Sector Views: Proceed with caution

Market backdrop

Our full-year 2025 US gross domestic product (GDP) growth projection is 2.1%, modestly higher than our previous estimation. Consumer spending remains the main driver of growth. Several factors have bolstered spending, including low unemployment and positive wealth effects—partially derived from record-breaking stock market valuations and built-up equity in the US housing market. In our view, US GDP growth will continue around trend in 2026.

There have been media headlines of corporations laying off large amounts of white-collar workers, but state-level data of initial jobless claims remain stable. In our view, the unemployment rate has neared its peak, and we see no immediate driver for the US job market to slow substantially from here. In our view, inflation will continue to be sticky. We have seen goods inflation pick up over the past several months after falling over the past two years. This trend should continue to keep the core Consumer Price Index well above the Fed’s 2.0% inflation target through the end of 2026.

Outside the United States, economic growth still faces some challenges. In Europe, we think growth will continue to be positive, but at low levels, amid the resolution of US trade tensions. In our estimation, GDP growth will likely remain in the area of 1.3% for this year and next, and inflation will continue to trend down toward the ECB’s 2.0% target. Similarly, we expect Japanese GDP growth of only 0.5% in full-year 2025, increasing to 1.0% in 2026. Inflation has been difficult for the Bank of Japan to get under control, but it should begin to decline, moving from a projected 3.0% in 2025 to 2.2% in 2026.

Tariffs

Tariff concerns have not yet made the price impact that many market participants assumed. Customs duties, while increasing, are still below theoretical tariff rates. Actual tariffs paid, as a percentage of imports, remain under 11%, compared to the expected 16%–18%. We still anticipate that the cumulative effect of increased tariffs will cause a one-off burst of inflation, about 1.0-1.5 percentage points. We have yet to see the full impact of this boost, partially due to the use of increased business inventories which had been built up prior to the implementation of new duties. These inventories continue to be depleted, leading to increased goods prices. Additionally, some businesses have chosen to absorb some of their increased input costs, but this is not guaranteed as companies will defend their profit margins.

US yield curve

Our view on the level and shape of the yield curve has not changed, and we expect intermediate- and longer-term UST yields to move higher over the medium term. The steepness of the curve has been impacted by the way the US federal government has been funding increased fiscal spending. New UST issuance has been skewed toward bills—those those with less than 12 months to maturity—rather than longer-term notes and bonds. This composition is seen as a key factor keeping the term premium in the yield curve contained. However, the market anticipates a shift in issuance toward longer-term bonds by mid-next year, which would exert upward pressure on the term premium, as experienced in October 2024 when issuance shifted toward longer maturities.

Fed path

The Fed delivered two successive 25-bp cuts at its September and October meetings. These cuts have been widely characterized as “insurance cuts.” In our view, this was somewhat premature. As has historically been the case, the Fed has chosen to focus on the maximum employment side of its dual mandate. Although we acknowledge that the US job market is cooling, it appears well under control, with historically low unemployment. Market expectations for future rate cuts have declined, but still project a terminal rate of approximately 3.0%. We feel that this “goldilocks” scenario, where the Fed can cut rates without inflation implications, is overly aggressive. The Fed still must contend with sticky inflation with positive pressures from tariffs. Our view is that the Fed has one more cut left;. any additional cuts would likely tie policymakers’ hands if inflation pressures in 2026 accelerate.

Overall risk outlook

Neutral with reason for concern

We maintain our neutral with reasons for concern outlook on fixed income spread sectors as valuations continue to look stretched across much of the fixed income market. The US economy is holding up well into year-end, and we expect GDP growth to continue at or above trend levels. This has supported fundamental conditions in corporate credit and securitized markets, along with strong technical conditions and ample demand for bonds. However, spreads across much of the fixed income universe remain at or near multi-decade tights. In our view, this continues to present an asymmetrical outcome picture. Spreads do not have the potential to tighten materially from here and any negative surprises could cause widening returning to more historical norms. This limits the upside potential for capital appreciation. Returns from fixed income products will predominantly come from yield and income provided by holding bonds. With our current view that the Fed will have limited room to enact multiple rate cuts unless we see a material deterioration of the US economy, we prefer lower-duration, high-quality assets under the current market environment.

Key sector viewpoints

Short-duration fixed income:

• Short-duration fixed income has delivered similar long- term annualized returns to well-known fixed income benchmarks, but with substantially less volatility (standard deviation), resulting in higher historical long-term risk adjusted returns (Sharpe Ratio).¹
• With attractive yields and less interest-rate sensitivity, short duration looks positioned to deliver greater return consistency versus core fixed income under different interest-rate scenarios, in our view.
• Investors can capture higher yields in short-duration relative to “cash”- like investments such as money market funds and short-term USTs.
• The yield differential may continue to increase moving forward due to Fed policy, changing yield-curve dynamics, and reforms on money market funds.
• As a result, we believe there is a strong case to use a short-duration strategy as a structural allocation within a diversified fixed income portfolio.

