The Big Picture | Western Asset

KEY DRIVERS & RELATIVE VALUE
SECTOR THEMES
INDUSTRY THEMES

"We continue to expect a strong year for fixed-income markets, driven by attractive yields and opportunities in select spread sectors. The unpredictability of US administration policy initiatives may continue to spark episodes of market volatility but should also provide opportunities to augment existing positions. We remain diligent about fundamental credit research and have taken measures to move up in quality in the near term."

Michael Buchanan, CFA
Chief Investment Officer

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We remain optimistic about the potential for fixed-income returns in 2025.
In the US, while tariffs will dampen growth, we do not anticipate a recession given the prospect of lower oil prices, tax cut extensions and a lenient regulatory environment.
The US disinflationary trend may be interrupted as tariffs are implemented, but we expect inflation to gradually moderate.
In Europe, we expect the ECB to continue rate cuts as inflation wanes. German infrastructure spending and increased EU defense spending is beneficial for confidence and future growth despite near-term headwinds.
China may face slowing economic growth due to US tariffs. The country will likely deliver a larger stimulus package to boost domestic demand and reduce consumption bottlenecks.

OVERVIEW

Proposed tariffs from the new US administration have created volatility in financial markets. Global growth is expected to slow given heightened unpredictability but should remain positive. US growth is downshifting due to a myriad of factors including tariff uncertainty, waning benefits from immigration and reduced government spending. A significant fiscal boost from European defense and German infrastructure spending should support eurozone growth and provide relief from tariff-related uncertainty. Deflationary pressures in China persist and confidence is weak amid property market concerns, but sentiment is improving with fiscal stimulus and policy easing. Monetary policy remains restrictive, and we believe that central banks will continue to cut rates in 2025. The Federal Reserve (Fed) remains well positioned to provide support if the US economy falters. Public debt levels continue to rise and yield curves may steepen given concerns over fiscal policies. While we retain a modest overweight to interest rate duration, we are concentrated in shorter maturities. Sector spreads have widened and valuations are now closer to fair value in our base-case scenario.

"Tariffs and central banks are engaged in a delicate balancing act in 2025. While proposed US tariffs have injected uncertainty into global markets and may temporarily interrupt disinflationary trends, central banks remain positioned to provide support through rate cuts. The Fed stands ready to counterbalance economic faltering, while other central banks are expected to ease policy. This monetary flexibility provides a crucial stabilizing mechanism as markets navigate trade policies."

Mark S. Lindbloom
Deputy CIO & Head of Broad Market Portfolios

KEY DRIVERS AND RELATIVE VALUE BY REGION

US: Soft Landing Remains on Track

This year's growth and inflation trade-off is highly dependent on Trump's policies. Despite market uncertainty, the US economy should just manage to retain positive growth in 2025. Core inflation measures already show moderating services inflation, while the impact from tariffs should be a one-year event only. Barring a recession, we expect US Treasury (UST) yields to trade in a range of 4% to 5%.

EUROPE: Lacklustre Growth with Inflation at Target

We expect the European Central Bank (ECB) to deliver further cuts this year. Headline inflation is trending close to target, and service inflation is beginning to soften in line with our expectations. The large German infrastructure fund and increased EU defense spending should boost both growth and confidence. We maintain a modest overweight duration position through both nominal and real yields.

UK: Further Removing of Policy Restraint Remains Appropriate

Growth has been limited since mid-2024 and is likely to remain subdued. Headline consumer price inflation has risen, but should return to the Bank of England's (BoE) 2% target over its forecast horizon. We expect further labour market weakening to add downward pressure to wage growth, providing confidence for the BoE to cut rates beyond what the market is currently discounting. UK gilts should provide positive returns.

CANADA: Data Tug of War Continues

The Bank of Canada (BoC) has cut rates to the middle of its projected long-term neutral range, though both inflation and growth risks are pointing in opposite directions. We expect the BoC to move very cautiously while US tariff uncertainty persists. Substantial tariffs would slow the economy, and the impact of reduced immigration only adds to the difficulty in gauging the economic impact.

