In December 2023, when the Scottish Budget for 2024–25 was set, total resource funding in 2024–25 was expected to be £47.6 billion. Of this, £6.3 billion was expected to be spent on social security and £265 million used on debt service, leaving £41.1 billion available for public service spending. Table 1 breaks down the sources of resource funding in more detail.

Since the Scottish Budget was set, the funding available to the Scottish Government for this year has increased.

Changes in funding up to the Autumn Budget Revision (ABR), published on 2 October (before the UK Government’s Autumn Budget) increased the amount available for day-to-day (resource) spending on public services by £1.2 billion. As we will discuss below, this was used to help address pay and other pressures facing the Scottish Government.

Some of the increase in funding was due to changes in UK government funding. At the UK Spring Budget in March 2024, additional spending on some devolved areas (predominantly health and local government) generated Barnett consequentials for day-to-day spending of £293 million. At Main Estimates in July 2024, an additional £437 million of resource Barnett consequentials were allocated. This additional funding largely represented the higher assessed costs of unfunded public sector pensions. These costs will also need to be met by public sector employers in Scotland, so this funding does not increase the real spending power of the Scottish Government.

The new UK government’s July 2024 decision to restrict winter fuel payment to only pension credit recipients from this winter led to a reduction in funding for the Scottish Government of around £140 million. The Scottish Government has said it will replicate this policy, meaning that the amount of funding available for public service spending will ultimately be little changed. However, if it wanted to, the Scottish Government could choose to defer the reduction in funding (given the UK government’s policy decision was made after the 2024–25 Scottish Budget was finalised), which would allow it to spend that money elsewhere in the short term, but it would need to be paid back later on. We understand a final decision on this has yet to be made, but the funding figures published at the ABR assume the funding adjustment will be applied in-year rather than deferred. Forecasts for other social security block grant adjustments (BGAs) and spending, and tax BGAs and revenues, were not updated at the ABR.

Scottish Government decisions also increased the funding available for day-to-day spending this year. These decisions included: an increase in planned drawdown of ScotWind – one-off income from leasing the Scottish seabed for windfarms – from £200 million to £424 million; the planned drawdown of £162 million in reserves, following underspends in 2023–24; and the cancellation of a planned £89 million transfer from its resource to capital budget.

The announcements made by Rachel Reeves in the UK Budget on 30 October led to a further big increase in funding for the Scottish Government this year: just under £1.5 billion in total. Of this, around £1.4 billion reflected Scotland’s population share of increases in spending announced for England via the Barnett formula. There was also £35 million of additional non-Barnett funding.

The combined effects of changes made in Scotland’s ABR and the UK’s Autumn Budget have improved the Scottish Government’s resource funding position this year.

Based on the latest inflation forecasts, the amount available for day-to-day spending on public services as of the original Scottish Budget plans would have been 0.6% lower in real terms than was spent last year. The top-ups announced in the ABR changed this to a 2.3% increase, while the further top-ups as a result of the UK Budget, if spent in full, would mean an increase of 5.9%. Some of the top-ups reflect SCAPE funding for higher assumed pension costs – and so not a genuine increase in spending power – but even stripping this out the increase would be around 4.9%.

The Scottish Government could choose not to spend all the resources now available to it – which the more difficult financial outlook for future years means may be wise. If it chose to use around a third of the extra funding confirmed in the UK Budget to cancel planned drawdowns of ScotWind proceeds, the increase in the amount available to spend (after stripping out SCAPE funding) would be 3.8% in real terms. If instead, half of the extra UK government funding were effectively banked (allowing the cancellation of ScotWind drawdowns and a small payment into rather than drawdown from reserves), the spending increase this year would still be 3.1% in real terms.

As with funding, the initial plans for public service spending set out in December in the 2024–25 Budget implied a real-terms cut in spending compared with the final budget and out-turn for 2023–24. The changes made in the ABR mean this is no longer the case, although different services have fared differently, as shown in Figure 2. Further changes (including the use of funding confirmed in the UK Autumn Budget) will be officially confirmed in the Scottish Government’s Spring Budget Revision (SBR) – although an update may be given alongside the Budget for 2025–26 next month.

The changes in planned spending reflect the Scottish Government’s efforts to address significant in-year spending pressures – most notably related to public sector pay deals. Such pressures were highlighted by the UK Chancellor in her ‘Spending Audit’ published in July, and a particular challenge in Scotland given relatively higher public sector employment and pay. As part of these efforts, the Scottish Government published a fiscal update in September, setting out plans to reallocate around £250 million from existing budgets, specifying in detail where around £188 million of this would be found. Some of these changes were accounted for in the ABR, but some will not be reflected until the SBR.

All told, the ABR increased spending on public services by £1.2 billion (mirroring the increase in funding), and reduced spending on social security benefits by £148 million following the decision to follow the UK government’s decision to restrict eligibility for winter fuel payment to those receiving pension credit.

