Asset allocation

Headwinds or Tailwinds? Why cross-asset class diversification matters

Raj Singh

Portfolio Manager, Multi-Asset

For Institutional, Professional, Qualified, and/or Wholesale Investor Use Only in Permitted Jurisdictions as defined by local laws and regulations.

This content was published on Hong Kong Economic Journal on 1 April 2025. (Chinese only)

The new U.S. administration is introducing import tariffs and federal employee job cuts in the first few months of the presidential term. So far in 2025, the U.S. economy has faced headwinds and has yet to benefitted from any tailwinds. Tariffs were enacted earlier than expected, and the threatened tariffs are significantly larger than anticipated, with a potential increase in the effective tariff from 3% to 11%¹ - four times the increase seen in U.S. President Donald Trump’s first term and almost twice as large as what had been widely expected by analysts.

Investor concerns around recession have spiked. However, while the economy is likely to slow over the coming months as it absorbs the negative growth impact of tariff policy uncertainty and federal employee cuts, a recession is not assured, given the multiple supports that are either already in play or likely to come into play over coming months.

As optimism fades amid elevated policy uncertainty, increasingly adding downside price pressures, lessons from historical cycles suggest that earnings growth will need to take the baton from valuation expansion for the rally to reassert itself. Today, earnings breadth is improving, with growth expanding beyond technology into more cyclical industries. Some additional market tailwinds are on the horizon, including a more accommodative Federal Reserve, fiscal stimulus, and structural drivers like technological innovation. Although the “Magnificent Seven” has borne the brunt of the turn in investor sentiment, the earnings growth potential from key U.S. tech players remains strong and likely to continue contributing significantly to overall earnings growth and the broad economy. Additionally, the large cap U.S. tech players fundamentals remain strong underpinned by solid balance sheets and cash flows which could make them resilient if the economic uncertainty persists.

As always, risks persist. Inflationary pressures, tightening financial conditions, or renewed macro uncertainty could compress valuations before earnings growth fully materializes.

China market continues driven by positive sentiment surrounding AI developments and signals from the government of a more supportive regulatory environment. Headlines made by Chinese startup in DeepSeek were followed by other local tech companies in the space released their own AI models and announced that they have plans to add more funding into AI investment after DeepSeek’s breakthrough in GenAI foundation modelling. This underscores how impactful innovation can still occur without the latest and most advanced computing chips. The recent positive sentiment in China may be a boon in the short term, but fundamental shifts that filter through data need to be observed to sustain momentum in the economy. The government has taken multiple steps to bolster consumption and liquidity in recent months, and it will be important to watch what further action it will take as it signals support for the business sector.

Global diversification remains crucial for managing portfolio risk and capturing opportunities. Indeed, global economies, which are more cheaply valued than the U.S., have been looking to shore up their economic resilience to U.S. policies. Their improved fundamental outlooks, coupled with the more attractive valuations, have driven impressive outperformance against the U.S. so far in 2025. However, investors should be careful in chasing the rally as though paused U.S. secular exceptionalism is not completely dead.

The benefits of cross-asset class diversification have been on full display in recent weeks as bonds have rallied, and equity markets have struggled. With this negative correlation fixed income perform its ballast role, helping portfolios weather the economic slowdown and market pullback. Moreover, the higher rate environment means investors can now lock in attractive yields without taking excessive credit risk. Credit quality, duration exposure, and liquidity should remain top of mind as well. In addition, with inflation threatening signs of persistence amidst the tariff threats, investors should also prioritize real assets such as Gold that can provide downside and inflation mitigation in this environment of geo-economic and political uncertainty.

Source: Principal Asset Management.

Disclosures

Risk considerations

Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal. Equity investments involve greater risk, including heightened volatility, than fixed income investments. Small- and mid-cap stocks may have additional risks including greater price volatility. Fixed‐ income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Asset allocation and diversification or a downside risk reduction/protection strategy do not ensure a profit or protect against a loss.

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Reference number: 4366624