Michael Metcalfe, Head of Macro Strategy, State Street Markets, has provided the following 2025 market outlook, ‘Market Signals and Shifts’, which identifies a number of pressing questions, the answers to which would shape global financial markets this year. But in just three months, the market’s conviction, as captured in concentrated positions in risk and US assets, has quickly evaporated in the face of policy and economic uncertainty.
As we move into the second quarter, we return to these questions, and using State Street’s metrics of investor behavior, assess the recent dramatic market adjustments. Do they mark a bottom or are they the start of a longer-term adjustment process?
Will investors remain overweight equities in 2025?
Investors came into 2025 with an extended overweight position in equities. Over the past 25 years, the average allocation to equities has sat around 20 percent above investors’ allocation to fixed income (in keeping with the 60/40 portfolio). In January, the equity allocation stood at 27 percent above fixed income, a 15-year high.
As we noted in January, given allocations to equities relative to bonds typically fall during Fed easing cycles, this overweight position represented a potential vulnerability for asset markets — a vulnerability that has been realized as policy and economic uncertainty has risen sharply in the first quarter. In response, investors have rapidly reduced their allocation to equities, but from historically high levels.
And given the sheer size of the overweight position in equities, the reduction through early April has resulted in the allocation to equities relative to bonds falling from 27 percent to 25 percent (Figure 1). So asset managers still have some way to get back to a benchmark allocation of equities should uncertainty and cyclical news get worse from here.
Can the US remain exceptional?
Asset managers began to reduce their significant overweight position in US equities in the closing months of 2024, but still came into the year broadly positioned for US exceptionalism — a view that has been challenged so far in 2025.
The overweight in US equities has fallen by around a third and now stands at its lowest level in three years (Figure 2). European equities have been the prime beneficiary of this shift, as investors eliminated their underweight in the region’s equities and have begun to build an overweight. While this overweight remains modest in aggregate, it is very uneven on a sector basis and our data suggests that as of the end of Q1, investors now have larger active overweight in European banks than they do in US tech.
The bottom line is that investors are still positioned for US outperformance, but their conviction in the idea is at a three-year low. We now await whether relative fundamentals will encourage investors to remain overweight US or rebalance further in 2025 and begin to eliminate their still substantial underweight in emerging market equities, which remains larger than where it began the year.
Is there trouble ahead for Treasuries?
Asset manager demand for US Treasuries has been both a source of hope and a potential risk for some time. In December 2023, the resiliency of asset manager demand for Treasuries was one our seven surprises for 2024. In the end, that resiliency held for much of the year. But asset manager demand for Treasuries and duration in particular ended the year timidly and what was previously resilience now remains a potential risk for 2025.
In aggregate and on a duration-weighted basis, demand for Treasuries has been in the bottom quartile of observations seen over the past five years for much of the first quarter. As of early April, reduced growth expectations and the weakness in equity markets have not resulted in a recovery in demand for Treasuries, particularly long-dated Treasuries.
This will prove an interesting test in the second quarter and for the remainder of the year as to whether potential impediments to inflows into Treasuries, from concerns about future inflation or future deficits, can be allayed or more fully offset by weaker economic news. Here our real-time, high-frequency inflation data from PriceStats will, at least, give us a timely read on how quickly (or not) actual tariffs or even the looming threat of them is impacting price formation.
Will the US dollar strength persist?
In a similar vein to US equities, asset managers began 2025 with a significant overweight in the US dollar. This overweight took many different forms, but was best demonstrated in changes to managers observed hedging activity
(Figure 4).
For fixed-income managers based in the US, the fear of a rapid US dollar appreciation following the US Presidential election manifested itself in a surge in forward US dollar buying that took their hedge ratio on their foreign bond holdings to a peak of near 80 percent, a 25-year high. This ratio peaked in mid-January and as the feared US dollar overshoot failed to materialize, US managers sold their US dollar forward rapidly to bring their hedge ratio back down below 60 percent and close to its long-term average. This part of the US dollar unwind would seem therefore to be done.
However, not all investors have adjusted to the US dollar’s weaker trend. Non-US investor hedge ratios on their US equity holdings remain unusually low. This means that for all the foreign buying of US equities in the past five years, there have been relatively more forward sales of the US dollar to offset the currency risk. This is understandable as typically during this period the US dollar has offered a natural hedge to equities. Generally when equities have declined, the US dollar has appreciated given its empirical safe-haven status.
But this relationship has been challenged so far in 2025. As investors have reduced their US asset holdings, the US dollar has depreciated alongside equity market declines. This may challenge the view that non-US investors should maintain such a low hedge ratio on their US equity exposures and is one area we will watch closely in Q2 for a potential continuation of forward US dollar sales from asset managers.
Q2 and beyond
In response to the unprecedented uncertainty about policy and the economic outlook, investors have reduced their exposures to risky assets. But as of the first week in April, holdings of equities in aggregate, and US equities in particular, remain above benchmarks and long-term historical averages. To that end, they remain vulnerable to further position unwinds should escalations in the trade war or recession risks grow in the coming months. At the same time, we are watching carefully how asset manager demand for Treasuries evolves in light of concerns surrounding fiscal deficits and inflation expectations.
Finally, and in a departure from post-COVID trends, asset managers have also reduced their US dollar holdings, as they have reduced their risk appetite. Having begun the year with a significant overweight in the currency, asset managers begin Q2 with US dollar holdings close to neutral levels. But we note that non-resident investors still have unusually low hedge ratios on their US equity holdings, which may prompt further US dollar selling in Q2 if the usually reliable link between the US dollar and equity performance continues to be questioned.