The Health and Social Care portfolio saw by far the biggest boost to spending in the ABR, with its resource budget increased by £1.1 billion. Of this, around £0.2 billion represented funding for increased SCAPE costs, meaning the ‘real’ increase available for other pressures, including higher pay costs, was £0.9 billion. As we highlighted at the time of the Scottish Budget, a significant top-up to health spending was always likely as the original plans implied a cut in spending. Rather than falling by 1.4% in real terms compared with what was spent in 2023–24, the updated plans imply a 3.2% real-terms increase.

The Finance and Local Government portfolio also saw a top-up, of £155 million. After stripping out the £86 million that is for additional SCAPE costs, its spending is still set to fall slightly (by 0.6%) in real terms compared with 2023–24, although it is worth noting that councils also receive funding from other portfolios and council tax, and so their overall funding is set to grow in real terms. Top-ups were also made to the Justice and Home Affairs portfolio leaving its budget 1.2% higher in real terms than spending in 2023–24, after stripping out additional SCAPE costs.

Other areas mostly saw little change or cuts to their budgets in the ABR. There were cuts to the Net Zero and Energy (£20 million), Rural Affairs (£10 million) and Education (£7 million) portfolios, reflecting savings announced in September. However, spending on all these portfolios is still planned to be higher in real terms than the amounts spent in 2023–24. The Social Justice portfolio saw the biggest reduction in total funding at the ABR (£160 million), mostly due to the restriction of pension age winter heating payment to those receiving pension credit. The Social Justice portfolio stripping out social security spending is set to fall compared with 2023–24.

Further substantial top-ups are likely in the SBR, with initial information on the likely scale and nature of these potentially provided alongside the Budget for 2025–26. It seems likely that the Health and Social Care portfolio will see a further top-up, with each £190 million generating a further 1 percentage point increase. Another key decision will be whether to ‘undo’ some of the cuts announced in the September fiscal update.

Our focus so far has been on day-to-day (resource) funding and spending. There have also been increases in the capital funding available to the Scottish Government this year since the initial Budget was set, but these are much more modest in scale. As a result, an increase in forecast whole-economy inflation since the Budget (from 1.7% to 2.4%) means that capital funding this year is little changed in real terms compared with what was expected at the time of the Scottish Budget – in stark contrast to the situation for resource funding.

Turning to the future, the UK’s Autumn Budget set the Scottish Government’s block grant funding for 2025–26 for the first time. However, at the time of its 2024–25 Budget, the Scottish Government made projections of block grant funding, which informed the Scottish Fiscal Commission’s (SFC’s) overall projections for Scottish Government funding. These assumed that the block grant for day-to-day (resource) spending would grow in line with UK-wide resource spending limits – which at that time meant growth of 2.3% in cash terms between 2024–25 and 2025–26 – and implied a block grant of around £38.3 billion in 2025–26. The capital block grant was instead set to stay flat in cash terms, implying real-terms falls in each year.

The UK Autumn Budget confirmed substantially larger block grants for both day-to-day (resource) and capital spending next year: £41.1 billion and £6.5 billion, increases of £2.8 billion (7%) and £0.9 billion (17%), respectively, compared with the expectations set out in the 2024–25 Scottish Budget last December. However, as with funding in 2024–25, part of the increase in resource funding (around £0.3–0.4 billion) reflects extra SCAPE costs rather than an increase in spending power. And these figures exclude compensation for Scottish public sector employers for the big increase in employer National Insurance contributions announced for April 2025. It is currently unclear whether the Scottish Government’s share of compensation will be based on the Barnett formula, or its higher-than-population share of the public sector wage bill. If it is the former, some of the general increase in block grant funding would have to be used to part-fund higher employer National Insurance bills.

Updated figures for the Scottish Government’s other sources of funding – such as net income from devolved taxes, and the use of borrowing and reserves powers – are not yet available. But some assumptions allow us to project scenarios for overall funding, in order to provide a sense of the potential budgetary trade-offs that will be faced by the Scottish Government in its forthcoming and future Budgets.

The first element of our projections is devolved income tax. While forecasts of the net proceeds of income tax (revenues minus the BGA) will not be updated until the upcoming Scottish Budget, some new information has become available. In particular, out-turn figures for revenues in 2022–23 mean that the Scottish Government will receive a £447 million reconciliation payment in 2025–26 as a result of initially pessimistic forecasts of the net income tax position in 2022–23. This is good news but less good news than the SFC was forecasting last December, when it expected a reconciliation payment of £732 million.

