Balancing fixed income risks amid rising uncertainty

Uncertainty surrounding the impact of the US administration’s policy plans weighed on markets, including the implementation and reversal of tariffs, job cuts across the federal workforce and tightened immigration enforcement.

US growth momentum has slowed, with significant uncertainty in the outlook and risks likely skewed to the downside. Fundamentals had been resilient, with consumer spending supported by real income growth, firm labour market demand and relatively low unemployment on a historical basis. However, tariff announcements and broader policy uncertainty have contributed to weakening consumer and business sentiment and have the potential to negatively impact real incomes, business investment and inflation. Recession risks appear to be rising.

Inflation dynamics complicate the Federal Reserve’s (Fed’s) policy decisions. Inflation implied by the Consumer Price Index and the core Personal Consumption Expenditures Index remains elevated. The Fed has indicated that it is seeking clarity on the impact of the Trump administration’s policies before it moves again, having cut the federal funds target rate by 100 bps in the last few months of 2024. Still, broader economic growth challenges and possible labour market weakness could lead to more cuts this year.

Potential policy changes from the Trump administration have raised the degree of uncertainty in the economic outlook and could weigh on global growth. The distribution of outcomes related to tariffs, taxes, regulation and international relations seems unusually wide. The initial impact of announced tariffs could meaningfully lower global growth. While the starting point for growth looks stronger in the US than in other global regions, the risks to the US seem skewed to the downside.

While economic fundamentals in many international regions currently look weaker than in the US, fiscal responses could be supportive over time. Following decades of a stable alliance, Europe is responding to a more isolationist US with increases in fiscal stimulus, which could in turn spur economic growth over the medium-to-longer term.

German stimulus and the EU’s plan to raise defense spending under ReArm EU are positive steps that should pave the way for closer European integration and faster growth in the coming years. Meanwhile, the European Central Bank appears set to lower interest rates, with the balance of risks tilted toward additional cuts given the growing chance of a trade war between the US and Europe.

In Asia, China has started to stabilise, although stimulus remains limited. That trend could change as Chinese officials look toward more fiscal measures to offset tariff risks.

Given heightened uncertainty, we are focused on building resilience and balance in portfolios. The implications of recently announced tariffs in the US could significantly alter the global growth picture, a scenario which markets are beginning to appreciate. We have looked to construct portfolios that reflect balanced risks across excess return drivers. We favour credit sectors where the income component is relatively more compelling.

We believe positioning for a steeper yield curve offers favourable risk-reward dynamics and could serve as a risk-off hedge to complement risk exposures elsewhere. In our view, the steepener position could benefit either in a worse-than-expected economic slowdown or with inflation and deficit dynamics driving long-term yields higher. We view duration more positively given that growth momentum is slowing, uncertainty is building and recession risks are rising. An underweight position in global duration could be beneficial as fiscal stimulus in non-US developed markets might cause the differential between US and non-US rates to narrow.

Within credit, we are maintaining an up-in-quality bias with a tilt toward more defensive areas of the market. This positioning reflects our concerns around increased macro and policy uncertainties. Though credit fundamentals have been sound, volatility and downside risks are likely to remain elevated. We believe select exposures across high-yield and emerging markets debt remain attractive, though credit selection is key.

We believe positioning for a steeper yield curve offers favorable risk-reward dynamics and could serve as a risk-off hedge to complement risk exposures elsewhere. In our view, the steepener position could benefit either in a worse-than-expected economic slowdown or with inflation and deficit dynamics driving long-term yields higher. We view duration more positively given that growth momentum is slowing, uncertainty is building and recession risks are rising. An underweight position in global duration could be beneficial as fiscal stimulus in non-US developed markets might cause the differential between US and non-US rates to narrow.

Within credit, we are maintaining an up-in-quality bias with a tilt toward more defensive areas of the market. This positioning reflects our concerns around increased macro and policy uncertainties. Though credit fundamentals have been sound, volatility and downside risks are likely to remain elevated. We believe select exposures across high-yield and emerging markets debt remain attractive, though credit selection is key.

 

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