Third quarter outlook: Downside risks to growth

In the soft-versus-hard landing debate, the soft-landing camp has so far been the clear winner. The global economy has been much more resilient to global trade policy shocks than many had predicted. Several factors may have contributed to this resilience: (1) the gradual increase in effective tariff rates; (2) the slow pass-through of tariffs to consumer prices; (3) relatively healthy private sector balance sheets; and (4) the ongoing artificial intelligence (AI) capital expenditures (capex) boom.

US economic growth has slowed only modestly since the tariffs were initially announced. Consumer spending and housing have slowed, but corporate investment has remained strong. However, we have seen a more significant cooling in the labor market with employment growth falling toward zero. Labor market weakness has largely been due to a lack of hiring, with layoff rates remaining relatively low. A sharp decline in immigration has also slowed labor supply growth.

Within the gross domestic product (GDP) versus employment growth divergence, we are more focused on the weakness in the labor market and the attendant downside risks to growth that go with it. Ultimately, near-zero employment growth is not consistent with healthy real GDP growth. As a result of the downside risk to growth, we are bullish on US bonds, cautious on corporate credit, and positioned for further weakness in the US dollar. We also remain constructive on emerging market (EM) local currency bonds. Year to date, this asset class has outperformed the US equity market. Going forward, EM bonds should continue to benefit from relatively elevated real yields, attractive currency valuations, the absence of major macroeconomic imbalances, and limited foreign ownership levels.

Going into the fourth quarter of 2025, it seems logical to expect and position bond portfolios for what has been a dominant market influence over the past several years—range-bound yields with many opportunities to earn the coupon. We are not looking for a repeat of the fourth quarter of last year, but developed market (DM) bond markets may deliver something that rhymes with it. Similar to last year, we are seeing an uptick in monetary stimulus with many central banks easing policy rates. Even the Federal Reserve (Fed) has restarted its 2024 easing cycle. Meanwhile, fiscal stimulus could be shifting back to more of a positive influence as the massive US tax and spending bill, or OBBBA, starts to kick in. The challenge for bond investors in the fourth quarter will be to determine whether the fiscal drag from the tariffs, which are a tax on consumption, offsets the positive impact of the OBBBA.

For more clarity on the uncertainty around the US labor market, initial jobless claims will be among the most important economic data points as they will be a timely gauge of whether the demand for labor is softening. The supply of labor also is shrinking, but alone that may not be enough to move 10-year Treasury yields meaningfully below 4%. Another high frequency economic report to watch is US mortgage applications for signs that the housing market is recovering in response to lower mortgage rates.

Unless there is a breakout, we expect the fourth quarter will be an extension of investing in the recent range. The US economy has been range-bound for the last few years so, it is no surprise the bond market also remains constrained (see Exhibit 1). We will have less conviction in the middle of the range and more on the extremes. If 10-year Treasury yields rise above 4.50% and close to 5%, in particular, we expect the Trump administration would act as backstop. Similarly, the current health of the economy does not support benchmark yields meaningfully below 4%. There might be better relative value in the unloved 30-year part of the curve as the steepening trade has been popular. However, the “pain trade” will be if the Fed does not follow through with an additional two rates cuts for the remainder of the year.

The US Treasury market should set the tone for global DM markets in the fourth quarter. We still expect European markets to have limited price appreciation potential given their overall better growth prospects, aided by fiscal stimulus and a long overdue shift toward less regulation.

We continue to have no interest in having exposure to Japanese government bonds as their real yields are not compelling. The Bank of Japan needs to take a firmer posture on hiking rates to break the upward inflation bias in Japan (see Exhibit 2).

Investment grade (IG) corporate bonds have delivered strong performance in recent months, with spreads tightening and new issuance easily absorbed by investor demand. Deals remain oversubscribed, underscoring the solid technical backdrop. Despite heavy issuance (see Exhibit 3), investors continue to show strong appetite for quality credit.

Yields for IG corporates remain above 5% — a level rarely seen in recent years (see Exhibit 4). These higher starting yields not only provide attractive income but also set the stage for strong total returns. While spreads are supportive, they are already tight, leaving limited room for further compression. These conditions make Treasury yield volatility a more significant driver of near-term performance than corporate fundamentals themselves.

As we move through the latter part of the year and into 2026, IG corporate credit markets continue to show signs of resilience, and the outlook for the sector remains constructive. Elevated yields, solid corporate fundamentals, and strong investor demand create a favorable environment for both income and total return potential. While spreads may not tighten much further, the potential for Treasury yields to decline in 2026 adds another leg of support.