Most of this difference reflects two errors with the HMRC statistics the SFC had previously been using to forecast reconciliation payments. It is currently unclear how far we should expect these issues to affect the net income tax position in subsequent years, and other factors – such as updates to employment and earnings forecasts in both Scotland and the rest of the UK – will also have a bearing on new forecasts of the net income tax position. But a plausible assumption is that the net tax position will similarly be £285 million less positive in subsequent years than forecast by the SFC last December. Taken together, this means total revenue from income tax would be £570 million lower in 2025–26 than last forecast – with half of this due to a lower reconciliation payment and the other half due to lower in-year revenue forecasts.

We then assume all other elements of funding for day-to-day (resource) spending will be unchanged on a net basis (so, for example, any changes in other tax and social security BGAs are offset by changes in associated revenues and spending). These other elements are likely to change somewhat but, given they could be higher or lower than previously projected, assuming they are unchanged seems like a reasonable baseline assumption.

On this basis and as shown in Figure 3, overall funding for day-to-day (resource) spending on public services would be £45.0 billion in 2025–26, up from the £42.7 billion projected last December (again noting that £0.3–0.4 billion of this increase reflects SCAPE costs). This would be a cash-terms increase of 2.8% and a real-terms increase of 0.4% compared with the current financial year if the Scottish Government chose to utilise immediately all of the additional funding provided in the Budget for 2024–25, rather than carry forward some for future years.

The UK Autumn Budget did not provide figures for the Scottish block grant (or indeed any individual department) for years after 2025–26. These are due to come in a Spending Review in late spring 2025. But it did set out overall resource and capital spending envelopes and, with assumptions about how these will be allocated, it is possible to project forward the block grant. In particular, let us make the same assumptions used in the IFS’s post-Budget analysis of the trade-offs facing the Chancellor in the upcoming multi-year Spending Review: that English NHS spending is increased by 3.6% a year in real terms, an expansion of childcare provision in England continues as planned, and commitments on defence and overseas aid spending are just met. On this basis, the block grant would increase by an average of 2.8% a year in cash terms or 0.9% a year in real terms between 2025–26 and 2028–29. This is a little slower than the overall growth in resource funding across the UK during these years (1.3% a year in real terms), reflecting the so-called ‘Barnett squeeze’ (because Scotland’s funding per person is higher than England’s, a population-based share of the funding increase in England translates into a smaller percentage increase), as well as the extent to which the protected areas of spending are ‘Barnettable’.

Based on these block grant projections, together with projections for other elements of funding made on the same basis as for 2025–26, Figure 3 shows projections for the Scottish Government’s total funding for day-to-day (resource) spending on public services. Funding would increase to £48.6 billion by 2028–29. This compares with an SFC projection made last December at the time of the 2024–25 Scottish Budget of £45.8 billion (although note again that £0.3–0.4 billion of this increase relates to SCAPE costs).

The projections also imply increases in funding between 2025–26 and 2028–29 that average 2.6% a year in cash terms and 0.7% a year in real terms. This compares with increases of 0.4% a year in real terms implied by the SFC’s forecasts as of last December. Top-ups to overall UK government capital spending plans mean that capital funding for the Scottish Government may grow a little in real terms between 2025–26 and 2028–29, rather than fall. But growth will be much slower than the bumper increase now planned for next year.

These projections are subject to significant uncertainty, with future funding levels potentially billions of pounds higher or lower because of revisions to forecasts and new policy decisions by the UK and Scottish Government. But the projections do demonstrate two key points: first, that funding in future years is now likely to be higher than expected this time last year, driven by increases in UK government funding confirmed in the Autumn Budget; and second, that despite this, tough choices on tax and spending in future years still loom for the Scottish Government.

These tough choices are illustrated in Figure 4, which shows the implications for other areas of day-to-day (resource) spending of different choices for spending on the Health and Social Care portfolio – the largest single area of Scottish Government spending. The top panel illustrates trade-offs in 2025–26, while the bottom panel illustrates trade-offs in the three years to 2028–29.

The first two sets of columns in each panel show scenarios based on our baseline projections for resource funding set out in Figures 1 and 3 and an assumption that all funding for 2024–25 confirmed in the UK Budget is ultimately spent this year. Increasing the Health and Social Care budget by 3.6% a year (in line with our previous assumption for England) would require a real-terms cut to other areas of spending of 2.3% in 2025–26 and an average of 2.2% a year in the following three years. However, as discussed in IFS research earlier this year, the last plans for the NHS workforce in Scotland were much less ambitious than those planned in England, and health spending has grown by less in Scotland than in England over the last two decades. If the Health and Social Care budget was increased by 2.0% a year in real terms, the cut to other areas would be 0.9% next year and an average of 0.5% a year in the following three years.

