With Markets Caught in Macro Crosscurrents, We’re Refocusing on the Fundamentals

The inflation story is taking a back seat to growth

Despite cooler consumer inflation and producer inflation prints, yields this week remained high. While the price data is encouraging, it’s backwards looking. Investors are more focused on growth (more on that below).

However, the market may be overly excited for lower tariffs to reduce inflation pressures. The Laffer curve-like relationship below shows that lower tariff rates can, in fact, increase price pressures because at lower rates businesses tend to pass on higher costs. But when tariff rate (and price) increases contribute to demand destruction, prices are likely to fall to meet demand.

Policy is dictating the market’s growth outlook

Even as economic data softens, markets last week leaned into a higher growth outlook, driven by two key policy developments:

• U.S.-China trade truce: The 90-day tariff pause on China gave long-end rates a floor, as markets saw trade relief not as disinflationary, but as growth-positive. In short: less tariffs = more trade = stronger growth impulse.
• Tax reform momentum: Progress on the reconciliation bill, particularly the tax section, would allow businesses to immediately expense certain capital expenditures rather than depreciate it over time. This boosts future earnings and after-tax cash flow.
   

Markets welcomed both developments, as seen in the pricing out of expected Fed rate cuts. If growth holds and inflation persists, the case for near-term easing weakens.

The Fed: working hard or hardly working?

As the chart above suggests, the market expects less action from the Fed this year, and we agree. That doesn’t mean the Fed is sitting on its hands. It recently published research on the real-time impact of tariffs on consumer prices, finding that the February and March 2025 tariffs on China have already pushed core goods prices up by 0.3%.

More importantly, the Fed will likely use this research to better distinguish between sources of inflation – whether price increases are tariff-driven or demand-driven. That distinction matters. If inflation is being pushed up by supply-side shocks like tariffs, the Fed may be more willing to look through it. But if inflation shows signs of persistence or broadening beyond tariff-affected categories, the Fed may need to reassess. For now, the bar for additional hikes remains high.

Portfolio strategy

We believe generating income is a valuable way to buffer portfolio returns against the cross-asset volatility and general uncertainty investors are facing today. Within fixed income, we see a few opportunities for a check-in:

Manage rates risk. If economic growth holds up while policy uncertainty increases, yields are likely going to see volatility but remain range-bound. We are still sticking with our expected range for the U.S. 10-year yield of 3.5% to 5.0%. Today, with the 10-year yield around 4.5%, we see more upside to bonds than downside on a tactical basis.

Consider converts. For investors with a longer lens, this is also a moment to diversify fixed income exposure. Convertibles are off to a strong start this year, outperforming both the U.S. aggregate bond market index and the S&P 500. Convertible bond supply typically tracks M&A activity, which has slowed amid elevated uncertainty. But that same uncertainty is driving demand – investors are leaning into convertibles as a way to build in downside protection while staying exposed to upside in volatile markets.

Quality is ample – use it. Yields are likely to remain structurally higher, meaning some companies will still be squeezed by higher interest costs. We suggest investors focus on high quality issuers which should have no trouble covering their debt expense. Beyond asset class selection, our preferred umbrella way to implement this view is to keep credit exposure – IG, HY, and muni – short duration. We see no signs of systemic credit quality issues in general; ample short-term liability coverage ratios across borrowers add an extra layer of comfort for the risk-averse investor. Investors can use this as a way to amplify income generation outside of cash.