Without reforms in China or other trade surplus countries to cut implicit manufacturing subsidies and stimulate consumption, the U.S. could try to implement interventionist trade policies (e.g., a system of universal tariffs or foreign direct investment taxes) to compel these changes. However, distributing the burden of the U.S.’s global reserve status by making U.S. assets more expensive to hold would likely raise the cost of capital and – absent more aggressive fiscal deficit reduction – increase U.S. government borrowing costs.

Such aggressive short-term measures to reverse long-term trends would likely contribute to economic disruptions, near-term currency volatility, and U.S. equity market underperformance, even if they were to succeed at creating stronger, more balanced global growth longer term. Hence, President-elect Donald Trump’s tolerance for U.S. equity market volatility is a key question for the outlook.

These proposed policy pivots amplify both upside and downside risks to U.S. growth – especially as the exact combination, timing, and scope of any such policies remain unclear. However, we think the balance of potential policy outcomes increases near-term U.S. inflationary risks while posing greater downside risks to growth for non-U.S. countries, particularly those with high global trade exposure that run persistent surpluses with the U.S.

For example, any larger-than-expected U.S. government spending cuts, aggressive trade actions, or immigrant deportation could pose cyclical downside risks to both U.S. and global growth. Conversely, greater U.S. tax cuts and deregulation could enhance U.S. growth prospects, potentially aiding consumer and business confidence and risk asset performance. A focus on achieving fairer global trade, more efficient markets, and a sustainable U.S. debt trajectory could help maintain rising U.S. living standards. Thoughtful immigration overhauls that expand the productive labor force, streamlined regulations that encourage investment, and opening export markets for U.S. projects could also yield benefits for U.S. businesses and workers.

In the very near term, higher trade policy uncertainty could weigh on global industrial production, investment, and trade regardless of actual policy outcomes. While these isolationist, pro-U.S.-growth policies offer mixed risks for U.S. growth, they are generally more likely to be inflationary, especially since the U.S. economy is currently estimated to be operating at or near its potential. 

The U.S. Federal Reserve (Fed) has taken note of these changing risks. In December, when the Fed cut its policy rate by 25 bps, officials revised projections to indicate fewer expected cuts in 2025 amid greater uncertainty around continued inflation progress. Fed Chair Jerome Powell said that some officials had factored potential Trump administration policies into their revised projections.

Although conventional wisdom suggests that central banks should look through one-off price level adjustments, such as those from tariffs, any tariffs that are accompanied by other pro-U.S.-growth policies could come with more persistent inflationary pressures. In various scenarios, Fed officials could remain concerned about the knock-on effects of rising inflation expectations and elevated wage growth. As a result, they could react by cutting less than previously expected, at least at first.

Thus, after 100 bps of policy rate reductions in 2024, the timing of further Fed cuts has become less certain, indicating a more gradual, data-driven approach in 2025. The futures market has reflected this uncertainty in recent months (see Figure 2). Despite the Fed cutting its policy rate by 100 bps during this period, market pricing removed the expectation of 100 bps of additional easing in the year ahead.

The long-term outlook for U.S. government debt is likely to remain a significant concern. Nevertheless, there is a possibility of some incremental deficit improvement with the potential for rollback of certain Biden administration policies – such as renewable energy investment credits and other elements of the 2022 Inflation Reduction Act – and cuts to Medicaid. Higher tariffs could also reduce deficits through increased government revenue collection.

Still, any meaningful deficit improvement will be difficult, with the expected extension of the Tax Cuts and Jobs Act – Trump’s first-term bill – and some additional tax cuts, including, for example, provisions to raise state and local tax (SALT) deduction caps. Although some spending reductions could be found through policies to improve government efficiency and reduce waste, any larger-scale cuts, including reforms to Social Security and Medicare programs, will require an act of Congress and likely be difficult to pass given the narrow Republican majorities, especially in the House of Representatives.

Investment implications: Bonds are better positioned

Financial markets seem to be pricing in a very positive baseline expectation – reflected in the strength of U.S. and other equity markets in recent months – at a time of elevated geopolitical uncertainty. Historically high equity valuations and U.S. deficits, along with the potential for escalating trade tensions, raise questions about the durability of stock market gains. Risks appear tilted to the downside, with little margin for safety. This environment presents a compelling case for taking some chips off the table.

We believe bond yields are increasingly attractive when measured against equity valuations and credit spreads. High quality fixed income starting yields – which are highly correlated with five-year forward returns – are 5.10% based on the Bloomberg US Aggregate Index, and 4.91% based on the Global Aggregate Index (U.S. dollar hedged), as of 10 January 2025. While continued equity gains would require valuations to be sustained well above long-term norms, bonds simply need historical trends to hold to generate attractive returns in line with starting yields.

Bond market returns can be further enhanced by capital gains in adverse macroeconomic or market scenarios. Historical trends also support bonds as an attractive risk hedge and portfolio diversifier (see Figure 3). Looking back at bond and equity markets on average since 1973, during similar periods when U.S. core bonds are yielding around 5% or greater while U.S. equities’ earnings ratios are around 30 or higher, bonds have offered higher five-year subsequent returns, and with potentially lower volatility (for more, see our December commentary, “From Cash to Bonds: A Strategic Shift in Post-Pandemic Investing”).

Rates and curve

Markets are pricing in terminal policy rates for global central bank easing cycles that appear somewhat high relative to our baseline outlook. There is significant near-term potential for lower central bank rates outside the U.S. in the event of more aggressive U.S. trade policies that weaken global growth and weigh on commodity prices (see Figure 4). In the U.S., even as elevated policy uncertainty could lead to a lengthier pause in the Fed’s cutting cycle, intermediate-maturity yields look attractive relative to our long-term 0%–1% neutral real interest rate baseline.