AUSTRALIA: Shallow Rate Cutting Cycle Begins

A hawkish rate cut in February highlights the conundrum for the Reserve Bank of Australia (RBA) as the relatively tight labour market continues to pressure inflation. Trimmed mean inflation (core) has declined to open the window for more cuts, but the speed of these moves is in question. Further RBA cuts in 2025 should keep the recovery in motion and may offset slowing global growth.

JAPAN: Higher Rates Ahead

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Japan's economy should grow at around 1% in 2025, supported by private consumption and business investment. Inflation will likely stay between 2.5% and 3.5%, which is above the Bank of Japan's (BoJ) 2% target for the next few quarters. The BoJ will continue hiking to at least 1% at a measured pace due to uncertainty over the neutral rate. JGB yields should climb higher, but may display a flatter yield curve.

CHINA: China Prepares for US Decoupling with Economic Stimulus and PBoC Easing

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US tariffs are expected to reduce China's GDP significantly. To counter this, China is likely to deliver larger stimulus faster, including monetary easing, fiscal support, and structural reforms to boost domestic demand and reduce consumption bottlenecks. China is expected to expedite its 2025 budget, cut rates and provide relief to exporters.

MEXICO: Key Milestones on the Horizon

Mexico's growth is challenged due to a slowing US economy, tariff uncertainty and a large fiscal deficit. President Sheinbaum has limited capacity to increase spending due to the previous administration's fiscal looseness and ongoing support for Pemex. Monetary policy will need to compensate, with Banxico recently accelerating rate cuts. We continue to favor local rates and expect Banxico to remain dovish.

INDIA: RBI Likely to Remain Dovish

The Reserve Bank of India (RBI) began cutting its key policy rate this year and is likely to remain accommodative in the near term. Trade negotiations with the US continue following Vice President Vance's visit to India. The first stage of a bilateral agreement with enhanced US exports reducing India's trade surplus and lower tariffs for Indian exports is expected later this year.

BRAZIL: Climbing the Ladder

Since Lula took office in January 2023, Brazil's fiscal balances have deteriorated amid government spending concerns. Any further spending ahead of Lula's 2026 presidential bid would be challenging. COPOM has raised rates by 375 basis points (bps) since September 2024 to 14.25%. Further hikes should anchor inflation expectations and the Brazilian real (BRL). While we see value in the BRL, we prefer local rates.

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"CMBS offers compelling opportunities with improving commercial real estate fundamentals and attractive spreads. Constrained underwriting has created high-quality, low-leverage investments with income and total return potential. Property prices are growing from cyclical lows with healthy fundamentals. We remain cautious about tariff impacts that could cause demand destruction across CRE sectors."

Simon Miller
Portfolio Manager

SECTOR THEMES

Investment-Grade (IG) Corporate Credit

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IG corporate fundamentals have been resilient. Management commentary and outlooks have been more cautious given policy uncertainty. We have started to see sector dispersion amid recent volatility: banks, noncyclical industrials and utilities are outperforming while autos, energy and lower-quality rating cohorts underperforming. Technicals remain supported by steady demand from institutional buyers. We see opportunities in global banks as a potentially advantageous risk/reward mixture to play offense in a defensive way.

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European credit fundamentals remain sound, especially in banking. Utility sector ratings in Europe have stabilised with headroom for balance sheet expansion to fund energy transition investment. Some sectors such as autos are facing cyclical and structural headwinds and tariff-related uncertainty. We remain overweight financials, utilities and select property companies.

In Australia, fundamentals remain sound due to defensive issuer selection. The high concentration in monopolistic and duopolistic businesses (as well as in regulated utilities and infrastructure) naturally provides predictable cash flows and profitability. We maintain concentrated shorter-dated credit holdings but are opportunistic amid high volatility. We retain a preference for new issuers with premiums, select REITs and utility/infrastructure assets.

High-Yield (HY) Corporate Credit

In the US, HY credit spreads reflect balance sheet strength, the prudent behavior of management teams and supportive demand for higher-yielding securities relative to supply. We continue to see selective opportunities in service-related sectors that are still recovering from pandemic-era recession, energy (E&P) and potential rising stars. We are more cautious about consumer products, retailers and home construction sectors.

