Seeking Stability

Correcting these imbalances would require structural changes, including curbing the share of GDP derived from consumption in the U.S., reducing the contribution to GDP from manufacturing and savings in trade surplus economies, and lowering the concentration of global excess savings flows entering U.S. capital markets.

Implementing these changes faces economic, political, and market constraints, both in the U.S. and abroad. Doing so over a six- to 12-month cyclical horizon would likely disrupt economies and markets, even if the result is eventually a more balanced global system.

We anticipated such disruption in our January 2025 Cyclical Outlook, “Uncertainty Is Certain.” Policy uncertainty is now unfolding daily and emanating mainly from the U.S., historically a source of global stability.

Threats to U.S. exceptionalism

This shift reflects an international role reversal, with the U.S. signaling a pullback from some traditional functions while other countries step in to fill the voids. Long-held assumptions about the U.S. as a reliable international leader are being challenged.

These changes may coincide with the twilight of the recent U.S. capital markets outperformance relative to the rest of the world. In Europe, the peace dividend – the economic benefits of reduced military spending after the end of the Cold War – looks to be over, with countries across the continent now set to increase their defense budgets.

In January, we said our baseline called for an economically manageable increase in tariffs – which, along with U.S. tax and spending policy, would leave federal fiscal deficits largely unchanged in 2025 and 2026.

However, we also said these pivots, depending on their scope, widened the range of possible growth outcomes in the U.S. and deepened economic risks elsewhere, especially for countries heavily reliant on global trade and that run surpluses with the U.S. We thought U.S. equity market volatility would be a limiting factor.

The Trump administration has since launched aggressive measures on trade, government containment, and immigration. These are likely to slow the U.S. economy more than previously expected and hurt the labor market, regardless of whether government spending cuts are codified into law.

Officials have argued that some near-term pain is acceptable in pursuit of longer-term goals, suggesting the tolerance for economic and market volatility is higher than previously thought. Eventually, higher prices, especially for food and energy, and lower equity values are likely to be a political constraint. 

Rising risks to U.S. growth and inflation …

While the ultimate implementation remains uncertain, disruptive U.S. policy announcements have already damped U.S. consumer and business sentiment and will likely weigh on investment and hiring decisions (see Figure 2). Globally, if businesses face tariff-related risks that are close to impossible to calibrate, then the likely result is delayed decisions on investment and expansion. In other words, tariff uncertainty is proving to be a headwind to growth, even if tariffs fail to materialize.

We see a risk that U.S. growth and labor market momentum downshift more decisively. After U.S. real GDP grew 2.5% to 3% annually over the past few years, we expect a below-trend pace in 2025 and 2026.

The average effective tariff rate on U.S. imports has increased an estimated 7.5 percentage points from actions against Canada, Mexico, and China. We expect additional trade policy measures to raise that figure significantly throughout the year, as Europe and other southeast Asian countries could face U.S. tariffs.

Businesses are likely to pass on tariff costs, boosting inflation during the period of price adjustment and delaying the return to the Federal Reserve’s 2% target. More concerning for Fed officials, surveys of consumers and business suggest inflation expectations are moving higher.

In Congress, the focus is already on U.S. tax policy. Given the circuitous nature of the legislative process and the very narrow Republican majorities, especially in the House of Representatives, we do not expect to see a signed bill until summer, if not later. While we still expect trade, spending, and tax policies to have a neutral net effect on the U.S. fiscal impulse in 2025, a more significant near-term growth slowdown could tilt the scales toward larger, more stimulative tax cuts. 

… While potential for fiscal stimulus and rate cuts helps the global outlook

Recent policy actions in other major economies appear to incrementally improve what were otherwise bleaker outlooks. Expectations for fiscal expansion are rising in countries such as China, Germany, Japan, and Canada.

China and Germany have strong incentives to implement structural changes. China’s housing overbuild and debt-deflation cycle contributed to an overreliance on exports – a model now strained by other countries’ unwillingness to import China’s production capacity. China appears more willing to implement policies to boost consumption while continuing to invest in technology and AI.

Germany is prioritizing increased spending on defense and infrastructure after the pandemic, the war in Ukraine, and intense competition from China have upended the German economic model. Other European countries could follow suit but may have less capacity than Germany, which tends to run fiscal surpluses.

We expect growth trends to remain stable and mediocre outside of the U.S. Trade uncertainty remains a headwind, but easier financial conditions in more interest-rate-sensitive economies and fiscal loosening should provide some offsetting support.

Looser labor markets and an expected moderation in wage inflation should keep inflation outside of the U.S. on a declining path, allowing DM central banks to continue easing policy to neutral levels. We expect 50–100 basis points (bps) of additional rate cuts across DM economies over the rest of 2025. The Bank of Japan remains an outlier and is likely to raise rates in the face of elevated inflation expectations. 

As a baseline, we expect the Fed to cut rates by another 50 bps later this year. The Fed is in a tricky spot, as higher inflation and lower growth risks have contrasting implications for the central bank’s price stability and full employment goals.

The main risk is that slowdowns in the labor market and real GDP growth cause the Fed to cut rates more deeply than the market is currently pricing, even if sticky inflation and rising inflation expectations delay the Fed’s reaction to early signs of an economic downturn. In the end, we expect Fed officials will cut more aggressively if they see recession risks rising faster than inflation expectations. In contrast, we believe the likelihood of the Fed reversing course and hiking rates in response to tariff-related inflation is low.

