2025 Recap, 2026 Reality: What Investors Need to Understand Now

What investors need to understand now, and what markets may be underestimating.

Markets have a habit of creating confidence just as risks start to shift.

2025 was a good example. Inflation looked beaten. Rate cuts arrived. Asset prices responded accordingly. And yet, by year-end, investors were once again grappling with uncertainty around inflation, policy direction and global stability.

As CIO at Mutual Limited, my role is to help translate market complexity into clear, practical guidance for investment team, and where helpful, our clients.

For investors generally, one of the most important truths in investing is that there is no single “right” portfolio for everyone. The way a diversified portfolio is positioned should reflect who you are as an investor — not just what markets are doing at any point in time.

Risk, time and diversification: the anchors

Two factors dominate portfolio construction.

The first is risk appetite. It is your ability to tolerate volatility, particularly during periods of market stress when assets all and uncertainty rises.

The second is time horizon. Investors with long timeframes can afford to ride through short-term volatility in pursuit of higher long-term returns.  Investors closer to drawing on capital generally prioritise income, stability and capital preservation.

Diversification sits at the centre of this framework. By combining growth assets such as equities with defensive assets like bonds, credit and cash, portfolios can be structured to balance risk and return appropriately. The exact mix will differ from one investor to another, but the underlying principle is consistent: your portfolio should be designed to help you achieve your goals while allowing you to stay invested with confidence through market cycles.

2025 in context: expectations drove outcomes

2025 was ultimately a year shaped by the interaction between monetary policy, inflation surprises, global growth narratives, and evolving geopolitical ‘normalities’. For Australian investors, returns across equities, government bonds and credit were driven less by single events and more by how expectations shifted over time, particularly around interest rates and economic resilience. 

Local markets were also heavily influenced by offshore developments, with global monetary policy, US asset-market leadership, China’s uneven recovery and geopolitical risk all playing a decisive role in shaping local asset prices, sector performance and capital flows. For the most part, geopolitical machinations was just white noise, but heading into 2026, the signal is becoming more deterministic, with potential for heightened uncertainty and risk aversion.

The dynamics of 2025 set the stage for 2026, where markets are likely to remain highly sensitive to inflation data, policy credibility, global growth momentum and the structurally evolving geopolitical landscape. 

Interest rates and bonds: a year of reversal

The year began with growing confidence the inflation dragon had been conquered and summarily slain, empowering central banks to begin easing policy settings.  With domestic inflation within target, the RBA cut rates three times, reducing the cash rate down to 3.60%. This supported bond returns, lifted equity valuations, and provided a favourable environment for credit.

Unfortunately, inflation was only playing possum. Structural headwinds (energy & housing) underpinned a resurgence inflation risk, forcing the RBA to pause its easing agenda and ultimately consider a full 180-degree pivot.  By late 2025, investors had largely abandoned all hope of further easing, and Australian bond yields rose sharply. This repricing weighed on rate-sensitive equities and reversed some earlier bond gains.

Australian government bonds performed well in the first half of the year as rate cuts were delivered. However, the inflation surprise in the second half drove a sharp reversal, particularly in shorter-dated bonds. Higher expected government issuance following the Federal Budget also contributed modestly to upward pressure on longer-term yields.

The result was a year where timing mattered, with bond returns strongest for investors positioned early in the easing cycle. Government bonds returned a modest +2.51% in 2025, moderately better than 2024 (+2.26% YoY) with bonds up +3.82% at the halfway mark before falling -1.26% over the second half as inflation resurfaced and an RBA policy pivot was priced in.  Between 2000 and 2025 government bonds have averaged +4.62%.\

The RBA is expected to begin hiking rates in 2026, with a strong case for the first hike coming at the next meeting (February) according to some market pundits. Personally, I think they’ll sit pat for the time being but expect the next move will be up when it comes. 

Equities: resilient returns, rising risks

The ASX 200 delivered modest positive returns in 2025, supported by strong bank earnings, dividend income and early-year rate cuts. Resources contributed intermittently, linked to commodity price movements and Chinese policy expectations.

