As stocks dip, bonds are stepping up.
Since mid-January, a new political regime in Washington has shaken the geopolitical landscape and global markets. In this volatile environment, bonds have performed well, resuming their traditional role as ballast against falling stock prices and attracting strong demand from investors.
We believe that bond investors should stay the course. In our view, the trajectory for global growth and bond yields remains slower and lower, boosting bond prices. Below, we share our expectations for the world economy and global bond markets, as well as six strategies for thriving in a complex and rapidly changing investment environment.
Policy Volatility Itself Is a Headwind to Growth
In the US, trade, immigration, fiscal and regulatory policies have become fast-moving targets, and policy volatility is obscuring the path of the US economy. Consumer sentiment data has fallen to its lowest reading in three years, while longer-term inflation expectations have climbed to 3.9%—the highest since 1991. Any combination of weak growth or recession with high inflation would be challenging for the US Federal Reserve.
More clarity around growth and inflation is likely in the next month or two. For now, we expect US GDP growth to slow in 2025 but to remain positive, and we expect the Fed to ease another 0.5% to 0.75% this year as it steers toward a 3% policy rate.
By contrast, sentiment in Europe is moving in the other direction. In March, Germany surprised markets with a highly stimulative fiscal package focused on defense and infrastructure spending. The announcement sent German yields higher, and the one-day move in 10-year Bunds was the largest since the fall of the Berlin Wall.
The announcement has bolstered optimism for growth in Europe’s largest economic zone. While we still expect European growth to slow, we now expect the European Central Bank to lower its policy rate by only another 50 basis points this year, to 2%.
Tensions, Tariffs and Trade Wars
As countries grapple with rapidly changing policy stances, there is one certainty that seems to have emerged: trade restrictions are likely to increase, with China as a primary target. In our view, raising trade drawbridges will dampen global growth.
Over the near term, trade barriers typically slow economic growth by raising the price of imported goods, reducing consumer purchasing power and creating uncertainty that hinders business investment. Financial markets may also struggle, as slowing growth amid rising prices challenges central banks’ ability to support the economy.
Over the longer term, trade tensions heighten geopolitical risks. Previously stable diplomatic relationships, crucial for mutual economic interests, may weaken.
The consequences of rising tensions could be especially significant for China. China has strategically adjusted its export composition since 2018 to be less vulnerable to economic disruptions from trade wars. But that doesn’t make it immune. We expect further fiscal and monetary stimulus from Beijing to help offset this risk.
The critical question is what happens when trading partners feel compelled to choose between the US and China. Recently, we have seen Mexico and Korea indicate their intention to curb China’s backdoor entry for exports before entering trade negotiations with the US. If countries decide to deny all Chinese goods to align themselves with the US, that could significantly impede Chinese growth.
However, we see choosing sides as a double-edged sword. Countries that have benefited from acting as intermediaries in the rerouting of Chinese goods would likely also suffer.
To us, these conditions suggest a less harmonized global regime, in which economic cycles vary more significantly across regions, and a less efficient world economy, with more inflation relative to growth. Companies may need to navigate fractious trading relationships, brittle supply chains, volatile inflation and growth conditions, and potentially divergent monetary policy paths.
But ultimately, we see some room for optimism. Technological innovation and a resilient private sector may offset some damage, and policymakers may decide to change course as the effects of trade wars are felt. Eventually, we expect the world economy to reach a new equilibrium.
Six Strategies for Staying on Your Toes
1. Manage duration.
Predicting the direction of bond yields over the near term is challenging. Our focus remains on the intermediate term, and we think that’s where investors should focus too. Historically, yields have declined as central banks have eased. Thus, in our view, bonds are likely to enjoy a price boost as yields trend lower in the coming two to three years in most regions.
Demand for bonds could remain exceptionally strong, in our analysis, given how much money remains on the sidelines seeking an entry point. As of March 19, $7 trillion was sitting in US money-market funds, a relic of the “T-bill and chill” strategy popular when central banks were aggressively hiking interest rates. Now that money-market rates are declining, we anticipate roughly $2.5 to $3 trillion will return to the bond market over the next few years.
We expect bonds, having recently resumed their traditional role as anchor to windward, to retain that role. In other words, duration will likely be negatively correlated to equities, in our view, and we believe it should be part of an overall asset allocation.
If your portfolio’s duration, or sensitivity to changes in interest rates, has veered toward the ultrashort side, consider lengthening it. As interest rates decline, duration benefits portfolios by delivering bigger price gains. Government bonds, the purest source of duration, also provide ample liquidity and help to offset equity market volatility.
But don’t just set your duration and forget it. When yields are higher (and bond prices lower), lengthen the duration; when yields are lower (and prices higher), trim your sails. And remember: even if rates do rise from current levels, high starting yields provide a cushion against price declines.
2. Think global.
As monetary policies diverge, idiosyncratic opportunities increase globally, and the advantages provided by diversification across different interest-rate and business cycles become more powerful.
3. Focus on quality credit.
In this uncertain environment, credit has shown more resilience than stocks, though both investment-grade and high-yield spreads have recently widened from their lows.
When formulating an outlook for the credit markets, we believe it’s more important to focus on yield levels than on spreads. Yield has been a better predictor of return over the next three to five years than spread, even in very challenging markets. And today, yields across credit-sensitive assets are near historic highs. High-yield bonds, for instance, now offer more yield than at any point since the Fed began easing last year—some 20 basis points more than at year-end.
Current conditions demand careful security selection. Changing policies and regulations won’t affect industries and companies uniformly, nor will weak economic growth. For instance, energy and financials are likely to face less regulation, while import-reliant industries such as retail could struggle.
We think it makes sense to underweight cyclical industries, CCC-rated corporates—which account for the bulk of defaults—and lower-rated securitized debt, as these are most vulnerable in an economic slowdown. A mix of higher-yielding sectors across the rating spectrum—including corporates, emerging-market debt and securitized assets—provides further diversification.
4. Adopt a balanced stance.
We believe that both government bonds and credit sectors have a role to play in portfolios today. Among the most effective strategies are those that pair government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio.
This pairing takes advantage of the negative correlation between government bonds and growth assets and helps mitigate tail risks such as the return of extreme inflation or an economic collapse. Combining diversifying assets in a single portfolio makes it easier to manage the interplay of rate and credit risks and to readily tilt toward duration or credit according to changing market conditions.
5. Partner up with a systematic approach.
Today’s environment also increases potential alpha from security selection. Active systematic fixed-income approaches may help investors harvest these opportunities.
Systematic strategies rely on a range of predictive factors, such as momentum, that are not efficiently captured through traditional investing. Because systematic approaches depend on different performance drivers, we believe their returns complement traditional active strategies.
6. Protect against inflation.
We think investors should consider increasing their allocations to inflation strategies, given the heightened risk of future surges in inflation, inflation’s corrosive effect and the affordability of explicit inflation protection.
Be Nimble, Be Active to Seize Opportunities
As we see it, investors should get comfortable with evolving policy expectations and near-term turbulence, while positioning portfolios to take advantage of opportunities created by heightened volatility and market tailwinds in the coming months.
Above all, keep an eye on broader trends, such as slowing economic growth, attractive starting yields and pent-up demand. This is a favorable environment for bond investors. We believe today’s conditions may prove fruitful for bond investors poised to take advantage.
The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.
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