Given that, we expect to be overweight duration, a gauge of interest rate risk, particularly after the recent rise in yields.

Over our longer-term secular horizon, we still expect yield curves to gradually steepen, driven by central bank easing and a continuation of the recent rise in term premium amid concerns about elevated sovereign debt (for more, see our December PIMCO Perspectives, “Thoughts from the Bond Vigilantes”). However, we see scope for some cyclical flattening in the U.S. due to the possibility of delayed Fed cutting amid potential near-term inflationary pressures and marginal deficit improvement.

Balancing these secular and cyclical views, we are underweight the 30-year area of the U.S. yield curve and overweight in the five- to 10-year maturity range. U.S. Treasury Inflation-Protected Securities (TIPS) also remain a reasonably priced hedge against higher inflation outcomes, in our view.

Credit outlook

Corporate credit spreads are historically tight. While we expect corporate credit can continue to do fine in our baseline scenario, the range of outcomes appears skewed toward wider versus tighter spreads given the balance of global risks. Overall, we favor higher-quality bonds and maintaining liquidity.

We continue to prefer structured products, the investment grade credit default swap index (CDX), and high quality investment grade credit versus lower-quality investments. Given broadly tight credit conditions, we are shifting focus beyond global market-weight spread allocations toward high quality spread in harder-to-source areas. U.S. agency mortgage-backed securities (MBS) remain an attractively priced, high quality, and more liquid alternative to corporate credit.

Within private credit, we continue to prefer asset-based lending, especially assets tied to higher-quality DM consumers and residential mortgages. We also see value in many non-consumer forms of asset-based risk, emphasizing sectors with secular tailwinds such as aviation and data infrastructure. We remain cautious on the existing stock of lower-quality, floating-rate debt outstanding, especially in corporate markets.

We have also observed a trend toward more aggressive financial engineering in some corporate credit areas. That is creating opportunities to use independent credit analysis to identify potential gaps involving perceived credit fundamentals and ratings.

Global views

While we see U.S. duration as attractive, at the same time upside and downside risks are more evenly balanced due to trade, fiscal, and regulatory policies. In the rest of the world, the balance of risks leans toward the downside. This environment supports global diversification across bond markets, particularly high quality duration. We favor the U.K. and Australia based on valuations and economic risks compared with the U.S. Tariffs can further bolster the case for global diversification, as many of the biggest disruptions are likely to occur outside the U.S.

EM local debt, external debt, and foreign exchange positions offer reasonable return potential and reduce reliance on U.S. credit, as these markets appear to price in more downside risk than do U.S. equities or corporate credit. We see foreign exchange carry strategies as an attractive and relatively liquid way to generate income from EM exposures, when combined with careful management of the currency basket to avoid excessive U.S. dollar correlation. At the same time, with the U.S. dollar likely to strengthen on tariffs, we favor long U.S. dollar positions versus the euro, Canadian dollar, and Chinese yuan, which can offer reasonable return potential in the baseline scenario and may offer protection against more adverse trade outcomes.

Structural tilts and active management

As the most accessible markets become increasingly expensive, sophisticated investors can unlock value through more structural strategies. The concept of structural alpha involves identifying repeatable structural inefficiencies in markets – e.g., decisions made by noneconomic investors such as central banks – and creating a diversified portfolio of these inefficiencies, reducing reliance on a directional macro view.

One example of structural inefficiency is home country bias, where investors feel more comfortable investing in their own country than elsewhere. We see this as a growing opportunity as capital markets continue to expand outside of the U.S.

Another example is the rise of passive exchange-traded funds (ETFs). Required daily data disclosure by ETFs has created an information advantage for active asset managers, who can track trading shifts in less liquid market areas. Also, as ETFs gain traction in mainstream sectors such as corporate credit, they enable larger trades. In recent years, synthetic indices of diversified credit instruments have become more liquid than the underlying bonds and have often outperformed those bonds due to technical factors, creating further opportunities to enhance returns.

Conclusions

Favorable global economic conditions, the capital preservation qualities of fixed income, and the potential for capital gains position bonds as a critical element of portfolios in 2025 and a source of diversification to complement exposure to riskier assets. Short-term volatility presents opportunity for active bond managers, while current yields and historical valuation trends suggest more predictable longer-term returns that are likely to be attractive compared with both cash and equities.

About our forums

PIMCO is a global leader in active fixed income with deep expertise across public and private markets. Our investment process is anchored by our Secular and Cyclical Economic Forums. Four times a year, our investment professionals from around the world gather to discuss and debate the state of the global markets and economy and identify the trends that we believe will have important investment implications. In these wide-reaching discussions, we apply behavioral science practices in an effort to maximize the interchange of ideas, challenge our assumptions, counter cognitive biases, and generate inclusive insights.

At the Secular Forum, held annually, we focus on the outlook for the next five years, allowing us to position portfolios to benefit from structural changes and trends in the global economy. Because we believe diverse ideas produce better investment results, we invite distinguished guest speakers – Nobel laureate economists, policymakers, investors, and historians – who bring valuable, multidimensional perspectives to our discussions. We also welcome the active participation of the PIMCO Global Advisory Board, a team of world-renowned experts on economic and political issues.

At the Cyclical Forum, held three times a year, we focus on the outlook for the next six to 12 months, analyzing business cycle dynamics across major developed and emerging market economies with an eye toward identifying potential changes in monetary and fiscal policies, market risk premiums, and relative valuations that drive portfolio positioning.