Two Policy Risks in the Spotlight

There are two significant policy risks looming in the weeks ahead: U.S. domestic policy risk and global policy risk. Overall, financial markets believe that these two policy risks could limit economic growth and cause inflation. However, we continue to believe that the optimal way to navigate these risks is through a tactical and flexible approach. As more details of policy changes emerge, we could witness substantial market moves in either direction. For example, meaningful progress in trade negotiations with Canada and Mexico could provide quick relief to markets and lead to a risk-on environment. On the contrary, a prolonged period of intense negotiations with all U.S. trading partners could cause investors to lose patience and exert downward pressure on risk assets.

Domestic Policy Risk: The current federal government funding expires on March 14th. To avoid a shutdown, Congress needs to pass new spending legislation or extend the current funding. There are significant disagreements between Democrats and Republicans over the Trump Administration’s actions, such as dismantling government programs and agencies, and freezing government grants. Some Democrats are willing to use the threat of a shutdown as leverage to force changes in the Trump Administration’s decisions. Given the slim majority in both the Senate and the House, it will be very difficult to pass funding bills without Democratic support. If a potential shutdown were to continue into the month of April, this could create further downside risks to growth.

Global Policy Risk: As expected, the Trump Administration started the process of renegotiating trade agreements with its major trading partners. While this did not come as a surprise, it happens at a time when the geopolitical landscape is in flux, with high-stakes diplomacy and potential shifts in trade policies creating uncertainty. The trade discussions between the EU and the U.S. are likely to intensify in the coming weeks. We believe that there are positive paths for both sides to agree on a deal which would involve greater EU imports of liquefied natural gas (LNG) and increased military spending. However, discussions about non-tariff trade barriers are unlikely to be resolved quickly. In summary, markets are priced for an increase in U.S. tariff rates last seen in the 1960s. While some of the benefits may show up in increased domestic capacity to produce certain goods (e.g. cars, steel, aluminum), this could be a slow process and could be undermined by pressure on consumer spending as prices for many consumer goods are likely to reflect higher tariff costs much sooner.

In conclusion, the financial markets are facing a period of heightened uncertainty driven by policy risks, slower growth, and inflation concerns. The combination of domestic political gridlock and ongoing global trade tensions requires investors to be disciplined about portfolio strategy and maintain flexibility to adjust their risk stance as new information emerges.

— Peter Wilke, CFA – Head of Tactical Asset Allocation, Global Asset Allocation

TARIFFS EXPECTED TO INCREASE FROM THE CURRENT LEVEL OF AROUND 2.5%

The baseline market expectation seems to be for the average tariff rate to increase towards ~5%.

Credit Markets

Credit markets continued to perform well driven by a mix of price gains, spread tightening and attractive coupon income. The technical backdrop for credit remains notably strong. Although the leveraged loan market continues to price record amounts of supply from repricings and refinancings, net supply across bonds and loans remains relatively muted. High yield (HY) saw strong outperformance, benefiting from rates and light supply for the month of January. As a result, the amount of high yield bonds trading at distressed levels has decreased for the sixth time in the last eight months to a 33-month low.

The distressed ratio is often looked upon as a forward looking indicator for defaults because bonds begin trading to recovery value as the market is forward looking in nature. The divergence between the distressed ratio and default rate could be an indication of bottoming in the high yield market. Cable and Satellite bonds account for 26% of bonds trading 1000bp+, which is followed by Healthcare (20%) and Broadcasting (12%). With the elevated level of uncertainty and distress in this cohort of the market, active management will be paramount to success in the upcoming year in some of these more troubled sectors.

— Eric Williams, Head of Capital Structure, Global Fixed Income

HIGH YIELD DISTRESSED RATIO

The divergence between the distressed ratio and default rate could be an indication of bottoming in the HY market.

Sources: Northern Trust Asset Management, J.P. Morgan. Data from 12/31/1994 through 1/31/2025. Distressed levels are defined as bonds trading greater than 1000 basis points (bps) of spread. STW = Spread-to-worst. Historical trends are not predictive of future results.  

• Credit markets continued to perform well driven by a mix of price gains, spread tightening and attractive coupon income.
• The amount of high yield bonds trading at distressed levels has decreased for the sixth time in the last eight months to a 33-month low.
• Cable and Satellite bonds account for 26% of bonds trading 1000bp+, which is followed by Healthcare (20%) and Broadcasting (12%).

Equities

The so-called January effect was in full force as markets around the globe rallied following a December swoon. U.S. large caps finished the month up 3.0% on decidedly better breadth than the depressed levels seen during most of 2023 and 2024. Despite market rattling events, equities remained resilient with U.S. large caps within 0.7% of all-time highs as of February 10. Outside the U.S., marking a turn, developed international markets led the way in January, up 5.0%. The dollar remains strong, but pulled back modestly in January against most currencies other than the pound. This provided a tailwind for U.S. based investors, which was not the case amid currency headwinds in 2024. Emerging Markets were also positive, up 1.8% in January with leadership out of Latin America.

U.S. economic data remains solid overall. Fourth quarter earnings have come in much better than expected, and the outlook for ’25 and ’26 continue to support elevated valuations in the U.S. and our overweight to U.S. equities. For developed ex-U.S. equities, despite the market bounce in January, the subdued economic growth outlook and exposure to potential tariffs continue to weigh on our outlook. 

— Jordan Dekhayser, Head of Equity Client Portfolio Management

BETTER BREADTH FOR A HEALTHIER RALLY

Following historically low breadth in ’23 and ’24, January saw broader market participation.

Source: Northern Trust Asset Management, S&P Dow-Jones, FactSet. Total return data from 12/31/1990 through 1/31/2025. 2025 (teal bar) only counts the month of January. All other years are annual. Past performance is not indicative or a guarantee of future results. It is not possible to invest directly in any index.  

• Markets shot higher to start the year as better than expected earnings provided comfort during multiple market shocks.
• Breadth improved after two historically low years of a small group of stocks leading markets higher.
• We maintain overweights to the U.S. and emerging markets. We are underweight developed ex-U.S. equities.