In this unusually uncertain macroeconomic environment, it’s prudent to prioritize simple, stable investments over trying to predict the unpredictable.

Elevated uncertainty is likely to challenge the U.S. equity outperformance of recent years. There is a strong case to diversify away from highly priced U.S. equities into a broader mix of global, high quality bonds. We believe we are in the early stages of a multiyear period in which fixed income can outperform equities while offering a more favorable risk-adjusted profile.

Historically, starting bond yields correlate very closely with five-year forward returns (see Figure 3). Yields on high quality bond portfolios are 4.65% based on the Bloomberg US Aggregate Index, and 4.80% based on the Global Aggregate Index (U.S. dollar hedged), as of 28 March 2025. Building on that baseline, active managers can identify opportunities in high quality sectors to seek alpha – returns above market benchmarks – to enhance the yields investors earn.

Meanwhile, the equity risk premium – a measure of the additional returns investors require to invest in riskier equities – turned negative in late 2024 for the first time in more than two decades, driven by historically elevated stock valuations coupled with the highest bond yields in years. It has since risen but remains near historical lows. (For more, see our February PIMCO Perspectives, “Where to Look When Equities Are Priced for Exceptionalism.”)

The portfolio diversification benefits of bonds have been on display in recent months. Equities and bonds typically move in opposite directions, allowing one part of a balanced portfolio to gain when another falters. As stocks have slumped, high quality bonds have thrived, delivering total returns comparable to equities over the past year while presenting favorable valuations today.

Duration looks more attractive

It remains unclear whether recent market volatility marks peak pessimism regarding U.S. policy uncertainty, or if the disruption will persist and further erode business and consumer confidence both in the U.S. and abroad, affecting economies and asset prices even more.

The rosy assumptions that buoyed risk asset pricing earlier this year have given way to a more cautious outlook. The decline in risk assets has accompanied a rally in U.S. Treasuries and Canadian government bonds, which contrasts with higher yields in Europe and the U.K. – in part the result of Germany’s planned fiscal spending increase.

Even after this year’s Treasury rally, the U.S. 10-year note yield remains firmly in the middle of our expected cyclical range of 3.75% - 4.75%. However, if recession risks rise, there is the potential for markets to price in more Fed rate cutting and for this range to shift down.

The German bond market experienced a sharp repricing in early March, reflecting changing political attitudes toward public spending. This shift is significant, given Germany’s unique position in the euro zone with its low debt levels.

Beyond Germany, we expect increased defense spending across Europe – though with measures likely to be less bold, given that countries with weaker initial fiscal conditions will struggle to fund such initiatives. Consequently, we have raised our expected range for the 10-year bund yield to 2.5%–3.5% from 2%–3%, indicating potential for further repricing.

Broadly, we favor an overweight to duration, a gauge of interest rate sensitivity. At a time of asymmetric risks across countries, we look to global diversification in high quality duration. We favor the U.K. and Australia for overweight duration positions. We view European duration as less attractive, given fiscal pressures, and expect yield curves to steepen across eurozone markets.

Rich global opportunities

The flip side of serial U.S. trade deficits has been the glut of foreign excess savings fueling U.S. capital markets. The world has been heavily weighted toward U.S. investments, particularly equities (see Figure 4), which now appear more vulnerable.

In this environment, we believe it makes sense to capitalize on global opportunities, particularly as bonds have become more attractive. In high quality duration, in credit, and in securities markets, we will look to emphasize the global opportunity set.

Emerging markets (EM) offer interesting alpha opportunities as well as diversification benefits. In high quality EM, historical default rates align with U.S. corporate credit, and premiums for structuring and illiquidity remain attractive. We see value in local currency opportunities that could benefit from capital flows being redirected from the U.S., as well as in hard dollar spreads where investment grade credit is increasingly available.

The risks to U.S. exceptionalism have reduced the attractiveness of the U.S. dollar. At the same time, tariff risks caution against short positions in the U.S. dollar, in case currency adjustment is the release valve should unexpected tariffs cause other currencies to depreciate. We favor carefully managed foreign exchange positions, to generate income outside of the U.S. while seeking to minimize correlations to the U.S. dollar or equity markets.

Favor asset-based finance over corporate credit

We are cautious on corporate credit, as we believe spreads fail to adequately account for potential downside risks.

While corporate bonds play an important role in portfolios, we currently see greater value in high quality alternatives. That includes credit derivative indices and an overweight position in agency mortgage-backed securities (MBS). We prefer high quality fixed income and securitized products.

In private credit, we believe asset-based finance (ABF) strategies offer the most favorable opportunities and entry points. We can identify attractive cash flow profiles that are typically fixed-rate, amortizing, and secured by tangible assets. This creates a narrower range of outcomes, making ABF a valuable addition to portfolios as other private credit assets face increased uncertainty.

This is especially true in corporate direct lending, where demand/supply imbalances (with more investor demand for loans than borrowers seeking solutions), weaker lender protections, and floating-rate coupons lead to a wider range of outcomes. We see competition in this space increasing, with significant investor dry powder chasing deals and banks returning to syndicated loan markets.

This is contributing to convergence in spreads between public and private leveraged credit markets. Contrary to expectations that the Trump administration would ignite merger and acquisition activity, heightened uncertainty has hindered M&A and slowed new deal flow.

Conclusion

With stock valuations and volatility unusually elevated, and credit spreads tight, high quality fixed income can offer attractive yields, stability, and a robust longer-term outlook for patient investors.

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.