Sector Views: Uncertain times, cautious moves

Executive summary

We have moderately downgraded our outlook for the US economy, projecting slower growth, higher inflation and increased unemployment due to a still uncertain US trade policy. Due to the lack of clarity on tariffs, the US Federal Reserve (Fed) has taken a wait-and-see attitude toward implementing additional rate cuts, a stance we believe will continue through the end of the year. Increased US tariffs will likely have negative growth implications for many developed countries, including China and the euro area. We are cautious about taking wholesale spread risk in fixed income markets due to current tight levels. We are also being judicious about duration as we are still looking for intermediate and long US Treasury (UST) yields to rise.

In this quarter’s Sector Views, we look closely at the following themes and provide our outlooks for fixed income sectors:

Third quarter 2025 market backdrop

• Path of the Fed: In her recent report, Sonal Desai lays out her argument that the Fed is unlikely to cut interest rates anytime soon. Despite recent signs of cooling inflation, the current backdrop of elevated uncertainty from tariffs will likely lead the Fed to prioritize inflation over growth.
• Overly tight spreads: There was some widening of spreads in April 2025, but since then, spreads have returned to near multi-decade tights, leaving little room for downside risks both systematic and idiosyncratic.
• Declining US dollar (USD): Since the inauguration of President Trump, the US dollar continues to weaken despite strong demand for USD-denominated assets. We feel that this phenomenon is partially due to international investors diversifying their portfolios away from USD assets by hedging out currency risk.
   

Portfolio themes

• Limit the potential impact of spread deterioration: With tight spreads and full valuations, we still don’t feel that investors are compensated for taking on wholesale credit risk across most sectors. We prefer shorter-duration spread products that can still provide improved income and carry, while limiting capital depreciation in the event of widening spread.
• Diversification still pays: When appropriate, we look to diversify our allocations, avoiding risk concentrations using a holistic approach to risk balancing across portfolios.
• Be nimble with our duration exposure: With our preference for shorter-maturity spread assets, we utilize a number of more liquid instruments to move our duration exposure closer to the stated benchmarks. Although we do not currently have a strong view toward duration positioning, we continuously reevaluate the interest-rate environment.
   

Overall risk outlook

We have become wary under current economic and market conditions since our last publication and, therefore, have downgraded our overall risk sentiment to neutral with reasons for concern. Although economic conditions in the United States have held up, so far, we do expect there is likely to be some weakening toward the end of this year. The spread widening we saw across many fixed income sectors post “Liberation Day” has largely been retraced, and spreads have returned close to their 20-year tights, stretching valuations. We are closely monitoring technical conditions, which remain strong, as we are seeing some signs that international interest in US dollar-denominated assets may be waning as the dollar continues to devalue against world currencies. In our opinion, the market is underestimating fiscal, geopolitical and economic risks that are likely to continue to add to both uncertainty and volatility in the market. However, we are finding pockets of opportunities for assets in sectors that have lagged the market, taking advantage of our experience in managing through a wide range of market conditions.