Quarterly fixed income outlook: January 2025 | Insight Investment

We continue to see a stabilising growth environment, with inflation remaining above target but falling and real rates falling. We acknowledge that the supportive base effects helping to push inflation lower are no longer there, so there is a greater likelihood of a modest rise in headline rates in coming months, with a risk of spikes higher still. The new Trump administration could also bring an inflationary pulse in the US if it imposes meaningful tariffs on imports quickly or proceeds with a large-scale deportation plan. However, in most areas (outside Japan) inflation data is not an impediment to easier monetary policy, but inflation data may well be choppy on a short-term basis. In addition to the existing geopolitical turmoil, the new US administration brings uncertainty. Meanwhile, the political backdrop in the core of Europe is still overhanging markets, while in Asia, notably in South Korea, political turmoil is also a wildcard.

After a relatively strong year for growth, compared to many other developed economies, we expect 2025 to deliver softer, though still positive growth of around 2.2%. Inflation is expected to trend lower, but progress is likely to be slow and it may remain volatile. Potential policy changes from the incoming administration create some uncertainty. Looser fiscal policy could provide a positive impetus to growth, while a mass deportation programme could do the opposite. Widespread tariffs would likely push inflation higher though. The Fed is expected to remain on an easing tack, but policymakers have indicated a slower and more considered approach, as rates move slowly down toward a more neutral level. The extent of rate cuts may be limited by risks that inflation could be higher than forecast, such that they may not decline far below 4% in 2025. We see 10-year Treasury yields gravitating towards 4.10% in a year’s time.

Prospects for growth across the eurozone remain underwhelming, and any US imposition of tariffs on imports would likely present further challenges for the region. We do see growth improving, though only to around 1.3% in 2025. Positive real wage growth in 2025 could support consumption, but savings rates remain elevated, and the manufacturing sector has been under pressure for some time and remains weak. Consumer confidence has bounced as inflation has moderated but remains below the long-term average. Political risk remains a concern with the new French Prime Minister still attempting to achieve a stable government and Germany facing elections in February. We see inflation gradually falling back to its target level and the European Central Bank being able to reduce rates further, to about 2%. Core/German bond yields are expected to decline slightly as 10-year yields move toward 2.10%.

Achieving consistent growth remains a struggle, and we see a similar profile to the eurozone, with some improvement towards 1.5% growth in 2025. Inflation is likely to remain sticky, making a sustained return to the 2% target level challenging, particularly with wage growth remaining elevated. We see inflation remaining around 2.5% for much of 2025. The ability of the Bank of England to cut rates quickly could be compromised if the labour market remains tight, though we expect some further easing during the year ahead, taking base rates to around 4.0% in 12 months. Gilt yields are expected to decline, with 10-year yields declining to around the same level, though volatility is likely. However, a lack of progress on inflation may compromise achieving that level sustainably.

Prospects for improved economic growth in China may continue to struggle and could come under further pressure if the new US administration successfully imposes harsh tariffs on Chinese imports. Chinese yields are close to historically low levels, suggesting the market may not be optimistic for the path of growth ahead, or for a meaningful increase in inflation. We expect GDP to grow by about 4% in 2025, after undershooting its 5% target in 2024 also. Inflation is expected to gradually increase but we do not believe there is much of an upside risk to inflation, as is the case in much of the rest of the world, and the market, sees it struggling to meaningfully exceed 1%. Across other emerging markets, the uncertainty surrounding forthcoming trade policy of the incoming US administration and the associated potential for elevated currency volatility, has provided reasons for many central banks to pause and reflect before proceeding with more policy easing. Other emerging market central banks may also need to consider how best to defend their currency, should the US dollar continue to strengthen.

