Beyond the noise, conditions favour fixed income

With risk assets having shrugged off the latest series of negative economic headlines, many investors will be approaching year-end looking for signs that markets are getting complacent.

President Trump’s tariffs have landed, two high-profile bankruptcies in the US have raised fears of more widespread credit weakness, and geopolitical risk remains high. Against this backdrop, the S&P 500 US equity index is up 14% year-to-date and bond spreads – the premium investors demand to hold corporate over government risk – are not far off historic tights in many sectors.

While we do expect more volatility into year-end as economic headlines potentially worsen, in fixed income at least we believe the fundamental backdrop justifies the strength of valuations, and thus we prefer to stay invested in credit.

Despite tariffs, the growth outlook has brightened

Trump’s tariffs have taken the average tariff rate on US imports to 12%, its highest level since the 1940s. This rate exceeds the most bearish estimates we saw in the lead-up to “liberation day” on April 2.

However, hard economic data in the months since has proven resilient. While projections for US growth in 2025 remain below where they were at the start of the year, the more recent trend has been a gradual upgrade of estimates across developed markets (see Exhibit 1). The Eurozone, boosted by the prospect of increased government spending driven by Germany, has actually seen its growth outlook tick up slightly versus the start of the year.

President Trump’s threat in October to impose an additional 100% tariff on imports from China was a reminder of the uncertainty that still surrounds his administration’s trade policy. However, one factor behind the brightening growth outlook post-April 2 is the lack of exposure to US tariffs across developed market economies.

The US itself has a relatively closed economy, with goods imports accounting for only 11% of its GDP (see Exhibit 2). Germany and China have much more open economies, with exports accounting for around 30% and 20% of GDP, respectively. However, exports to the US (the portion exposed to tariffs) account for just 3.5% and 2.4%, respectively.

Watch the US labour market

Beyond tariffs, one of the key risks to the outlook for risk assets is the health of the US labour market after a series of weak non-farm payrolls (NFP) prints.

While the official NFP report for September was delayed because of the US government shutdown, the preliminary ADP private sector jobs survey showed a loss of 32k jobs over the month, well short of the forecast 50k gain. However, despite the clear slowdown in job growth being enough to prompt the Federal Reserve (Fed) into a 25bp rate cut at its September meeting, other indicators such as hiring and job openings have been more stable (see Exhibit 3).

History shows sharp rises in US unemployment can be hard to stop once they get going. However, it is worth noting that the Trump administration’s immigration curbs are expected to significantly reduce US net migration from its recent all-time highs, with the resulting reduction in labour supply helping to keep unemployment in check despite slower job growth.

Recent rhetoric from the Fed also suggests a tick-up in inflation due to tariffs is unlikely to deter further rate cuts to support the economy, with markets now pricing in a terminal Fed Funds rate of just under 3% – below the central bank’s estimate of the neutral rate.

Fundamentals justify tight spreads

Despite periods of widening when macro uncertainty has been more acute, credit spreads have rallied steadily across 2025 and are now very close to all-time tights across investment grade and high yield corporates in both the US and Europe.

In this context, it is little surprise that the bankruptcies of subprime auto lender Tricolor and auto parts manufacturer First Brands in quick succession in September raised concerns about more widespread issues in corporate credit.

However, in our view, the swift recovery of sentiment in the weeks since reflects the persistent strength of corporate fundamentals. Corporate earnings remain solid, consumer balance sheets are also healthy, and cash continues to flow into credit – offering material technical support for corporate bonds.

Certainly, at this stage of the cycle fixed income investors must be vigilant when it comes to signs of overexuberance; strong demand for corporate credit can be a double-edged sword if investors do become complacent about default risk in weaker companies. One example would be dividend recapitalisation activity, which reached €29bn year-to-date in European high yield (HY) in September, already a record figure with three months of the year still to go.

However, at present we are not seeing typical signs of excess in indicators such as corporate leverage or interest coverage. Nor do we see much evidence that investors are blindly moving into riskier securities in search of more spread. The share of CCC rated issuance in HY remains subdued, for example, having trended down over the last decade (see Exhibit 4). 

Yields support staying invested in credit

Fundamentally, we believe market conditions remain supportive for balanced fixed income portfolios.

Low (but positive) growth, combined with solid corporate and consumer balance sheets and a well-capitalised banking sector is a good investment environment for those who keep their focus on income rather than capital gains. 

Despite extremely slim spreads, overall yields remain elevated relative to history, which means it is possible to build bond portfolios that deliver an attractive level of income without taking undue credit or duration risk. The yields available on single-B rated HY bonds four or five years ago can be achieved in BB or even BBB rated bonds today, so our focus is on clipping these yields while avoiding defaults.

We continue to prefer credit to government bonds, since we believe the former will continue to outperform the latter over the medium term. Government bonds have a place in portfolios, partly as a hedge against a more severe economic downturn, and partly because of relative value. Investors can debate whether, at around 4% currently, 10-year US Treasuries are good value or not, but broadly speaking government bonds are now offering healthy real yields, which was simply not the case in the previous cycle. That said, further rate cuts look fully priced in, so we don’t see a sustained rally in government bonds in the absence of that more severe economic scenario, hence our preference for credit.

Investors waiting for markets to fall are often reminded of the famous John Maynard Keynes quote that markets can stay irrational longer than you can stay solvent. For fixed income markets right now, perhaps the more appropriate phrase would be that markets can stay expensive longer than you can stay uninvested.