Navigating Policy Risk: Identifying Value in Dislocated Markets

As we approach the midpoint of 2025, the global economic outlook appears increasingly challenging. The first half of the year has been characterized by significant volatility, largely due to the policy shifts implemented by the new US administration. Notably, the introduction of aggressive tariff measures has pushed the effective US tariff rate to approximately 20%—its highest level in four decades.

Although these changes are not yet fully reflected in hard economic data, soft indicators such as hiring intentions, capital expenditure plans, and corporate earnings guidance have turned decisively negative. This is compounded by a growing sense of economic uncertainty, a leading indicator often associated with macroeconomic slowdowns. In May, the US employment report came in below the recent trend, and previous job numbers have been revised down notably, suggesting a broader deceleration is underway.

The US macroeconomic backdrop is weakening, and policy—both fiscal and monetary—is turning more restrictive. Over the past three years, fiscal expansion played a major role in sustaining US growth. However, the current administration’s tariff strategy effectively functions as a form of tax increase, weighing on real economic activity. In April and May alone, US customs collected nearly $40 billion in tariffs—funds diverted from the private economy into government coffers.

While fiscal stimulus remains a theoretical policy lever, the bond market is now exhibiting heightened sensitivity to deficit projections. Three months ago, the consensus estimates for the 2025 US budget deficit stood at approximately 7%. That figure has since been revised down to a range of 5.5–6%, suggesting policymakers are recognizing the constraints on further expansionary fiscal measures. The recent spending bill passed by the House—initially touted as a sweeping stimulus—has turned out to be more fiscally conservative than anticipated.

On the monetary front, the Federal Reserve faces a constrained policy space. Higher tariffs are pushing inflation expectations upward, thereby limiting the Fed’s ability to cut interest rates. The result is a policy mix that is increasingly restrictive, contributing to slower economic growth and limiting the central bank’s capacity to cushion any downturn.

Outside the United States, the impact of tariffs is arguably more aggressive. While the US experiences higher inflation from these policies, other regions, including Europe and Asia, are likely to see both a contraction in growth and a negative inflation shock. The global nature of trade linkages ensures that tariff-driven disruptions reverberate widely, exacerbating the downside for global macroeconomic performance.

In Europe, the macroeconomic response is complicated by already-low inflation and limited fiscal headroom. Nevertheless, European banks, particularly those issuing subordinated debt, continue to exhibit strong capital ratios and robust asset quality, and their valuations remain attractive compared to high-yield corporate debt. This segment may offer selective investment opportunities despite the broader macro headwinds.

Emerging markets offer a mixed but potentially rewarding landscape. Local currency bonds in several EM countries currently yield between 5% and 8% in real terms. This is particularly compelling in a context where many EM central banks are well-positioned to ease monetary policy further, especially if the US dollar remains weak. These dynamics could provide a supportive environment for fixed income investors targeting duration in local currency instruments.

Despite these macroeconomic concerns, risk markets appear increasingly disconnected from fundamentals. Since late spring, equity indices have rebounded sharply, with valuations—measured by price/earnings multiples—returning to cycle highs. Credit spreads have narrowed to seven-year lows, and implied volatility hovers near multi-year troughs. This points to a degree of investor complacency regarding the potential impact of restrictive US policies on global growth.

In this context, credit investors should exercise caution. High-yield spreads in the 280–300 basis point range offer limited compensation for rising macroeconomic risks. However, selective opportunities remain. In the US, certain sectors—such as broadcasting, telecommunications, and segments of the energy market—still offer double-digit yields with relatively low refinancing risk.

Meanwhile, the rates market offers potentially more attractive prospects. The first half of the year featured a tug-of-war between slowing economic activity and the possibility of renewed fiscal expansion. As US fiscal policy now trends more restrictive, and global central banks (excluding the Fed) lean toward easing, global bond curves may present a compelling case for increased duration exposure. US long-term real yields, nearing 3%, are among the highest observed in the past 20 years—implying a substantial term premium for fixed income investors.

Overall, the balance of macroeconomic risks has shifted decisively to the downside. Global economic activity is slowing, policy is tightening, and markets may be underestimating these risks. In this environment, a high level of selectivity is critical. Duration appears more attractive than broad credit beta. Within credit, careful positioning in high-quality segments can still yield attractive returns.

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