The 2024 credit spread tightening occurred alongside an upward trend in government bond yields, leaving ‘all-in’ corporate bonds yields at levels that appear attractive relative to history. Overall, we have adopted a more cautious active stance in the near-term. We expect a significant amount of issuance in the first half of 2025 as issuers seek to capitalize on strong demand which could exert some upward pressure on spreads, creating opportunities at more favourable levels. Nonetheless, underlying corporate fundamentals remain strong and policy easing continues coupled with resilient labour markets. From an economic perspective, major central banks are also easing policy rates, which should help prevent the US economy from falling stalling. The outlook for Europe is more complex, with weaknesses in core countries balanced by strengths in Southern Europe. From a valuation perspective, European credit markets remain more attractive, reflecting the softer economic environment.

Global high yield markets continue to be characterized by strong demand well in excess of supply. Issuance has been driven primarily by companies refinancing debt due to limited leveraged buy-out activity, leaving investors struggling to reinvest proceeds from maturing bonds and higher coupon payments. High absolute level of yields are likely to keep attracting inflows to the asset class in the medium term, despite spreads being tight relative to historical levels. Default rates remain subdued thanks to resilient growth, better-than-expected earnings, and improved capital market access, and we see no material signs of stress in the wider market. High yield corporates have weathered the period of higher rates well and declining interest rates may underpin future economic activity. Typically, the management teams of the companies we invest in are addressing 2026 – 2028 maturities and extending their capital structures, providing opportunities to invest in higher coupon issues.

Core rates moving higher is unfavourable for local currency rates. However, we still believe idiosyncratic opportunities remain. We favour local rates markets in selected countries such as Colombia, Peru and Brazil. Within hard currency corporates, defaults are beginning to normalise, and corporate fundamentals look healthier to us than they have done previously but policy changes and valuations could negatively affect the market. That said, when compared to US high yield, valuations are relatively more attractive than are high yield sectors of other developed markets. We are less favourable about investment grade corporates in the EM space and prefer high yield. At a regional level, we prefer Europe and Africa against Asia and Latin America and the Middle East. 

A stabilizing economic outlook and a gradual easing cycle would suggest that 2025 could be another promising year for secured market returns. We anticipate some reversal of the spread tightening trend as issuance increases, potentially with some front-loading as issuers aim to capitalize on robust demand. With spreads attractive relative to similarly rated corporate credits, we expect demand to stay high. Our preference remains for issues with seniority in the capital structure and robust transaction structures that divert cashflow in the event of underperformance in the underlying asset pool. Strong underwriting and servicing policies could also act to insulate investors if the economy unexpectedly weakens. Although Prime UK and Dutch residential markets have reached relatively full valuations, they remains attractive idiosyncratic opportunities, as well as global ones in both the Australian and US residential markets.  Collateralised loan obligations (CLOs) remain attractive to us, in the US and European broadly syndicated and middle market segments.

Municipal credit conditions remain robust navigating an uncertain post-election period. The resilience of credit conditions in state and local tax-backed sectors is bolstered by substantial reserves and accumulated cash balances. According to Milliman, the funded status of the 100 largest US public pension plans was 81.2% as of 31 October 2024, up from 72.4% a year earlier. We continue to favour revenue bond issues such as public power and water/sewer utilities, which offer greater stability due to their relatively predictable cashflows. Conversely, we are generally underweighting sectors offering less yield premium, such as state and local general obligation bonds. We also see good value in airport and toll road credits. In the short term, yield curve steepening has provided an incentive to extend duration and seek capture of attractive incremental yield. Further ahead, the prospect of higher inflationary impacts from the new administration's fiscal and tariff policies, could drive a more bearish steepening environment with if long rates increase.

The Republican clean sweep injects a notable amount of uncertainly in the global outlook. Although US growth is likely to continue to outperform other economies, President Trump’s new agenda may not be immediately supportive of domestic growth. This backdrop is likely to be supportive of the USD if it transpires that any trade wars have greater effect than what is currently priced. However, short-term caution may be advisable given the USD has already moved by an amount that is similar to that following the trade wars of 2018 and the market seems to be very short EUR/USD. Also, in our view, USD valuations are more stretched than they were in either 2016 and 2018 and the US economy is in a more delicate state with higher inflation and larger twin deficits. Lastly, previous USD strength is starting to elicit a response from Asian central banks both in the form of smoothing and jawboning, which may go some way to dampening further USD upside.