The last two sets of columns in each panel show the implications of the same scenarios for health spending based on alternative projections for resource funding that assume that the Scottish Government utilises only half of the increase in resource funding announced in the UK Budget this year, with a quarter used in 2025–26 and the remaining quarter split equally across the following three years. With 3.6% increases in Health and Social Care spending, spending on other areas could increase by 2.4% in real terms in 2025–26, but would need to be cut by an average of 2.4% a year in the following three years. With 2.0% increases in Health and Social Care spending, other areas could increase by even more in 2025–26, but still need to be cut back somewhat in subsequent years.

These figures are of course illustrative, but they show that the Scottish Government looks set to continue to face tough trade-offs in future years. Carrying forward funding would ease trade-offs between services next year. But such funding can only be used once: it will only help the budgetary pressures facing the Scottish Government in later years if it is successfully utilised to help boost productivity, address the drivers of service demand, or boost economic performance and hence tax revenue. Even if successful, such efforts may take several years to bear fruit, meaning without further top-ups to UK spending plans and/or increases in Scottish taxes, some services will likely face cuts in future years.

In this context, the Scottish Government should plan realistically – recent years have seen something of a habit of over-promising and then delaying or scaling back some initiatives in order to free up funding for pay and NHS pressures. Plans for next year will be set in the upcoming Scottish Budget, and plans for later years should be set in a Spending Review in the summer, aligned with the time frames set out in the UK-wide Spending Review planned for late spring. It may be tempting to use these to offer some pre-Scottish election ‘goodies’, but the difficult medium-term funding outlook means continuing with them post-election could mean higher taxes or cuts elsewhere.  

If it feels able to, it may be wise for the Scottish Government to ‘bank’ some of the increase in funding this year (by drawing down less from reserves and ScotWind proceeds, for example), to invest in skills, technology and other ways to boost public sector productivity or more generally to grow the economy. And on the capital side of its budget, it could use its borrowing and reserves powers to smooth out the profile of capital spending over the next few years – money will likely be better spent with a bit more time to plan.

The Scottish Government should also evaluate key policies that increasingly differentiate it from the rest of the UK – including its higher public sector pay and income tax policies and wider tax strategy. Alongside the new decisions announced by the Scottish Government in its Budget, these are issues we will return to in our main post-Budget report.

Since last year, the ECB has included a reference that it aims to keep monetary policy ‘sufficiently restrictive’ for as long as necessary. Following the disinflationary process that has gained traction through 2024, the updated staff projections next week are likely to forecast inflation on target from 2025 and onwards. Thus, whether monetary policy should stay restrictive is likely going to be debated. We believe that the slightly hawkish bias in the ECB’s communication is set to change as the need for a restrictive monetary policy stance in the Eurozone is no longer obvious. But the camps inside the GC are obviously divided. In a recent interview the ECB’s Schnabel said that in her view the restrictive part of the monetary policy stance is already fading. At the same time, we see the dovish camp, for example Villeroy, saying that there ‘won’t be any reasons’ for policy to remain restrictive.

With activity indicators looking bleak heading into 2025, the case for a 50bp rate cut has strengthened, as the starting-point for financial conditions is restrictive based on most measures. However, given the ECB’s sole inflation mandate, and the ‘political’ aspect of having a gradual rate cutting cycle, we believe it will favour a 25bp rate cut.

However, whether the ECB will deliver a 25bp rate cut or 50bp rate cut in December is not that important in isolation, as the communication around it will be key as well. There seem to be diverging views on how to cut the cake. Most recently, Schnabel’s interview clearly suggested that she would opt for a 25bp rate cut, as would Vujcic, while others such as Lane, Villeroy and Centeno are more open to discussing a 50bp rate cut.

That said, rather than focusing on the rate cut next week, we should focus on where the policy rate will end in this cutting cycle, albeit we do not expect any verbal guidance on this. Markets may though interpret a 50bp cut as a signal of a lower terminal rate – and that may even be a signal that the ECB wants to send.

But as we do assume the ECB does not want a hawkish reaction from markets, leading to tighter financial conditions, we expect it to opt for a dovish 25bp cut, focusing on the communication on a potential jumbo cut.

Since the October meeting, the momentum in underlying inflation has fallen further and growth indicators have weakened. The composite PMI indicator declined sharply to 48.3 in November mainly driven by the service sector, which is now also in contractionary territory. Data indicates that the eurozone’s two largest economies, Germany and France, are likely to contract in Q4 while Spain should drive aggregate euro area growth together with Portugal and Greece. The deteriorating growth indicators combined with rising political uncertainty since the October meeting have mainly given ammunition to the dovish members of the ECB. However, the hawks’ last battalion, namely the labour market, continues to show resistance with the unemployment rate remaining at a record low of 6.3% in October and the national account data showing increased employment in Q3.