However, with tight spreads and risks still present, the outlook into next year requires a nuanced perspective. For investors, the strategy remains clear: staying allocated to high-quality investment grade credit, balance yield with duration exposure, and remain vigilant for risks that could test resilience in the months ahead. Going forward, the opportunity lies in capturing attractive yields while staying mindful of interest rate risk. Striking the right balance between yield and duration exposure allows investors to lock in meaningful income today while keeping portfolios positioned to benefit if Treasury yields decline in 2026. The goal is not to maximize one at the expense of the other, but to blend income generation with prudent rate sensitivity in a way that supports both stability and total return potential.

As the gateway between core bonds and stocks, high yield corporate credit continued to perform well in the third quarter. The labor market slowed enough for the Federal Reserve (Fed) to resume rate cuts, but stock valuations marched higher and credit spreads lower. Meanwhile, high yield is outperforming loans, which are hurt by a declining base rate and higher defaults.

Low defaults and strong demand relative to muted net new supply continue (see Exhibit 5). Defaults remain well below historic averages as fixed-rate coupons are serviced with nominal earnings that benefit from inflation. Strong demand for credit across all geographies and channels continues to be met with muted net new supply as most issuance is for refinancing.

The spread and yield generally have both come in markedly during the third quarter. The yield is still over 200 basis points higher than at the beginning of 2022, and the Fed is cutting rates (see Exhibit 6). But, from these levels, investors should prepare for higher volatility and wider spreads as it does not take as much to reintroduce some risk aversion into asset prices.

Since the beginning of this year, emerging market (EM) local bonds have outperformed with the JP Morgan Government Bond Index-Emerging Markets gaining around 15% year to date. Over the past 20 years, returns in EM local markets on a volatility adjusted basis have been poor due to the strong US dollar. Looking ahead, however, select EMs could benefit from a weaker dollar alongside still elevated real yields, declining inflation, and improving fiscal balances (see Exhibit 7). Renewed Federal Reserve (Fed) easing in the fourth quarter would also provide tailwinds to EM local currency bonds. Markets are currently pricing the terminal Fed rate below the neutral level of 3%. Any further declines could signal rising recession risks, which may put pressure on EM carry trades.

Within regions, Latin America continues to offer both high nominal and real yields, which helps to buffer a fixed income portfolio (see Exhibit 8). Select Central European economies also are poised to benefit from declining inflation, central bank rate cuts, and still reasonable real yields. Meanwhile, Asia could outperform in the following quarters if China leans toward stronger yuan (CNY) fixing, thereby pushing Asian currencies along a path toward an appreciation trend.

Expectations for monetary easing, solid household balance sheets, peak housing unaffordability, gradual stabilization of the office real estate market, benign financial conditions, and a robust market technical all have supported securitized credit. Fixed-rate products, including commercial mortgage-backed securities (CMBS) rated BBB, jumbo prime MBS, and agency MBS, along with floating-rate sectors, including credit risk transfers (CRTs) and collateralized loan obligations (CLOs), have outperformed for the year to date (see Exhibit 9).

Looking ahead to the fourth quarter, resilient credit fundamentals, high all-in yields, cheaper relative valuations, peak rate volatility, and easing bank regulations should support further spread tightening (see Exhibit 10).

Key opportunities include:

1. CRT: This sector offers high all-in yields and fast deleveraging with government-sponsored enterprise (GSE) tender upside and reinvestment demand. Scarcity value exists in non-investment grade (IG) segments due to no new issuance and ongoing rating upgrades. Solid credit performance is supported by low unemployment rates and significant home equity accumulation.
2. CLO: BBB and BB mezzanine tranches provide attractive yields and credit resilience. Reset/refinance and CLO ETF inflows boost liquidity and demand.
3. Agency MBS: Cheap relative value versus IG corporate bonds, relatively benign negative convexity, and potential demand from GSEs and banks should bode well for further spread tightening.
4. CMBS: Tightened underwriting, distressed valuations, gradual office market stabilization, and sensitivity to lower interest rates should provide spread compression potential.
5. Asset-backed Securities (ABS): Riding the tailwind of exponential growth of AI and data centers, data center and fiber ABS offer strong growth, IG ratings, scalability, and attractive relative value.

In addition, light net issuance across all sectors bolsters positive market technicals. These factors combine to offer compelling value in structured credit for the latter part of 2025.

Our overall thesis of a weaker US dollar remains intact, although nothing moves in a straight line. The lower dollar view is informed by several factors.

First, despite the US Dollar Index (DXY) falling almost 10% year to date, the currency remains expensive on long-term valuation measures. On a real effective exchange rate basis, the dollar is still more than one standard deviation expensive with room to move lower still.

