Did we mention there might be some volatility?

We titled last quarter’s write-up “Volatility, Velocity and Vigilantes” in anticipation of what proved to be a bumpy start to 2025. In the first quarter, while we saw some of the latter two V’s, we saw an awful lot of the first V – Volatility. It shifted dramatically during the quarter, reversing the lead between equity and fixed income returns. With the S&P 500® down -4.27% and the Bloomberg US Aggregate up 2.78% as of March 31, it was the first three-month outperformance by bonds since March 2020.

Last quarter, we also talked about how the sequence of events would matter in this so-called game of chess (chicken?) between President Trump and global capital markets. We believed that investors would ultimately view tariffs as disruptive, but also considered deregulation and tax policy as potentially constructive depending on timing and magnitude.

Ultimately, tariffs have come first and been disruptive, initially in the prolonged and uncertain run-up to April 2, and more so with the Liberation Day Rose Garden announcement. We now have another V to consider as the uncertainty volcano has erupted.

How the first quarter evolved

Risk assets broadly outperformed through the first month of the year but fell behind over February and even more so in March as uncertainty built around the ultimate scope and impact of tariffs. Investors were faced with weighing the “Trump put” (his tendency to back off on tariffs) versus the perceived Trump risk premium (strong fiscal growth). Along the way, yield volatility continued as the Fed remained in pause mode, and the significant trend, as we had been expecting for a while, was the ICE BofA High Yield Index OAS (option-adjusted spread) widening approximately 100 basis points from late January to the end of March. The widening continued with the Rose Garden event, and the 10-year US Treasury yield, flat during March, fell 25 basis points in the first few days of April.

Most of our fixed income strategies had competitive performance in Q1, as the strong market swings proved to be challenging for many managers. From an attribution standpoint, our investment process handed off the “alpha baton” from the rate side (duration and yield curve) which added value in 2024, to the sector side – specifically via underweights to credit – Investment Grade, High Yield. We believe this demonstrates that our alpha-seeking process has the ability to add value in multiple market environments.

Not your great grandad’s tariffs?

In the near term, given that the Rose Garden announcement was even more onerous than expected with regard to tariff levels, we think the bond market is responding rationally by extending first quarter themes of rates declining and credit spreads widening. Looking forward we believe that how far the market runs with this theme will be determined by if and when the administration softens its positions. In the long term, philosophically, if the administration continues to pursue protectionist policies, it will remove one of the major pillars of disinflation that the bond market has enjoyed over the past half century (some of us remember double-digit mortgage rates). Also, in our opinion, the biggest economic challenge the US faces is not the trade deficit, but rather financing a trade deficit with an increasingly large budget deficit.

While tariffs were relatively well telegraphed, another impact that we didn’t necessarily foresee was the aggressive approach to Government sector cuts performed by DOGE. The chainsaw visual accompanying the handing out of pink slips suggests unilateral cost saving but doesn’t change the fact that unemployment data (and costs) impact will appear when severance packages run out in the early second half of the year. We would also argue that the costs of a host of lost services remain unknown, along with secondary and tertiary effects to government contractors, third-party vendors, etc.

We’re not assuming the worst is over

Now comes the harder part for investors. Those market participants who seem to favor risk-on positions, tend to focus on the extended tax cuts and deregulation which are promised after the tariffs are implemented. We still expect these to occur, but can the sequencing move fast enough to avoid a recession? That’s what investors have to figure out. In the meantime, we expect at least a few quarters of zero to negative growth, leaving the declaration of a recession a matter of opinion. 

Given that expectation, we remain positioned largely in risk-off mode at the start of the second quarter. We’re constructive duration – slightly longer than benchmark – while maintaining underweights to Credit – both investment grade (IG) and high yield (HY). We would expect to see another 50-100 basis points of HY widening  if the announced tariff prescription is left unchanged. And not all credit is created equal; we  might have a macroeconomic environment where high yield bonds sell off in general. At the same time, the HY market has a little less exposure to global markets while IG has more. Emerging market bonds (EMD), which have performed well as of late, may continue that trend, although the impact to the US dollar from the tariffs fallout is not yet known, and combined with potential shifts in global demand, reinforces our neutral outlook on EMD.

What could possibly go right?

A few concepts should be apparent now: perhaps global trade is not a zero-sum game; skilled workers are not likely to fill farming and new manufacturing jobs; and we still expect to do business globally, just not with the same dynamics and resources available in the days of McKinley, or even the days of Trump 1.0.

As bond investors, we remain on guard for positive developments: such as  clarity on trade leaning in the direction of zero tariffs and/or immediate consensus on tax and deregulation policy;  as well as negative developments: escalating tariff wars that lead to more expensive production norms across the globe, or simply something breaking, akin to the Great Financial Crisis or Covid supply chain disruption. The good news is we think that our access to and usage of multiple bond management tools gives us a good chance to continue to add value in bond portfolios.