Fixed income remains key to long-term diversification

While we’ve been bracing for policy impacts, the April 2 tariff announcements were a bolt from the blue in terms of their severity, far exceeding our expectations. The reciprocal actions and unfolding situation continue to add uncertainty and complexity across financial markets.

Our previous risk scenario of a "stagflationary impulse," which was growth below 1% and inflation above 3%, is now our base case, and the shadow of a recession looms larger. As my colleague, Joe Davis has said, we are now dancing with a recession.

Our active portfolios were well-prepared, having trimmed credit risk and moved up in quality, while utilizing duration as a hedge. Looking forward, we remain overweight duration, with a bias to yield curve steepening, reflecting the increased odds of a recession, as well as potential rebuilding of term premium. We also remain defensive in credit, with ample dry powder to deploy at wider credit spread levels. In addition, the teams are leaning heavily into security selection and relative value trades, as the opportunity set is strong in this period of volatility.

Our index portfolios continue to employ sophisticated techniques and robust risk management to manage liquidity and ensure tight tracking of the indexes amid rapidly evolving liquidity conditions.

The Federal Reserve is caught between a rock and a hard place, with its dual mandate now in conflict amid material market shifts. Tariffs are like a double-edged sword, expected to spike inflation in the short term while stifling growth and threatening the labor market. The Fed is likely to be cautious about cutting rates preemptively in the face of higher inflation in balancing their dual mandate. However, in the tug of war between stag and ‘flation, we believe the economic slowdown will ultimately tip the scales. This view is supported by long-term inflation expectations remaining stable, as seen in the 10-year breakeven inflation (BEI) rate at 2.20, firmly anchored near the Fed’s target¹. 

We continue to advocate that investors tune out the short-term noise and focus on the long term. Fixed income has an indispensable role in a well-diversified portfolio. Year to date, fixed income has been a port in the storm, with the U.S. aggregate index up by 1.3% while the S&P 500 has fallen by 8.8% year to date (as of market close Friday, April 11, 2025). Despite recent bond market volatility, yields remain attractive by historical standards—and starting yields are a strong indicator of future returns. Furthermore, in the event of a recession, we expect a rally in high quality fixed income, which would serve as a ballast, providing essential stability and enhancing portfolio performance. Short term, we anticipate continued volatility in the fixed income market.

Portfolio diversification with a strategic allocation to fixed income is one of the most potent strategies investors have to smooth portfolio returns over the long term. While market downturns are inevitable, patience and a steadfast commitment to your long-term investment strategy are crucial.