While headline inflation has increased from the three-year low in September, mainly reflecting base effects, the underlying momentum has continued to ease. The average month-on-month increase in seasonally adjusted core inflation has been 0.14% in the past three months, which is well in line with 2% annualised inflation. Importantly, the lower momentum in underlying inflation has been driven by service inflation where momentum is also quickly approaching the 2% target, according to the ECB’s own seasonally adjusted data. Hence, inflation developments have clearly also supported the doves in the ECB. For the hawks, an argument for a cautious cutting approach is wage growth that remains elevated given the tight labour market. Negotiated wage growth increased to 5.4% y/y in Q3, albeit largely driven by one-off payments, and has averaged 4.6% so far this year, compared to 4.4% in 2023.

We expect the ECB staff to take note of the recent easing in the momentum of underlying inflation and incorporate this into a lower forecast for core inflation next year relative to the forecast in September. We expect core inflation to be revised down to 2.2% y/y in 2025 (from 2.1%) and headline inflation to 2.1% y/y (from 2.2%). Oil futures were 6% lower at the cut-off date for the staff projections compared to December, but gas and electricity futures were higher, so we expect only a marginal reduction in the headline forecast. We expect the growth forecast to be revised down in 2025 to 1.1% y/y from 1.3% y/y due to the continued struggles in the manufacturing sector combined with cautious consumers and a weak German economy. In contrast to the ECB’s previous projections, consumers continue to have an elevated savings rate, which prevents consumption from picking up in the near term. The new staff projections will also include an additional year, albeit we do not attach significant weight to those projections given their embedded uncertainties.

Speculation around a 50bp cut has diminished, with markets now largely positioned for a 25bp move, with only 27bp priced in. However, the post-decision communication will be crucial, given divisions within the Governing Council that could drive a range of market responses.

We view a dovish 25bp cut, where the ECB signals flexibility to adjust the size of future cuts, as the most likely scenario. Such an outcome would likely have a limited impact on EUR/USD, and with the probability of a jumbo cut still being priced in markets. However, should the ECB indicate a preference for continuing the easing cycle in 25bp increments, market pricing could shift, potentially triggering a hawkish response and a moderate EUR/USD rally, albeit given the meeting-by-meeting approach and thereby keeping full flexibility about future monetary policy decisions, we see that as a low probability outcome. By contrast, a 50bp cut – an outcome we believe is underappreciated despite weak euro area growth and inflation – would likely prompt significant EUR depreciation, with EUR/USD potentially dropping sharply.

Looking ahead, the Fed’s December meeting is likely to have a more decisive impact on EUR/USD’s near-term trajectory, with Friday’s US jobs report a critical input. While markets currently assign a decent probability to a Fed pause, we expect a 25bp cut. If this materialises, it should help contain further EUR/USD downside into year-end. Seasonal trends and our short-term valuation models support this view, as EUR/USD appears oversold after its sharp decline since October. We expect the pair to close the year at around 1.06.

From a strategic perspective, we maintain our bearish EUR/USD outlook, driven by the relatively stronger US growth narrative. Our 12M target remains 1.01, making parity a plausible level over the coming year. On the rates side, we note that the significant decline in rates over the past month has brought the spot level for long swap rates close to our 12- month forecast, thus offering a very limited declining profile from here, see more in Yield Outlook – Transatlantic decoupling but not for much longer, 28 November 2024. We do not expect a signal from the ECB to address the French spread widening to peers.

The dominance of Big Tech in digital services has enabled them to scale and grow in unprecedented ways, but has also raised concerns about their expanding power. As the world becomes increasingly reliant on a handful of tech giants and AI technology advances rapidly, governments worldwide are intensifying regulatory efforts.

Google commands 89% of the global search engine market, Apple holds 51% of the U.S. mobile phone and tablet market, Microsoft powers 62% of desktop operating systems and Facebook and Instagram together capture 57% of the social media market. With this stronghold, Big Tech wields significant influence in setting industry standards, shaping consumer behaviors and influencing public discourse.

In response, various proposals have been put forward, including antitrust actions, stricter data protection laws and increased transparency requirements. The U.S. Department of Justice's recent antitrust case against Google marks a historic move against tech monopolies. After a landmark court ruling found the company monopolized the search market, the case could potentially require Google to divest parts of its business. Regulators have also scrutinized companies like Apple and Nvidia, while foreign governments are taking aim over U.S. dominance in digital markets.

The incoming Trump 2.0 administration will play a key role in shaping tech regulation. While uncertainty remains, early indications suggest:

AI Innovation over Regulation: Trump’s approach will likely be shaped by figures like Elon Musk, who emphasize the need for a freer environment for AI development that enables the U.S. to maintain its competitive edge. This likely involves undoing President Biden’s executive order on AI in favor of a more hands-off approach to regulation.

Evolving Antitrust Focus: The scrutiny on Big Tech’s market dominance will persist, but focus may shift towards issues like free speech and competitiveness rather than wholesale breakups of tech companies. FTC Commissioner Lina Khan will likely be replaced by someone with a less interventionist approach, slowing the pace of actions taken against Big Tech firms.

