Quarterly fixed income outlook: April 2025 | Insight Investment

It seems likely to be the actions of the US administration that will be a guiding impulse on growth and inflation. As US import tariffs take hold, economic theory suggests they are likely to create higher US inflation and dampen growth outside the US. Retaliatory tariffs elsewhere could put upward pressure on inflation in the other countries and squeeze US exports. Overall effects may be difficult to quantify and the timeframes for those effects will be equally challenging to predict. Higher inflation generally may make monetary policymakers reticent to ease interest rates further, which could have an additional stifling effect on activity. Additionally, geopolitical events and uncertainty remain key concerns for many investors, with the conflict in Ukraine still showing no definitive signs of ending.

While the imposition of import tariffs could see some switch in demand to domestically produced goods or relocating of production into the US, any reciprocal tariffs could have detrimental effects on US exports. Inflation is expected to remain around current levels, and struggle to reach the target level, remaining at or just above 2.5%, while the slow descent of inflation towards the 2% target level will not be helped by tariffs. We believe growth will be around 2.0% this year, decelerating sightly to around 1.7% in 2026. The Federal Reserve is likely to ease policy only slowly with two rate cuts of 25bp in 2025, and two more in 2026, in our view. Policymakers could halt easing completely if inflation rises, even with a weaker economy, until they believe price pressures are back under control. Despite the risks of higher inflation, we believe the prospect of softer growth will see 10-year US Treasury yields fall back in the next year, to around 3.90%.

Prospects for growth in the eurozone continue to be soft, affected by US tariffs, although the anticipated fiscal expansion in Germany and potentially elsewhere could help offset that drag. On the path toward sustainably achieving target inflation, the eurozone is well ahead of other regions. While wage growth had been elevated, we believe that is likely to moderate as 2025 progresses, which will help reaching that objective for inflation overall. The European Central Bank is likely to continue easing policy and we now forecast that rates will be brought down to 2% by the end of 2025, remaining there for some time thereafter. The recently approved changes permitting Germany to expand its borrowing on both infrastructure and defence spending mean we have raised our expectations for German government bond yields. We now see 10-year German yields at 2.55% 12-months ahead, and longer-dated yields closer to 3%.

UK growth is expected to sub-trend but marginally positive expansions both in 2025 and 2026. The labour market is likely to remain relatively tight though with fragile confidence. Inflation continues to exceed the target level of 2% with the path to achieving that objective remains gradual at best, even if the UK can avoid the worst of the US tariffs. We see consumer price inflation being around 3.2% for 2025 although there are risks to the upside but believe it will decline to around 2.5% in 2026. We expect the Bank of England will be able to cut rates further, though not substantially, taking the base rate to 4.0% later this year. In a slower growth environment, the government could be faced with needing to spend more, even despite having sought spending reductions through recent budgetary cuts. With that in mind, we have increased our yield forecasts, seeing 10-year gilt yields being slightly below prevailing levels in a year’s time, at around 4.35%, with shorter-dated yields lower than that and with higher yields at longer maturities.

In China, we do expect some modest improvement in domestic demand. Despite the drag from the property sector is reducing and there is policy support from fiscal as well as the focus on measures to support consumption from the National Peoples’ Congress may help. However, the external sector will likely move from a tailwind to a headwind due to the tariffs imposed by the US, particularly if they are imposed to any significant degree. The picture across other emerging markets is mixed, with individual nations facing differences in the levels and extent of US tariffs. Mexico is a key provider to the US and may be one of the harder-hit countries, affecting its growth prospects, while other countries may escape the same degree of sanction. The path of inflation is otherwise still generally downward, which in the absence of pressure on currencies, could provide individual central banks with the capacity to continue easing policy, or as in the case of Brazil, to reverse begin reversing recent rate increases.

Overall, despite the uncertainty, we remain cautiously positive on investment grade credit. Although spreads remain at the tighter end of historical averages, many corporates have strong fundamentals, and the high absolute level of yields continues to draw investors towards credit markets. We expect issuance to remain elevated through the first half of 2025 as corporate treasurers seek to take advantage of the level of demand. This could create attractive opportunities to add exposure cheaply. A significant driver of returns might be the extent the headwind to global growth from tariffs could be offset by interest rates, if they are reduced to underpin activity. Politically induced volatility typically provides significant opportunities for active managers, creating the potential to add value by identifying those companies and sectors likely to benefit or suffer from the new policies.

Although we acknowledge the potential for further volatility until political uncertainties subside, we would view the widening in spreads as an opportunity to increase allocations to the asset class. While tariffs may pose a challenge to growth, lower interest rates and a more favourable outlook for European growth, bolstered by the announcement of the German infrastructure programme, a modest upward trajectory is expected to be maintained. That would create a backdrop likely to be supportive for high yield, with many companies already boasting strong fundamentals and robust cashflows. Defaults remain low, and we see few signs of stress in the market. Demand for the asset class remains high, as the level of absolute yields offers the potential for investors to generate meaningful compound returns over time. We see increased issuance creating ample opportunities for active managers to select issuers they view favourably and invest in higher coupon issues.

Valuations for investment grade sovereign and corporate emerging market sectors remain tight by historical standards, particularly corporates, both in absolute terms and relative to the US. High yield sectors are similarly tight, and the cyclical backdrop currently appears neutral at best. We do see some tactical opportunities in all hard currency areas, but they are few. Local currency markets offer a more attractive opportunity set, particularly where real yields are historically high in places such as Brazil, Colombia and Turkey. Emerging market currencies do not offer widespread appeal at present, though some tactical opportunities exist in some places.

We expect a continuation of the trends that have been a feature in recent years, but with slightly lower cash rates resulting in modestly reduced returns. With spreads appearing attractive relative to similarly rated corporate credits, we see little reason for demand to materially decline. We aim to remain an active buyer in primary markets, seeking to capitalise on new-issue premiums and more broadly seeking out relative value opportunities that we see offering attractive risk-reward profiles. Our preference remains for issues with seniority in the capital structure and robust transaction structures that divert cashflow in the event of underperformance in the underlying asset pool. Strong underwriting and servicing policies may also act to insulate investors if the economy weakens.

In an increasingly uncertain environment, muni investors may be able to find reassurance in the substantial reserves and cash balances accumulated by state and local governments over recent years. We believe those reserves could help enable issuers to navigate periods of adverse economic conditions. Currently, we favour a long duration position given the steepening of the municipal curve through the first quarter. At a sector and issuer level, we believe significant relative value opportunities exist. Airports and toll roads generally offer good value, in our view, while mass-transit systems remain challenged due to the number of workers (users) still operating remotely. We continue to favour essential utilities such as public power and water providers over state obligations. These utilities typically benefit from stable revenue streams and predictable cashflows.

We expect disruptions to continue as President Trump’s agenda unfolds. Trade risks are likely to remain elevated at least until there is greater clarity over the imposition of the so-called “reciprocal tariffs” and on the final form of the tariffs imposed on Canada and Mexico. Although the second quarter might be the peak of trade uncertainty, the fallout on global growth and inflation will likely take some time to manifest. In the US, we look for slower growth as uncertainty weighs on both businesses and consumer, although a temporary bounce from the weather affected January is certainly possible. Against this backdrop fiscal policy will need to play a key role in supporting US growth. In the short term, we are cautious about chasing USD weakness after its recent decline, risks to the Fed’s outlook more two-sided, and announcements on reciprocal tariffs. Nonetheless, the expected policy response from the eurozone is meaningful and we do believe we are close to peak policy uncertainty, and possibly peak US exceptionalism, as such we look for opportunities to sell the USD on rallies.