Quarterly fixed income review and outlook | Insight Investment

The global growth outlook remains underwhelming, with expansion rates generally in the 1% to 2% range in the major developed market economies, which is almost universally a sub-par rate. Elsewhere, China is struggling to achieve the target growth rate it sets for itself. Inflation is expected to remain sticky and above central-bank target levels in some places. Further rate cuts are expected to be dependent on inflation expectations and whether labour markets slacken or remain relatively robust. The primary wildcard is the effect that US trade tariffs will have on growth and inflation going forward. We believe the US Federal Reserve will ease policy further before reaching a neutral rate, with 2026 facing the uncertainty of who is appointed to lead the Fed after Chair Powell’s term ends. The Bank of England is likely to ease rates once more, while the European Central Bank may have completed its policy easing for this cycle. The Bank of Japan faces entrenched inflationary pressure and is expected to tighten policy further, albeit gradually. Political uncertainty remains elevated with leadership elections in Japan, ineffectiveness in France and the likely shutdown in the US. Geopolitical risks remain a latent source of volatility. While recent diplomatic efforts have failed to create a breakthrough in Ukraine, markets have largely priced in the status quo, keeping geopolitical concerns in the background for now.

Some macro indicators suggest there is resilience within the US economy, but other factors such as the evidence that the labour market may be softening significantly, align more with further slowdown. While we continue to believe that a recession is unlikely, it does remain a clear risk if the effects of tariffs and immigration crackdowns squeeze demand further. We anticipate GDP growth of 1.6% for 2025 as a whole, with similar sub-trend activity again in 2026. Inflation is still above the Fed’s target and the effects of tariffs are likely to maintain upward pressure on prices if businesses do not or cannot absorb them. However, the weaker labour market may further dull demand and help prevent an unruly escalation in inflation levels. We expect the inflation rate to be around 2.7% this year and 2.8% in 2026. Having eventually resumed its easing cycle after nine months, the Fed appears to be turning its attention as much to the labour market as to tariffs, and we see further cuts to come in 2025 and potentially into 2026, taking the Fed funds rate to the 3.25% to 3.5% range. Treasury yields are expected to ease, with the 10-year yield declining below 4%, towards 3.85% in 12-months’ time. The backdrop of political pressure on the Fed and expansive fiscal policy creates some further potential for bond market volatility. The US government shutdown will potentially lead to weaker sentiment and, until resolved, reduce the availability of data produced at a federal level (including the high-profile non-farm payrolls data, due in early October).

Leading indicators for the eurozone have been resilient in the face of ongoing tariff uncertainty. The recovery continues to be led by Spain. German and French growth is anaemic, while Italy’s is slowing as the super bonus tailwind fades. The manufacturing sector, which has been under pressure for some time, remains very weak. Positive real wage growth in 2025 could support consumption, but savings rates remain elevated and subdued consumer confidence offers little cause for optimism the consumption will accelerate. The labour market remains resilient. On the positive side, the prospect of a large German fiscal package adds some upside risks to our growth forecast, while the US tariffs add significant downside risk via both the trade and uncertainty channels. Eurozone inflation has been around 2% for some time now but we forecast it will modestly fall next year owing to base effects. The effect of tariffs will be nuanced; any retaliatory tariff price hikes may be tempered by softer demand and Chinese goods dumping. We believe the ECB will probably not ease rates further in 2025, though there remains the possibility for one more cut to take the deposit rate to 1.75% in 2026. Bond yields are not expected to diverge greatly from current levels for the time being, and we see 10-year yields around 2.65% in a year’s time. Politically, in France, difficulties in forming a government continue. As we expect little progress in the near term given the polarised nature of the French parliament, the situation leaves political risk elevated.

The UK economy is growing, though not particularly strongly, and we do not expect that situation to change materially for the better for some time. A lurch into recession should not be ruled out. The labour market is likely to continue softening slowly and inflation is
expected to remain above trend for the foreseeable future. We expect GDP to expand by just 1.3% in 2025 and 1.1% in 2026. Inflation is expected to remain elevated compared to the eurozone at around 3.5% for 2025, before falling back to 2.7% in 2026, still well ahead of the Bank of England (BoE) target rate. There are medium-term structural changes that we believe will likely put upward pressure on inflation: consumers may be more attentive to inflation so that inflation expectations rise, leading to a self-fulfilling outcome; and low labour-market participation rates could help restrict the labour force, maintaining wage growth at a higher level and more government borrowing. The stickiness of inflation is a key reason why we believe the BoE will only cut rates once more in this cycle, probably in November. Any further rate cuts in 2026 are likely to be data-dependent. Meanwhile, we expect elevated government borrowing to help keep gilt yields close to current levels over the foreseeable future with 10-year yields close to 4.60% in a year’s time. The market continues to look forward to policy measures to be announced at the November autumn budget, with tax rises widely expected to form a core part of the chancellor’s plan to meet the government’s fiscal rules.

China’s economy appears to be stabilising but ongoing domestic issues, notably in the property sector, remain a hurdle to achieving the growth trajectory that the authorities would like. Tariffs and global trade tensions are combining with the underlying demographic factors that will likely lead to a falling working-age population as a proportion of the whole. The government’s policy focus will likely remain on supporting domestic demand, managing financial risks, and navigating geopolitical uncertainties to sustain moderate growth. We believe the 5% target for GDP growth will be missed both this year and in 2026. Given the subdued growth outlook, we expect inflation to remain low, and it may struggle to achieve our expectations of 1% for this year and 1.3% for 2026. The Chinese authorities are expected to intensify fiscal and monetary support, aiming to stimulate domestic demand and the property sector. Any interest rate cuts that the People’s Bank of China implements will likely be only modest, but we believe that the current low levels of bond yields will gradually rise in time with the 10-year rate moving to 2% and higher in the course of the next 12 months.