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In Europe, corporate fundamentals continue to be positive. Net supply remains low as most bond issuance is aimed at refinancing. We continue to focus on BB/B rated issues with a bias toward telecom/cable, consumer and select capital good companies.

Bank Loans

As growth expectations moderate, we prefer the core of our bank loan exposure in BB rated loans with strong underlying balance sheets, and a selective allocation to B rated loans within defensive sectors to take advantage of outsized carry relative to other fixed-income products. We expect cyclical sectors to be volatile with specific concerns around the automotive, chemicals, building materials and telecom industries.

Collateralized Loan Obligations (CLOs)

We find value in BBB and select BB rated tranches. Spreads are likely to follow macro sentiment, particularly for the lower-rated segments of the capital structure. However, most CLOs are backed by broadly diversified baskets of bank loans. We remain selective, avoiding below-IG CLOs that are either less diversified or have substantial exposure to specific names within the automotive, chemicals, building materials and telecom sectors.

Mortgage and Consumer Credit

Agency mortgage-backed securities (MBS) yield and spread levels are attractive, given limited mortgage refinancing activity and low prepayment risk. We favor 20- and 30-year MBS as well as non-benchmark subsectors and focus on active coupon and collateral management to enhance total returns.

Declines in home sales tend to coincide with elevated mortgage rates as well as sharp declines in equities prices; however, sales tend to recover rapidly months after the end of correction. We are cautious of new-issue deals and favor more seasoned collateral that has built equity and benefited from rising home prices. We favor credit risk transfer (CRT) as well as non-QM deals that present strong borrower profiles and higher credit qualities.

In non-agency commercial MBS (CMBS), the recovery in CRE is on hold as changes in fiscal policy play out. CRE will be highly sensitive to changes in tax regimes, and significant increases in cost of goods and/or services that impact economic growth will negatively impact most income-producing real estate. New-issue underwriting offers the best quality in over a decade with low leverage. While there are opportunities in high-quality mezzanine or subordinate credit and event-driven trades, we favor up-in-quality, diversified pools until policy volatility subsides.

While consumer fundamentals are expected to deteriorate in the new tariff regime, higher-quality consumers are more prepared to weather the storm. The end of the student loan moratorium is expected to put pressure on consumer credit scores, but lenders had ample time to prepare. We have a strong preference for higher-quality consumer credit, staying further up the capital structure. Consumer deal structures remain robust with deleveraging features.

Inflation-Linked

US Treasury Inflation-Protected Securities (TIPS) real yields remain attractive at near-two-decade highs, and breakeven inflation (BEI) levels are near Fed targets. Only the very front end of the TIPS curve incorporates higher inflation risks from tariffs. Longer-dated TIPS have underperformed nominals recently due to tariff news. BEIs are close to fair value, but unlikely to outperform until the Fed is more worried about growth than inflation.

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European inflation expectations (via 5-year swaps) remain around 2%, which is consistent with the ECB achieving its inflation mandate. Near-term low energy prices should contribute to falling headline inflation into the summer, and fiscal stimulus could support inflation in 2026. Both will likely have modest impacts.

In Japan, the inflationary environment has shifted upward due to a structural labor shortage and the consumer price index above 2%. We maintain an overweight to Japanese real yields versus nominal yields, as the current BEI rate is still below 2%.

Municipals

Record supply conditions have contributed to higher tax-exempt income opportunities and improved after-tax relative value within the muni market. The yield curve has steepened meaningfully and offers better opportunities in intermediate and longer maturities. Fundamentals remain strong. We believe that municipals can serve as a ballast and potentially outperform more volatile assets amid broad economic uncertainty in 2025.

Emerging Market (EM) Debt

We believe that frontier market sovereigns continue to represent compelling carry and total return opportunities given wide valuations and key idiosyncratic credit stories. IG-rated EM sovereign spreads remain tight and can be considered a source of cash for trades with better relative value across EM and other sectors.

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Given high real yields, we currently favor Latin American local rates, while Asian local currency bonds appear unattractive given historically low yields relative to USTs. We are monitoring US growth exceptionalism and the tariff impact across select economies as risks to EM foreign exchange (FX) going forward.