Semiconductor Independence from China: Trump could expand the semiconductor export restrictions introduced during the Biden administration and increase incentives for domestic chip manufacturing.

Loosening Cryptocurrency Guardrails: A friendlier stance on blockchain and digital currencies could reduce SEC enforcement and reshape the regulatory framework for digital assets. These efforts could attract investment and spur advancements, encouraging blockchain applications in various sectors.

For investors, the takeaways are clear: the regulatory landscape for Big Tech is set for change, but the potential challenges from antitrust enforcement and AI regulation may be less severe under Trump. Focus on semiconductor independence, tech advancement and U.S. exceptionalism could create new winners and losers, but these changes will be highly sensitive to policy developments and enforcement. As tech developments evolve, investors should remain vigilant to capitalize on emerging trends while mitigating concentration risks to those companies most scrutinized.

If the prevailing theme in asset allocation since early 2023 has been that bonds are back, a nascent theme today is correlation: Specifically, the negative relationship between stocks and bonds has reemerged as inflation and economic growth moderate.

This is great news for multi-asset investors: It means they can increase and broaden their allocation to risk assets, seeking potentially higher returns with the potential for adding little to no additional volatility within the overall portfolio. Equities and bonds can complement each other in portfolio construction, and both are likely to benefit in our baseline economic outlook for a soft landing amid continued central bank rate cuts.

PIMCO’s multi-asset portfolios therefore focus both on equities, with a slight overweight in the U.S., and on fixed income – especially in high quality core bonds, which we believe offer notable risk-adjusted return potential. Strategic investments in options and real assets can help manage risks, and systematic equity trades may enhance returns and help mitigate risks.

Investors are also considering the potential impact of U.S. policy under the second Trump administration and a narrowly unified Republican Congress. Bond markets had largely anticipated the Trump victory, and given the prevailing economic landscape, we expect bond yields will remain in an attractive range amid the transition to new leadership in Washington. In equity allocations, investors may want to consider U.S. companies that don’t rely as heavily on imports (given potentially higher tariffs), as well as those likely to be buoyed by deregulation and more favorable tax policies. Finally, an allocation to inflation-linked bonds or other real assets could help hedge against the potential risks of increasing inflationary pressures arising from fiscal policy or tariffs.

In our view, staying invested in core, high-conviction trades within a well-balanced portfolio can help investors achieve target objectives while navigating unexpected twists ahead.

While this business cycle has experienced pandemic-related surprises, inflation has now moved down the list of concerns. The precise trajectory of monetary policy may vary, but the Federal Reserve and most major central banks have clearly indicated their intentions to lower interest rates toward neutral. (Learn more in our latest Cyclical Outlook, “Securing the Soft Landing”.)

How do rate cuts affect stocks? Basic principles of asset valuation teach that, all else equal, lower central bank rates (as proxies for “risk-free” rates) lead to higher equity prices. Yet all else is rarely equal, and our historical analysis shows that economic activity has been the dominant driver of equity returns during rate-cutting cycles. If an economy slides into recession, rate cuts alone may not prevent stock market losses. However, if economic activity stays buoyant, rate cuts have potential to boost stock valuations.

There is no guarantee, of course, that these historical patterns will continue, but they can offer a guide. In Figure 1, we focus on the performance of the MSCI USA Index, a broad measure of large and mid cap equities, six months before and after the Fed’s first rate cut in cycles from 1960 through 2020 (the most recent rate-cut cycle prior to the one that began this year). This dataset encompasses nine soft landings and 10 hard landings. In the median soft landing, U.S. equities rallied through the first Fed cut, but performance tapered off three months after the cuts began. In the median hard landing, U.S. equities declined both before and after the first cut, bottoming about three months after the cuts began.

In both hard and soft landings, the initial rate cut typically led to stronger equity performance, at least in the first month or so, as cuts generally boost sentiment and real economic activity. However, before long, equity markets usually start to reflect the prevailing macro environment.

Examining historical equity market performance by factor and sector in the six months after the first rate cut shows that, on average, growth outperformed value, large caps outperformed small caps, and dividend yield and quality offered positive returns overall. Homing in on the six rate-cutting cycles accompanied by soft landings since 1984, we find that later in the rate-cut cycle (approaching 12 months), small caps began to overtake large caps as economic growth accelerated. Additionally, technology, healthcare, and consumer staples generally outperformed, while energy, communications, and financials lagged.

Every cycle is different, as is the macro environment that accompanies it. However, the historical pattern suggests that an equity allocation today could effectively combine secular growth themes with more defensive, rate-sensitive beneficiaries, such as real estate investment trusts (REITs).

