Fixed Income Outlook 2Q 2025
Risk-Aware, Return-Ready
Changing Landscape: Adapt in Dynamic Markets
The investment landscape is changing rapidly, and as we navigate the second quarter, investors are facing more questions than answers. The potential economic, policy, and market implications of escalating US tariffs and heightened uncertainty remain unclear. As we highlighted last quarter, the 2020s have taught us to expect the unexpected, and recent developments have only reinforced this lesson. For example, the US dollar has defied its traditional appreciation trend amid risk-off sentiment. Additionally, while US Treasuries have provided diversification benefits for much of the year, recent weakness—partly due to concerns about a potential reduction in foreign holdings of US debt—emphasizes the need for adaptability, humility, and disciplined investments in these dynamic markets.
Structural Shifts: Global Trade System, Geopolitical Order and Technological Revolution
The investment landscape is being reshaped by three structural shifts: an economic rewiring of the global trade system driven by the US Administration; a new geopolitical order with changing national security alliances and priorities, leading to a German fiscal breakthrough; and a technological revolution characterized by growing AI adoption and disruption. These shifts underscore the importance of active security selection, as their implications will vary by country, sector, and company.
Taking Stock of the Tariff Shock
Our latest quarterly fixed income investment meetings took place during the week of the April 2 tariff shock, which injected fresh uncertainty into the global economic and fixed income outlook.
Outlook: US Economy, Fed Response, US Dollar and European Prospects
For the quarter ahead, we are focused on four key market dynamics: the outlook for the US economy, the Fed’s reaction to a policy-induced downturn, the portfolio properties of the US dollar in a world of trade decoupling, and improved prospects in Europe due to the fiscal regime shift in Germany. We foresee a deceleration in US growth but do not expect a deep downturn given the strong starting point for the economy, though we acknowledge that risks are skewed to the downside. Combined with near-term inflation risks, this suggests the Fed is unlikely to proactively cut rates until significant cracks appear in the labor market. While we anticipate continued near-term downside for the dollar, we believe it is premature to call for its structural demise. However, we do see a structural breakthrough in Europe due to shifts in defense and German fiscal spending.
Risk Aware, Return Ready
Lastly, while we have adopted a more defensive stance in our investment portfolios amid elevated uncertainty and heightened economic risks, we remain "Risk Aware, Return Ready." We are prepared to capitalize on market corrections to increase exposure to high-conviction views at attractive levels when risk-adjusted return potential becomes appealing.
Source: Goldman Sachs Asset Management, Goldman Sachs Global Investment Research, Bloomberg, Macrobond. As of April 3, 2025.
What We’re Watching
US Policy
US tariff policy caused significant market uncertainty and volatility in the first quarter but may improve investor sentiment in the future if the focus shifts towards deregulation and potential fiscal support. That said, tariffs are viewed as a strategic tool to address trade imbalances, geopolitical tensions, raise revenues, and stimulate domestic manufacturing. Therefore, we believe the baseline 10% tariff imposed on all US trade partners, excluding Canada and Mexico, is likely to remain, even if other tariffs are reduced following the expiration of the 90-day pause in July or additional sectoral exceptions come into effect. Tariffs on China also look set to remain elevated.
Corporate Earnings
Our focus during the first quarter earnings season is on signals regarding the outlook, though we anticipate some companies may withdraw formal forward guidance and many may lower forward guidance. We are closely monitoring profitability trends, particularly if companies choose to absorb tariff costs rather than pass them onto consumers to maintain sales volumes. In addition, we will be looking for indications that companies may look to offset tariff-driven margin pressure with lower costs in other areas, especially labor. The economy can potentially avoid a hard landing if unemployment stays low. There are signs of a softer labor market, but some hard data shows the job market is holding up with no signs of DOGE-related layoffs flowing into job losses yet.
Existing inventory levels may mitigate some near-term pressure on profitability, and certain companies could benefit from a front-loading of demand ahead of the July 9 deadline for reciprocal tariffs. Encouragingly, the starting point for credit fundamentals in the face of the tariff shock is strong. At the beginning of the year, we anticipated that 1.3% of the US investment grade market (approximately $100 billion in corporate bonds) and 0.8% of the European investment grade market (around €25 billion) had a 30% chance of migrating to high yield. This reflects challenges faced by some companies due to higher rates, slower growth, or secular challenges to their business models. In a recession scenario, these figures could rise to around 2% and 1.2% in the US and European markets, respectively. Even then, this would be lower than the peak rating migrations seen in the US market during the pandemic (3.2%), the 2016 energy crisis (2.2%), and the global financial crisis (6.2%). In addition, the high yield market is higher quality today than in past cycles and has a shorter duration, suggesting that even in a recession scenario, defaults may peak at lower levels than in the past.
In the investment grade market, capital allocation plans may offer insight into business sentiment, as companies tend to be more conservative in times of heightened uncertainty, delaying new investment. We will be monitoring for any signs of slowing capex investment, especially in areas that have attracted lots of capital in recent periods, such as data centers and the buildout of electricity generation. Companies may also look to bolster liquidity positions through reduced share buybacks. Among banks, a sector that we are overweight, we are assessing any uptick in provisions for potential loan losses or changes in consumer debt delinquency trends. Across non-financial sectors including consumer goods and autos, we are focused on how companies respond to potential increases in input costs from tariffs and whether those with scale seek to stay price competitive to maintain or expand market share. Meanwhile, for energy companies, we are tracking future investment plans and share buyback activity amid headwinds from slower global growth and lower oil prices. The homebuilding sector also faces dual headwinds from the impact of higher tariff rates for materials and lower demand amid high mortgage rates. Lastly, we are interested in any potential change in appetite among companies outside the US with respect to investing in the US economy.
Fiscal Support
The response of governments to help manage the economic impact of tariffs through fiscal support, both in the US and globally, will be crucial for gauging the ultimate hit to growth and recession odds. US tariffs represent a significant hit to US consumer purchasing power, which may create political pressure for fiscal support. However, everything takes time. If fiscal support requires Congressional approval, such as in the case of enacting tax cuts, the timeline may misalign with the peak economic impact.
Our Fixed Income Outlook 2Q 2025 features:
• Tariffs and Their Effects on the US Economy
• Macro at a Glance
• Asset Class Views
...and more. Download our quarterly outlook below.
