Global capital markets have seen a noticeable shift in expectations this year. Although backward-looking economic fundamentals still look solid — unemployment is low, inflation has moderated and corporate fundamentals are generally strong — investors are feeling more cautious. The optimism that peaked following the U.S. election has given way to concerns over downside risks to growth. Markets have responded to this shift with equities struggling, credit spreads widening and Treasury yields falling.

Entering 2025, investors expected pro-growth policies (deregulation and tax cuts) to take center stage. Instead, the focus has been on tariffs and tighter immigration policies — both of which could weigh on growth. The Federal Reserve (Fed) has also acknowledged that risks are skewing to the downside.

As investors grapple with these challenges, fixed income has regained its traditional role as an effective portfolio diversifier. In this environment, a focus on high-quality bonds and selective credit exposure is essential.

Drivers of bond market returns

Several factors have shaped bond market performance so far this year:

• Softer U.S. growth expectations: Economic growth in 2024 was solid, but concerns are rising about headwinds in 2025. Geopolitical risks, policy uncertainty and weakening business and consumer sentiment have shaken investor confidence.
• Inflation uncertainty: While the inflation surge of 2022 has largely faded, the potential impact of new tariffs looms large. With recency bias likely playing a role, investors are wary of a scenario where inflation reaccelerates, which could keep the Fed on hold longer than currently expected.
• Government spending and pro-growth policies outside the U.S.: The U.S. bond market typically drives bond yields globally, but in recent weeks global developments have been impacting U.S. markets. Notably, expectations for fiscal stimulus and other pro-growth policies in Germany and Japan have exerted upward pressure on U.S. rates.

So far this year, credit has underperformed duration. Despite this weakness, credit markets have remained orderly, with buyers stepping in to capitalize on improved valuations. Today’s modestly wider spreads reflect lower Treasury yields rather than outright weakness in corporate bond prices. As expected in this environment, high-quality fixed-rate debt has outperformed high-yield, bank loans and other floating-rate instruments. Overall, however, credit is still fairly expensive by historical standards.

A surprising source of outperformance, relative to expectations at the beginning of 2025, has been emerging markets. Investors in emerging market debt have already navigated similar tariff policies during the previous Trump administration, and risk premiums were built in last fall. Importantly, tariff discussions have been equally focused on developed market trading partners like Europe and Canada, as they have been on emerging market economies like China and Mexico.

What’s next for the Fed and rates?

The Fed held rates steady at its latest meeting but announced a slowdown in the pace of its quantitative tightening program. This suggests a subtle shift toward easing, even if rate cuts aren’t imminent.

The Fed faces a tricky balancing act. Tariffs could push inflation higher, but they could also hurt growth by reducing consumer spending and business investment. This interplay adds another layer of complexity to the Fed’s decision-making process.

The Fed has indicated that it remains open to cutting rates twice this year. Before committing to a path, it will likely need to see clearer signs of how the potential tug of war between rising inflation and weakening demand will play out.

Positioning portfolios in this environment

As credit spreads have widened, pockets of opportunity have emerged in sectors with less exposure to trade and growth risks. Security selection will be important here, as certain industries — such as autos and building materials — face greater pressure from tariffs and supply chain disruptions, while others, like chemicals and some consumer sectors, may hold up better. We think dispersion within the high-yield market is likely to grow, and credit selection will be a significant driver of returns.

One of the key themes this year is the return of fixed income as a portfolio diversifier. Unlike recent years, when bonds struggled to provide downside protection, high-quality fixed income has reasserted its role as a volatility buffer. With equity markets facing ongoing uncertainty, this dynamic is likely to remain in focus.

The bottom line

Investors should be prepared for a fluid economic outlook as the year unfolds. Growth concerns are rising, policy uncertainty remains high and the Fed’s next moves will be closely scrutinized. In this environment, a nuanced, diversified approach to portfolio construction will be essential.