GDP growth rates in other emerging market countries are relatively robust, but many still face the effects of US tariffs with little prospect of them being lifted soon. As with most developed market economies, inflation is expected to continue moderating slowly over time, though there may be volatility in that process. Interest rate cuts may also be forthcoming, particularly if the USD continues to give ground and the Fed cuts rates further.

Supply of US dollar corporate bonds has increased but is outweighed by strong investor demand, supporting the gradual tightening of spreads. Spreads are near the tighter end of historical ranges, but this could persist for some time given demand. Notably, in the 1990s, credit spreads tightened to similar levels but then narrowed further after the Federal Reserve began cutting rates. Absolute yield levels remain a key driver for investor demand, and we expect this to persist with the US able to avoid recession as AI-driven business investment offsets a softening labour market and a central bank that is widely expected to cut rates further. In Europe, corporate bond spreads offer better value, although investor interest is growing; the easing of Germany’s debt brake should support eurozone growth and present significant opportunities for security selection. Valuations in sterling credit lie somewhere in between, although economic growth is unlikely to benefit from either a rate cut or fiscal stimulus. Globally we remain cautiously constructive, favouring selective exposure to higher-quality issuers, with a modest tilt towards defensive sectors and euro-denominated debt where appropriate as we wait for broader valuations to improve.

The asset class has become an increasingly attractive hunting ground for investment grade portfolios seeking incremental yield given the compression of spreads in higher-rated credit. This trend is underpinned by a narrowing rating differential, as an increasing share of high-yield issuers migrate towards the highest BB rating, while investment grade markets continue to drift towards a BBB rating. Buoyant demand stands in contrast with modest issuance, with many issuers having already prefinanced their 2026 and 2027
maturities. Tariffs, and their broader impact on growth, remain a concern, and require careful consideration as we make new investments within active portfolios. However, many high-yield issuers manufacture and sell locally rather than internationally, which
helps to mitigate the impact of tariffs. Overall, we continue to believe the environment remains attractive for high yield issuers, many of which boast strong balance sheets and robust cashflows. Defaults remain low, and this likely represents a structural shift for high yield markets, with smaller and distressed issuers turning to private credit markets where there is far greater flexibility to restructure debt when necessary.

The macroeconomic backdrop for emerging markets remains robust, with GDP growth continuing at a healthy pace compared to the majority of developed market economies. Additionally, the consequences of US trade tariffs on activity in the emerging markets has yet to be fully seen but many central banks retain policy flexibility, allowing them to respond effectively should growth momentum slow. In an environment of US dollar weakness, we have seen a notable uptick in flows into emerging market credit. Our constructive outlook is supported by structural tailwinds, including the potential for an extended period of dollar softness and the ongoing reallocation of assets away from the US, positioning these regions to benefit from investors seeking to increase their diversification. Generally, spreads are tight partly as a consequence of net supply being negative. We see more value from high yield parts of the emerging market corporate markets over investment grade.

Returns in asset-backed markets over the summer have been predominantly carry-driven, supported by subdued supply and robust demand, which has led to a slow tightening in spreads. Esoteric issuance, particularly transactions linked to datacentre financing and AI-related investment, continues to attract investor interest. We anticipate issuance will continue into the early parts of the fourth quarter, which may exert mild upward pressure on spreads if investors’ collective risk appetite starts to weaken. From a collateral perspective, relatively resilient growth is supporting consumers and although areas such as the US labour markets appear to be softening, they are doing so only gradually. Looking forward, the expected easing from the Fed should help to support consumers. We continue to be active in primary markets, capitalising on new-issue premium and more broadly seeking out relative-value opportunities that offer attractive risk-reward profiles. 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 should also act to insulate investors if the economy unexpectedly weakens. In our view, US and Australian residential risk and European collateralised loan obligations continue to be areas offering value, while auto ABS also appear attractive at the senior parts of the capital structure.

Against a backdrop of greater policy uncertainty and our expectation of a slowing economy we are maintaining our bias towards more defensive sectors such as public power and water/sewer utilities given their stability, essential nature, and predictable cashflows. Against this we are generally underweight in state and local general obligation bonds which trade at a lower premium relative to Treasuries. We also remain cautious on healthcare given rising labour and equipment costs. After a considerable steepening in the yield curve, we have shifted to a small, long duration position to capture higher yields and in anticipation of further Fed easing ahead. Spreads are tight relative to history but may still have further to run given a solid fundamental credit backdrop and steady investor demand for municipal bonds.

A number of structural factors combine to be negative for the USD. They include a view that the US fiscal policy position is not sustainable in the long term and that the USD remains overvalued generally. Also, the market has yet to unwind its structurally long position in US assets with little hedging of currency risk in place. Continued perceived political attacks on the independence of the Fed will more likely undermine the dollar than support it, though equally real USD rates are relatively high and not expected to decline sharply in the absence of a significantly weaker US economic outlook relative to the rest of the world. While a weaker USD may be considered beneficial for US growth, if it prevents inflation declining quickly enough, the Fed may not feel able to cut rates as quickly as the US  administration would like.