America first to safety first – finding opportunity and shelter in fixed income

In the last edition of Alphorum we highlighted the end of an era dominated by monetary policy and predicted the onset of a far more politically driven macroeconomic environment in 2025. While US equity markets were buoyed by the prospect of Trump 2.0, we sounded a note of caution regarding the uncertain impact of Trump’s second first 100 days, and the potential for rates to become more volatile. In the event, the US administration’s recent actions have exceeded almost anyone’s expectations, effectively rewriting the rules of the macro world order. So, what could this mean for fixed income?

Shifting sands

Firstly, in the wake of Liberation Day, the world has become more uncertain, fragmented and conflictual. And with multiple factions flexing their muscles in an attempt to exert their authority, the scene is set for ongoing instability and volatility. In this respect, perhaps as important as the direct impact of tariffs is the geopolitical shift away from globalisation towards a greater focus on strategic autonomy, driven by trade fragmentation, energy security concerns and protectionism around markets and supply chains.

Suddenly, the path of ever-increasing globalisation and free trade between countries that has helped to deliver rising prosperity for more than half a century has been blocked, with the US trying to force the world to turn back and retrace its steps. As a result, the foundations of the global economy, which have survived major shocks including the crash in the wake of Black Monday in 1987, the global financial crisis of 2008-9 and the Covid pandemic, feel suddenly weaker.

The repercussions will very much depend on exactly how far the key players are prepared to go. We expect an increased likelihood of more pronounced rifts between trading partners – particularly the US and China – resulting in goods and capital flows being reoriented in search of a new equilibrium. Such a new and less integrated world order would weigh on the smooth liberal trade environment the world has experienced for decades, as well as ratcheting up geopolitical risks such as the potential for tensions to escalate in relation to Taiwan. In our view, this is likely to be a significant headwind for risky assets.

What does Trump want?

When compared to the first Trump administration, ‘Trump 2.0’ is more organised and seems to be focused on two connected aims: first, resetting the global economy to address perceived imbalances and unfairness; and second, rebuilding the US economy as a manufacturing powerhouse. Given the complex range of external factors involved, the potential impacts of this strategy are difficult to predict.

To achieve the US administration’s aims, barriers to trade are needed to drive reshoring of companies and labour. The assumption is that tariffs will bring in revenue that can justify tax cuts and stimulus; at the same time, an indirect consequence could be stronger competitiveness resulting from a weaker dollar.

The next steps are likely to take the form of tax cuts and the deregulation of both banks and industry to help finance and facilitate investment, providing a vital boost to a more domestically focused corporate America. At the same time, the ‘drill, baby, drill’ approach to energy is intended to ensure a plentiful supply of cheap power to drive this new manufacturing-led economy.

In this context, downsizing government can be seen as an attempt to save money and reduce friction. By providing a potential labour supply for a revived manufacturing sector, this measure could counteract the tensions created in the job market by policies of reduced immigration and higher deportations. However, it misses the point that the skillsets of people entering the labour force do not match those of workers exiting.

President Trump has gathered strong support around the idea that both the macro world order and the US economy need to be fixed. However the challenge will be to keep the different factions within the Republican powerbase on board and aligned, while maintaining the upper hand on an international level. In our view, the cracks are already starting to show.

Read also: What Liberation Day's reciprocal tariffs mean for investors

Domestically, the new administration faces opposition to its actions on various fronts. As we write, most notable is the lawsuit brought by a group of US firms asserting that Trump has overstepped his authority by spuriously declaring an economic emergency to enact the tariffs, as well as the bipartisan Senate bill seeking powers to review and approve tariffs.

Externally, China’s belligerence has already led to Trump excepting smartphones and other electronic devices from tariffs – although the administration has since indicated a semiconductor tariff will be introduced that would affect these products. Europe is also reacting to America’s radical new stance, aiming to reposition itself away from reliance on US military and diplomatic support and towards strategic autonomy.

Pursuing a global trade war to its conclusion will require a clear strategy, a strong nerve and a resilient economy. The US president is perhaps less of an ideologue than some in his administration and has already changed direction when confronted with the harsh reality of 30-year Treasury yields nearing 5% and the extended slump in equity markets. However, Trump’s unpredictability and fondness for trying to use uncertainty to his advantage means volatility is likely to be an ongoing part of the equation.

