increases. Such a policy looks unlikely to be implemented at face value and is more likely to be a negotiating tactic. We find it more productive to focus on the proposal to increase tariffs on China. As the United States’ main geopolitical adversary and less interdependence than with direct neighbors, we see this proposal as having a higher likelihood of passing. Whether it will be precisely targeted to minimize the effect on consumer prices, like those of the first Trump administration, or is more of a blanket policy is still unknown.

As we covered in detail in our last market insight, the government debt issue has the potential to become a major drag on markets and the economy at large. On average, the U.S. issues as much debt in a week as entire developed economies have outstanding in total. Policymakers will need to make outgrowing the debt a priority if we are to avoid a crisis that spirals out of control. The path for the Fed is an equally important input in bringing down the interest burden of the debt on discretionary government spending. They are dealing with the same set of uncertainties as the rest of us, data-dependence means they will also be watching and waiting. It’s entirely possible that we get four cuts this year and equally possible that we get none.

Speculation about the Fed’s path has kept both realized and implied rate volatility considerably higher than the norm of the 2010s. At the same time, credit fundamentals have arguably never been better as corporations termed out their debt during the zero-interest rate period. Measures of both interest coverage and leverage for the largest companies are at their lowest in more than a decade. The result is a counterintuitive composition of credit risk where your ‘risky’ components (spread) are more stable than your ‘risk-free’ component. So, while spreads are certainly tight, the fundamental picture is one that supports a lofty valuation. To counteract the possibility of a growth scare that blows spreads out 100 basis points (a major shock), we prefer to carry in the front-end of the curve where interest rate risk is minimal and the still generous real yield can fully absorb any loss in principal.

The Rule of 72 – Compounding Your Way to Portfolio Happiness

The Rule of 72 states that dividing 72 by your rate of return is approximately the number of years it would take to double your money. This draws on the notion that compounding growth can massively accelerate returns. Consider the simple example of an investment that returns 8% annually, under the rule of 72 this will double in value in 9 years and quadruple in 18. If we were to remove the compounding of returns from the calculation, we would be dividing the targeted return by the annual rate of return, so:

100/8 = 12.5 years to double, ~40% longer than the compounding investment

300/8 = 37.5 years to quadruple, more than double the time versus a compounding investment

The longer you allow your returns to continue to work for you the better your returns will be. A basic concept at its core, but severely underappreciated by market participants.

The opportunity to compound at an attractive yield with low volatility in fixed income remains amongst the best we’ve ever seen. There are convex opportunities to source yield across the global fixed income universe. High quality segments of the securitized products market are offering a generous pickup in spread over corporate bonds. Meanwhile the high yield market across both the U.S. and Europe is yielding around 7% while defaults remain low and the size of these markets is outright shrinking. Leveraged loans are another interesting relative value opportunity, offering 70 bp of additional yield above high yield bonds. The ability to compound returns at these yields while keeping portfolio volatility contained by limiting interest rate exposure is an incredibly attractive proposition on its own. For those that are able to, the volatility budget this affords you can be married with a selection of growth equities to take the compounding power of your portfolio to another level.

The seven stocks that have driven equity market performance for much of this cycle are no secret and have seen growing scrutiny as investors wonder how much further this concentration of returns can run. If the most recent set of earnings are any indication, it seems like they are still firmly in the driving seat. The Magnificent Seven tech stocks on average reported 18.1% YoY growth in earnings in Q3, the rest of the S&P reported just 0.1% growth. Consider also that the other 493 companies have seen free cash flow (FCF) shrinking since a peak in early 2022. The seven tech stocks have grown FCF by 20% in the same period. The largest companies now have so much cash that they are net lenders, not borrowers - they are benefitting from the higher rate world we live in. International investors recognize the dominance of these companies, too. The sheer quantity of market cap these stocks have created make them the only asset that can generate these kinds of returns on this scale. While the breakneck growth of the last two years is unlikely to be repeated, there is no indication they won’t continue to be the bellwethers of strong equity performance. We would also expand the universe of stocks to other high growth, technology-oriented firms that can provide durable compounding even as the economic variables play out.

Bringing this all together, the variables clouding the economic outlook can make it feel very uncomfortable to take risk. However, counting on the constants that underpin the remarkably resilient U.S. economy restores a great deal of confidence in the right expressions. The opportunities to source high-quality yield in today’s fixed income markets are abundant. Optimizing this portion of a portfolio for low volatility income allows you to take your volatility in growth equities which can compound unlike any other asset. For those with the capability to do so, private deals and storehouses of value like Bitcoin or gold in reasonable sizes can potentially add even more uncorrelated return to the picture. Pairing quality income with high growth potential can make a portfolio feel comfortable under even the most uncomfortable set of circumstances. When the unpredictable predictably happens year after year, harnessing the beauty of compounding returns while managing downside risk is a powerful combination.