Municipal (muni) bonds:

• In September, the muni bond market recorded its strongest monthly performance of the year, surpassing the returns of most other fixed-income sectors, as favorable supply and demand boosted returns.
• For much of the year, the municipal bond yield curve has been steepening, characterized by short-term yields declining with long-term yields rising. However, this trend reversed during the month, resulting in a tailwind for longer maturity municipals, providing investors with enhanced returns in this segment.
• Despite the robust returns observed in September, municipal bond valuations remain attractive, especially for maturities of 20 years or more. This suggests that there may still be compelling investment opportunities within longer maturity municipals.

Securitized:

• We continue to favor agency mortgage-backed securities (MBS) over the medium-term, with a favorable fundamental and technical outlook for the sector and attractive relative value to investment-grade (IG) corporates. IG corporate spreads relative to MBS option-adjusted spreads are still near historically tight levels.
• Although money managers’ overweight allocation is a potential hurdle for spread tightening, we anticipate increased demand from banks. Bank demand could increase if the yield curve normalizes or regulatory uncertainty dissipates. Although China, Canada, and Japan agency bond holdings continued to decline third quarter 2025, potential dollar weakness could attract buyers as currency hedge-adjusted yields become more attractive.
• We continue to find value in “out-of-the-money” agency interest-only (IO) bonds, which offer attractive carry with lower volatility since they remain largely insulated from prepayment risk
   

Sector settings overview

Moderately bullish

Emerging market (EM) sovereign debt: We believe strong supply and demand factors together with valuations should support EM debt performance into year-end. We retain our relative preference for EM high-yield (HY) bonds, given spread buffers, and favor issuers that stand to benefit from any rally in real assets, such as gold.

Municipal bonds: Credit fundamentals and technical conditions remain strong. Healthy investor demand and relatively attractive yields lead us to remain moderately bullish on tax-exempt muni bonds. 
 

Neutral with reason for optimism

Floating-rate bank loans: While we expect fundamentals to remain relatively stable, though bifurcated, higher-for-longer rates, policy uncertainty and market volatility could continue to pressure ratings in the near term.  

US Treasury-Inflation Protected Securities (TIPS): Inflation accruals are higher than anticipated, which has caused us to lower our expectations.
 

Neutral

Asset-backed securities (ABS): Given the prevailing uncertainties on policy (tariff and tax), possible headwinds could impact collateral performance and seller/servicer risks, especially for the bottom of the capital stack.  

EM corporate bonds: EM corporates have generally weathered tariff-related noise in 2025 with stable fundamentals. Leverage and margins remain intact, which should support spreads.

Global Sukuk: The relative strength of global Sukuk credit fundamentals, with supporting market technicals, provides a buffer against potential market stress, which in our view reinforces the case for long-term allocations to global Sukuk.

Agency mortgage-backed securities: Conditions are improving based on tighter spreads, prepayment risk in the higher coupon securities, and neutral fundamental outlook, offset by a favorable technical outlook, expectation of increased bank demand, and low net supply in the market.

Non-agency residential mortgage-backed securities: We are neutral on the sector, given rich valuation and modest home price growth expectation. Amid heightened macroeconomic uncertainty, we favor opportunities near the top of the capital stack.

US high-yield (HY) corporate bonds: We remain broadly constructive, albeit a neutral stance, believing that tariff-related economic volatility presents only moderate incremental risk to the range of market outcomes over the longer term.  
 

Neutral with reason for concern

Collateralized loan obligations (CLOs): In a higher-for-longer interest-rate environment, we think demand for floating-rate instruments, such as CLOs, should remain robust. The limited net supply of CLOs is likely to be absorbed by the market.

Commercial mortgage-backed securities: While the commercial real estate sector has been showing signs of improvement, and generic spreads are still well wide of historical tights and closer to long-term averages, we believe they do not reflect new risks—and spreads could widen.

European high-yield corporates: Strong supply-and-demand factors are helping to anchor spreads, with still- attractive yields stimulating inflows. A resilient European banking sector and expectations of fiscal stimulus should add support, counterbalancing any potential bouts of volatility.  

European investment-grade (IG) corporate bonds: Despite rich valuation levels, resilient fundamentals and strong liquidity should broadly support spreads.

Japanese government bonds (JGB): We have improved our stance on JGBs, as the Bank of Japan (BoJ) left the policy rate unchanged at 0.50% during its September meeting, as widely expected. The BoJ decided to begin unwinding its exchange traded funds and Japanese real estate investment trust holdings.

US investment-grade (IG) corporate bonds: Strong demand and solid fundamentals support US IG bonds, but tight spreads lead us to favor shorter-maturity, high-quality issuers, short maturities and lower dollar-priced bonds. 
 

Moderately bearish

European government bonds: We believe further ECB easing is unlikely given inflation near target and longer-term fiscal constraints. We maintain our cautious outlook, although noting rising euro sovereign political risk premium has been relatively contained.

US Treasuries: We maintain our moderately bearish stance due to continued uncertainty within the market and our belief volatility should rise over the next six months. We expect to see a shift in UST issuance toward longer-term bonds to fund fiscal deficits which should put upward pressure on yields.