FIG 1. LOIM Global Fixed Income: change in convictions, Q1-Q2¹

A monetary policy dilemma

For central banks, the new macro world order potentially creates a difficult dragon to tame, in terms of the need to adapt their reaction function to deal with two counteracting forces that are likely to be in evidence simultaneously: namely, rising inflation and slowing growth. At the same time, central banks need to show consistency, recognising that their credibility can be easily damaged. Their job is made more difficult by the disconnect between a macro environment that is changing almost daily and the 12–18-month lag for central policies to take effect.

If Trump follows through fully on his apparent plans, the Federal Reserve will have two choices: acknowledge the potential weakness in growth but risk inflation overshooting; or focus first on ensuring that inflation remains contained but risk a slowdown as a result. Chair Powell will want to look through temporary effects, and sooner or later there will be a need to act. We tend towards the view that the Fed will first need to play hardball to deal with inflation, but once growth and the labour market become soft enough, this will provide a reason to cut – possibly at a faster pace in return. In the meantime, the Fed must take something of a back seat, maintaining a watching brief while standing ready to act.

Read also: Bonds, ETFs or CDS – in high yield, which is more resilient to liquidity shocks?

Wider impacts

Clearly, the downside risk created by tariffs is not just a US issue but a global one, as trading partners decide whether to take the hit, raise their own tariffs, or attempt to pivot away from exporting to the US. For the rest of the world, the US administration’s actions create a series of questions: How far is Trump prepared to go? What is the price of resistance or capitulation? How much space is there for negotiation? Will legal challenges and political opposition stop Trump in his tracks? As we write, the answers to these questions are unclear, but they will soon become apparent. Fundamentally, short of a total climbdown from the US, the impact is going to be long lasting, and the road ahead will be bumpy.

The way the US-China confrontation plays out will have significant implications for global markets. While China is highly dependent on exports, it has some cards to play – such as its domination of rare earth processing, which is critical for chip production for use in AI, defence and other technological applications.

Europe has been forced to recognise that the world has changed, and it can no longer rely on the US for security. However, it will take time for that to translate into measurable action. Of note is Germany’s announcement of decisive measures on the fiscal side, with massive public spending plans on infrastructure and defence estimated to be worth not far short of one trillion euros. Germany’s low debt-to-GDP levels and comparatively small budget deficit mean it is well-positioned to launch a debt-financed repositioning of its economy – if carried through, this would represent a strong positive demand shock.

Safety first

Compared to the last few years, in which the strong focus on monetary policy to manage economies gave fixed-income investors a relatively simple framework within which to analyse economic trends, this new macro world order is a complex and challenging environment for investors to navigate. Given considerable political and policy uncertainty at a geopolitical, regional and national level, it will be vital to stay defensive until the path ahead becomes clearer, while remaining nimble and ready to deploy if and when the situation allows.

While rates have shown some volatility and this could reoccur, riskier assets can be expected to be far more volatile. In the current environment, it makes sense to focus on less risky assets unless you are being sufficiently compensated; so far, risk premia have yet to reach that point, in our view.

With the ongoing threat of tariffs significantly increasing recession risks, the likelihood of rates being lowered has increased, which would make government bonds more appealing. We believe a possible sequence of events would see the long end of the curve moving lower first in the light of a cautious Fed, with recession being priced in as curves flatten. Once the Fed gives the green light and declares victory on inflation, the whole curve would then shift down in a steepening move.

Read also: Fixed income in the new macro world order

In credit, we are staying up in quality, but are ready to start adding risk gently once we feel the correction has gone far enough. At the same time, we prefer to remain tactical regarding the possibility of fading rallies if spreads ease rapidly, given that tariff issues remain essentially unresolved.

While we consider a global slowdown to be an earnings story rather than a potential default issue so far, a sensible tactical approach may be to focus more on domestic names than global ones. At a portfolio level, this is typically achieved by weighting away from corporates and towards financials, which tend to be more focused on the country in which they operate. We also tend to prefer European credit, which is starting to offer quite appealing valuations that could be worth capitalising on once the dust settles; while Europe faces a struggle for growth, particularly if tariffs return, proposed defence spending may help to mitigate the impact.

As mentioned in our Q4 2024 Alphorum, in a volatile environment and with real yields high from a historic perspective, we like inflation-linked bonds – specifically US Treasury Inflation-Protected Securities, which also offer protection against unexpected inflation. Given ongoing events these instruments are looking more attractive than ever.

Overall, generating alpha is about avoiding downside while also finding upside potential, so we like to be active – and such volatile times are highly supportive of such an approach. We are taking all the factors discussed here into account, staying patient and positioning defensively, while remaining flexible in our allocation, staying nimble to avoid the downside risks and keeping alert for upside opportunities.