Historical analysis also shows that bond returns have been positive during Fed rate-cutting cycles across a range of macroeconomic environments. Moreover, analysis indicates that the starting yields of high quality core fixed income securities are strongly correlated (r = 0.94) with five-year forward returns. Thus, today’s attractive starting yields bode well for fixed income investments.

As the Fed proceeds with rate cuts, bond investors may benefit from capital appreciation and earn more income than what money market funds provide. In multi-asset portfolios, conservative investors can seek higher risk-adjusted returns by stepping out of cash and onto the curve, while balanced portfolios can increase duration exposure. Of course, high quality bonds may also offer downside mitigation in the event of a hard landing.

Within fixed income, high quality credit and mortgages can enhance yields and serve as diversifiers. In particular, agency mortgage-backed securities (MBS) appear attractively valued, with spreads over U.S. Treasuries near historical highs, making them a liquid alternative to corporate credit. Historically, agency MBS have also provided attractive downside resilience for portfolios: During recessionary periods, they have delivered an average 12-month excess return of 0.91 percentage points above like-duration U.S. Treasuries, versus −0.41 percentage points for investment grade corporates.

The stock/bond correlation tends to turn lower and then negative as inflation and GDP growth moderate, as is the case in the U.S. and many other major economies today. Analysis of monthly measures of stock/bond correlation data since 1960 tracked against inflation rates indicates a clear trend: When inflation is at or near central bank targets (around 2%), as has generally been the case in developed markets since the 1990s, the stock/bond correlation has been negative or very narrowly positive.

In practice, a low or negative stock/bond correlation means that the two asset classes can complement each other in multi-asset portfolios, enabling investors to broaden and diversify their exposures while targeting return objectives.

For instance, investors with a specific risk budget can own a greater range and number of risk assets while staying within their tolerance, while investors with a predefined asset allocation mix can target lower volatility, smaller drawdowns, and higher Sharpe ratios (a measure of risk-adjusted return).

In general, negative correlations can enable asset mixes that experience lower volatility than any individual asset, while still targeting attractive returns. A hypothetical efficient frontier exercise helps illustrate this (see Figure 2): When the stock/bond correlation is negative, there are regions along the lower-risk portions of the frontier where investors may target an asset mix that offers a somewhat higher potential return profile despite a drop in expected volatility.

A lower volatility from portfolio beta could also free up space for more exposure to alpha strategies, such as systematic equities – more on this later.

For multi-asset investors able to access leverage, negative stock/bond correlations could allow even higher total notional levels for a given risk target, as long as the portfolio returns exceed borrowing costs. The value of leverage in a diversified portfolio tends to be greater when correlations are negative.

A look at the historical extreme (“tail”) scenarios of negative returns in a simple multi-asset portfolio consisting of 60% stocks and 40% bonds further illustrates the beneficial characteristics of a negative stock/bond correlation (see Figure 3). Periods with positive stock/bond correlation have typically seen more severe (worse) left-tail outcomes for multi-asset portfolios than periods with negative correlations. This is true even though most recessions have had deeply negative stock/bond correlations, because equity drawdowns were partially offset by gains in the fixed income allocation.

While the opportunity set for multi-asset portfolios is rich, elevated risks related to public policy, geopolitics, and monetary policy mean that investors should consider designing portfolios capable of withstanding unlikely but extreme tail events. Even as one of the biggest global election years in history (by voting population) concludes, uncertainty remains about how policies could affect inflation, growth, and interest rates. Additionally, ongoing conflicts in the Middle East and between Russia and Ukraine, and potential for geopolitical unrest elsewhere, could roil markets.

While the negative stock/bond correlation means portfolios may be better positioned to navigate downturns, it can’t prevent and may not mitigate all the risks of tail events. But investors have other strategies available, such as dedicated tail risk management. Active drawdown mitigation may include selectively using options when volatility is reasonably priced. The availability of volatility-selling strategies in recent years, including the rapid growth of options-selling ETFs, has increased the supply of volatility options, especially in the short end of the yield curve. This trend can make downside hedging more economical during opportune times.

We also believe it is prudent to hedge multi-asset portfolios against upside risks to inflation. Although restrictive central bank rates have brought inflation levels down close to targets, the long-term fiscal outlook in the U.S. includes continued high deficits, and geopolitical surprises could cause a spike in oil prices or snarl supply chains. Trade policies, such as tariffs, and deglobalization trends could also pressure inflation higher. We believe inflation-linked bonds (ILBs) remain an attractively priced hedge, offering compelling return potential as long-term real yields are currently near their highest levels in 15 years. Furthermore, long-term breakeven inflation rates are priced around or below the Fed’s target, reflecting little to no risk premia despite the recent memory of a sharp inflation spike.

In any investing environment, it’s helpful to step back from the analysis of risks and opportunities to assess one’s investment process. At PIMCO, in addition to our investment views based on macro and bottom-up research, we use quantitative methods to help identify equity market inefficiencies and target structural alpha. Our process emphasizes diversification, minimizes concentration risk, and seeks to overcome behavioral biases.