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EM corporates continue to maintain strong balance sheets, especially compared to their developed market (DM) peers. However, given historically tight sector spread levels, we seek value in the primary market and in shorter-dated HY corporates.

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"We maintain a positive outlook for key sectors. Global banks benefit from resilient performance and low risk profiles. Energy midstream shows strength through strong balance sheets. Gaming fundamentals remain sound with promising growth in Asia. Telecom offers defensive characteristics with recurring revenue and strong cash flow. These sectors can provide a measure of stability amid volatility."

Michael T. Borowske
Head of Global Credit Research

INDUSTRY THEMES

Industry

Key Observations

Auto & Related

We favor market weight positioning in both IG and HY, as the risk/reward balance skews more negatively than in the last 12-24 months. Tariff uncertainties have resulted in significant spread widening across both US and European OEM and Tier I suppliers. We see very few rising-star candidates and anticipate rating agency downgrades this year.

Banks

We maintain a large overweight position to top-quality global banks given resilient performance, as banks have lower risk profiles due to stringent regulations, heightened oversight and improved risk management following the global financial crisis.

Energy

We favor market weight positioning with an overweight bias to the mid-stream/pipelines subsector. Continued themes of low growth/capital discipline, balance sheet strength and consolidation remain generally positive. Oil prices have reacted negatively to tariffs, increasing downside risks. Natural gas fundamentals remain strong.

Food & Beverage

The industry is impacted by consumers trading down and spending more cautiously, and less impacted by tariffs. Historically, this sector has been defensive, but we remain underweight due to rich valuations that do not fully reflect the challenging near-term macro environment and potential inflationary impacts of tariffs.

Gaming

Fundamentals in the US and Asia-based gaming markets remain sound. However, we are closely monitoring any signs of consumer weakness. Our recent trips to several regions suggest that softness (to date) has only been felt in the lower-income tiers. Outside the US, we view the long-term growth stories in both Singapore and Macau favorably.

Health Care

While the health care sector historically has been viewed as more defensive and recession-resistant, we remain underweight in IG and market weight in HY due to rich valuations and negative event risk. Portfolio positioning reflects an up-in-quality bias in terms of issuer selection, subsector exposure and seniority within capital structures.

Metals & Mining

We are market weight biased to copper. Tariff angst questions economic growth and demand. Eyes remain on China's fiscal and monetary policy response and execution to stabilize or improve growth prospects. Current low prices will likely exacerbate future supply shortfalls when demand returns, particularly for copper.

Pharmaceuticals

We are underweight IG and market weight HY due to continued sector headwinds and policy risk. We expect the industry to commit to more US-based manufacturing during the 1Q25 earnings reporting season. In HY, we are focused on names with visible credit catalysts (i.e., rising stars, liability management, M&A, etc.) and downside protection.

Retailing

The retail environment has become more competitive with elevated promotional activity and discounting as retailers attempt to gain market share and drive traffic. We remain selectively underweight to retailers since the combination of tariffs and waning consumer demand will negatively impact credit fundamentals.

Telecommunications & Media

Despite increasing market competition, we believe that telecom/cable remains well positioned given defensive characteristics with monthly recurring revenue and strong free cash flow prospects. Within media, we remain selective, as legacy linear TV remains challenged, and advertising is vulnerable to macroeconomic weakness.

Transportation

The largest US legacy carriers had strong results in 1Q25 due to lower fuel costs and robust demand for premium, loyalty and international travel. Our view remains constructive as US legacy carriers are well equipped to navigate tariff uncertainty thanks to diversified revenue streams, strong balance sheets and excellent liquidity.

Utilities

We are selectively using the new-issue calendar to reduce our underweight. The sector is perceived as defensive and insulated from higher capital costs due to the return on invested capital model through regulation. While residential demand is more resilient than that of commercial or industrial sectors, customer affordability is under scrutiny. Longer-term load growth remains positive.

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Macro Market Trends:

Global Public Debt Burdens

In his latest market commentary, Western Asset CIO Michael Buchanan examines the impact of rising public debt and market concerns over government fiscal policies. Elevated debt levels and fiscal policies have increased bond market volatility. Michael discusses the implications of global debt burdens by region with Western Asset's key macro decision-makers.

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