Performance, however, was uneven across sectors. Rate-sensitive assets such as REITs and infrastructure performed well early, then lagged as bond yields rose later in the year. Equity leadership shifted repeatedly as markets oscillated between optimism about growth and concern about inflation persistence. The local market also materially lagged offshore markets.

Many strategists are cautiously optimistic about further gains in 2026, reflecting expected earnings growth (don’t they always), decent macro fundamentals and continued yield support from dividends, even if returns are more modest than in 2025. There’s a range of views with some strategists suggesting the market could rise moderately on multiple expansion or moderate earnings recovery, and others warning of volatility due to inflation or rate uncertainty.

Strategists have the ASX 200 ending 2026 in the ~8,900 to 9,500 range (with variations around this depending on the firm and methodology). This reflects a modest upside outlook from current levels, with potential upside linked to earnings growth and global sentiment, balanced by risks from inflation, policy shifts and sector rotation.  At the time of writing, the ASX 200 was around 8,786, suggesting modest 2026-year end upside, somewhere between +1.7% YoY and +8.6% YoY.

While the consensus view is for the index to close higher, caution is certainly warranted given valuations are elevated compared to historical averages.  The ASX 200 has risen +20.0% since April 2025, when the index had its last correction.  The index is less than 3.0% below record highs and is trading at a 21.0x forward PE ratio, well above historical averages (17.0x).  Markets are pricing a favourable outlook, suggesting earnings will grow into these PE levels.  Maybe, but there are potential bumps on the road ahead. 

The earnings yield on the ASX 200 is modest at 4.77%, well down on historical averages of 6.40%.  Meanwhile, while the yield on 10-year government bonds is 4.78%, giving us an ‘Equity Risk Premium’ or ‘ERP’ of -0.01%, which is well below historical averages +2.70% (2005 to now).  This suggests an investor would earn a better yield from buying a ‘risk-free’ bond, with low-to-modest return volatility (1.21%) than buying equities, with materially higher return volatility (3.80%).

Credit: consistency in an uncertain environment

Australian credit markets have a reputation for generating steady returns, with only modest volatility, and 2025 kept that reputation intact.  

Floating rate credit returned +4.97% YoY, outperforming fixed rate credit with +4.34% YoY.  Aside from the odd flare up, which are typically triggered by a global systemic shock, i.e. Trump’s tariff policies in April, spreads traded in a relatively tight range through 2025. 

Throughout the year primary issuance was comfortably absorbed with no apparent indigestion, and underlying fundamentals remained robust – although as the Australian credit market is very much investment grade, and dominated by banks, this is par for course.  Liquidity conditions underpinned confidence, with Australia become a more meaningful market.  Strong growth in the structured credit market has contributed to this and given systemic changes to funding markets, the local market should continue to grow healthily.

With equities trading near record highs amid growing uncertainty many investors increased allocations to credit. History supports this approach.

Case in point was covid, credit fell 2% - 3%, but still paid income, whereas equities fell 30% - 40% with many firms pausing dividend payments. 

Short of some cataclysmic change in the geopolitical landscape, such as WWIII or something similar, credit spreads are expected to remain within a tight range through 2026. With the RBA expected to tighten policy at least once, possibly twice, floating rate credit should outperform fixed rate credit, providing steady income flows with minimal capital downside.

What this means for investors

This post is not about advocating for one assess class over another. It is about understanding relative value, risk and the trade-offs investors face.  

Different investors require different outcomes. The right portfolio is one that aligns with personal objectives, risk tolerance and time horizon, and allows investors to remain disciplined through market cycles.

Markets will remain uncertain. Portfolios should be built with that reality firmly in mind.

For investors wary of downside risk, who favour income stability with minimal capital risk, floating rate credit could be you.  Broadly speaking, over the past 25 years, investment grade A$ floating rate credit (per the AusBond Credit Index) is the only asset class to generate positive annual gains every year and monthly has generated gains 94% of the time (fixed rate credit is 79% of the time). During tightening cycles, floating rate credit has outperformed fixed rate credit 78% of the time.

For context, the ASX 200 has generated annual (calendar) gains 70% of the time and monthly 60% of the time.