First, we research and assign a composite score to a stock based on four key themes: momentum, growth, quality, and value. By integrating traditional metrics, such as earnings growth, with alternative data, such as insights from earnings transcripts and customer-supplier relationships, we aim to identify companies with potential for long-term outperformance.

The composite scores are then combined with considerations of risk and transaction costs to construct a highly diversified allocation that reflects conviction levels while adhering to various constraints. These include limits on active risk, market beta exposure, and concentration risk at the country, sector, and individual company levels, ensuring only modest deviations from the broad market.

With a systematic approach, rigorous research, and advanced analytical tools, including proprietary techniques, our strategies are designed to offer consistent excess return potential across different market conditions.

Investors can position multi-asset portfolios thoughtfully to seek to benefit from market trends while managing risks in an uncertain environment. As central banks continue to cut rates amid an outlook for a soft landing, both equities and bonds may do well. High quality core fixed income should be especially well-positioned.

A lower or negative stock/bond correlation allows for complementary and more diversified cross-asset positioning, especially for those with access to leverage. A robust options market can help investors hedge downside risks. Finally, making use of quantitative techniques and innovative tools can help smooth returns and lay the foundation for disciplined investing across market cycles.

The U.S. economy added 227k jobs in November, in line with the consensus forecast calling for a gain of 218k. Payroll figures for the two prior months were revised higher by 56k.

Private payrolls rose 194k, with the largest gains seen in health care & social assistance (+72.3k), leisure & hospitality (+53k), professional & business services (+26k) and manufacturing (+22k). The gain in manufacturing were largely payback from the month prior following the resolution of the Boeing strike. The public sector added 33k new positions last month.

In the household survey, civilian employment (-355k) fell by considerably more than the labor force (-193k), which pushed the unemployment rate up to 4.2%. The labor force participation rate fell 0.1 percentage points to 62.5% – a six-month low.

Average hourly earnings (AHE) rose 0.4% month-on-month (m/m), matching October’s gain. On a twelve-month basis, AHE were up 4.0% (unchanged from October). Aggregate hours worked rose sharply, up 0.4% m/m.

This morning’s release provided further evidence that October’s soft employment report was more to do with temporary effects stemming from hurricanes and labor disputes, and not a sudden deterioration in the labor market. Not only did job creation regain its vigor in November, but revisions to prior months were also a tad higher, and aggregate hours worked grew at the fastest pace in eight months.

Smoothing through the recent volatility, job gains have averaged 173k over the past three-months, or only a modest stepdown from the 186K averaged over the prior twelve-month period. But this likely overstates the degree of “strength” in the job market. A broader sweep of the data suggests that the labor market has already come back into better balance, and is no longer a meaningful source of inflationary pressure. Moreover, the fact that the labor force has contracted in each of the past two-months suggests that job seekers are starting to internalize the fact that jobs are becoming harder to come by – a further indication that the labor market is cooling. This should give policymakers the assurance they need to cut by another quarter-point later this month. But with inflation progress showing early signs of stalling and some of the incoming administration’s policy proposals (including the potential for tax cuts and tariffs) viewed as inflationary, the Fed is likely to proceed more cautiously with easing its policy rate in 2025

The AI revolution is a power-hungry one. The tech giants see that current electricity supply falls far short of what is required to power the massive new AI data centres they hope to build. They are already taking dramatic steps to secure stable, long-term power sources. Microsoft has contracted with Constellation Energy to reopen one of the old nuclear reactors at Three Mile Island. Google and Amazon are striking deals with US utilities and other providers to create small modular nuclear reactors (SMRs) for their planned AI data centres. But these are all long-term projects - for 2030 and beyond in the case of the latter two. What about the energy needs right here and now, as the AI arms race reaches new white-hot intensity already in 2025? 

In 2025, US power prices spike higher in several populated US areas, as the largest tech companies scramble to lock in baseload electricity supplies for their precious AI data centres.  This inspires popular outrage, as households see their utility bills skyrocket, aggravated by the huge spikes in power prices for electricity consumed at home during peak load periods in the evening. In response, many local authorities move in to protect political constituents, slapping huge taxes and even fines on the largest data centres in a move to subsidise lower power prices for households.  The taxes incentivise investment in massive new solar farms with load balancing battery packs, but also dozens of new natural gas-driven power stations, even as the demand for ever more power continues to rise faster than supply. Rising power prices drive a new inflationary impulse. 

A massive boom in US investment in power infrastructure. Companies like Fluor rise on signing massive new construction deals. Tesla’s accelerating Megapack gets increasing attention. Long-term US natural gas prices more than double, a significant contributor to a more inflationary outlook.