Second, the growth convergence narrative has been playing out with US growth moderating toward ex-US growth rates. The policy mix of the US administration continues to weigh on the dollar, particularly with respect to tariffs and immigration and the impact on the labor market. This current policy framework suggests some further softening of US growth, although we are yet to see the offsetting impact of an expansive deregulation agenda. Furthermore, despite a softening labor market, final demand remains resilient, suggesting some divergence in these factors. Should they start to realign, that would suggest either the labor market outlook improves, which is a risk to our view, or the soft growth outlook is confirmed via weakening final demand.

Third, the Federal Reserve remains on track to reduce the federal funds rate further. Markets are currently pricing 4 cuts and a 3% terminal rate 12 months out, supporting a rate differentials convergence story that would put downward pressure on the dollar.

Lastly, despite an official strong dollar policy, no one in the administration or Treasury is saying anything about the dollar’s weakness this year. This contradiction reinforces our view that a weaker dollar is really the desired outcome and a necessary component of returning manufacturing jobs to the US in a competitive manner.

Investment returns are often seen as a simple calculation of buying low and selling high. But the reality is far more nuanced. Share price returns are forged at the intersection of expectations and reality. A stock price does not just reflect what a company is doing today—it also reflects what investors believe it will do tomorrow. When those expectations are too high, even solid results can disappoint.

From extremes to opportunity

The past year has provided a dramatic case study in how expectations drive markets.

In 2024, US equities surged to unprecedented dominance, representing around 67% of the global benchmark. The valuation gap between US and non-US markets reached extremes not witnessed in decades. It was as if investors believed the US could do no wrong, and the rest of the world was left for dead.

But markets are cyclical, and 2025 has already shown how quickly expectations can reverse. In the first quarter, Europe and other international markets rallied as sentiment shifted. German fiscal stimulus provided a catalyst, while US markets stumbled under policy uncertainty and a reset in technology leadership. Even China, often written off as “uninvestable,” saw renewed interest in companies tied to artificial intelligence (AI).

The great expectations reversal

We believe we are witnessing a Great Expectations Reversal: a pivot away from expensive US equities toward undervalued global opportunities. Across our global opportunities set, we see the following:

United States: US equities remain attractive, in our view, with valuations echoing the late 1990s. Risks include tariff-driven inflation and limited Federal Reserve flexibility.

Europe: Attractive valuations, resilient labor markets, and fiscal stimulus make Europe the standout opportunity. Even some boring European banks have already delivered 35–45% gains this year.

Emerging Markets: Brazil shows improving fundamentals, Indonesia appears to have bottomed, and China offers selective opportunities in companies benefiting from AI.

We are focused on building a portfolio that accounts for a range of possible outcomes along with a margin of safety. Additionally, as disciplined investors focused on fundamentals, our goal is to find overlooked companies where expectations are low and valuations leave more room for positive surprises. Today, those opportunities are predominantly outside US borders.

US equity valuations remain stretched, and the broad market appears vulnerable to bad news. That said, for the S&P 500, the average stock is cheaper than the index due to the record concentration among a small set of stocks, and that same dynamic holds for most major US equity indices. Earnings growth estimates for 2025 and beyond have improved since their April lows, but the market does seem reliant on sentiment surrounding the AI boom. Beyond 2025, the market appears focused on operating margin improvement as the primary driver of earnings growth.

Economically, the outlook is mixed. Capital expenditures (capex) announcements look strong, regulatory relief—or, at least, less regulatory action—is constructive, and lower short-term rates would be positive, especially for small businesses. The recent tax and fiscal spending bill, or OBBBA, is expected to add $100bn to tax refunds in the first quarter of 2026, which represents a 35% year-over-year increase. If tariffs stick around though, there is a question of how much ends up getting passed through to the consumer. Generally, however, economic uncertainty continues to weigh on the consumer. The jobs market has clearly slowed, and the impact and trajectory of inflation and tariffs remain uncertain. Trust in US policy stability has been lowered by a combination of announcements with uncertain legality and political attacks on the Federal Reserve’s independence. And while lower rates would be a benefit to small businesses, less than 20% of household debt and 35% of business debt is exposed to short-term rates, according to analysis done by Empirical Research Partners of first quarter 2025 data. Furthermore, some of the consumer debt is credit cards, where a cut in short-term rates has a minimal impact.

We continue to favor sectors such as health care where the relative stability is not being rewarded as it has historically. Generally, we continue to avoid highly valued areas where there is less margin of safety from a valuation perspective.