Conviction in a Clouded Outlook: Bonds Between Growth and Geopolitics

Bond investors live in a world shaped by probabilities, not certainties. Yet at times, markets seem all too willing to price in a singular outcome—as if the macro landscape were stable, inflation predictable, and politics benign. Today is not one of those times.

The dominant themes in early 2025—slowing global growth, lingering inflation risks, and resurgent tariff tensions—are pulling markets in multiple directions. Central banks are treading cautiously. Fiscal dynamics are shifting. And investor positioning appears anything but extreme. All of this leaves the door open for opportunity—if one knows where to look.

Growth: Losing Momentum Without Breaking Down

Recent data from both the US and Europe suggest that economic activity is cooling, but not collapsing. That nuance matters. The soft-landing narrative still holds sway, but cracks are forming—most visibly in consumer confidence, real wage stagnation, and corporate forward guidance.

The Federal Reserve's reaction function remains slow and deliberate. After an aggressive rate-cutting cycle late last year, policymakers now appear to be waiting for clearer confirmation that inflation will stay subdued. The most recent PMI data for March shows a nuanced picture: the ISM Manufacturing PMI slipped back into contraction at 49.0, while the S&P Global reading held just above the expansion threshold at 50.2. In Europe, the HCOB Eurozone Manufacturing PMI rose to 48.6—its highest level in over two years—suggesting early signs of stabilisation, though activity remains below trend.

Meanwhile, central banks like the Bank of England have already begun easing, with a clear bias toward doing more. Markets are currently pricing in approximately two further rate cuts in 2025, although the timing remains uncertain. This shift, combined with Europe’s fragile growth path, suggests a global yield environment that is biased lower, though not one-way.

Tariffs: An Unquantifiable Risk

Where growth offers a probabilistic path, tariffs offer none. They represent an unpriced risk that could tilt inflation, distort trade, and add uncertainty to both policy and positioning. Investors hoping to model their impact will likely be disappointed. The transmission mechanism is indirect, the time lags uneven, and the second-round effects (particularly on supply chains and FX markets) difficult to hedge.

This week's announcement from President Trump — introducing a baseline 10% tariff on all U.S. imports, with sharply higher levies on goods from China, Vietnam, and the European Union — reaffirms the centrality of trade uncertainty in the current macro backdrop. Market participants had largely anticipated the direction of travel, but many were caught off guard by the breadth and immediacy of the measures. Equities sold off sharply across Asia and Europe, reversing earlier risk-on sentiment, while demand for safe-haven bonds rose markedly.

The initial market response underscores a broader lesson: even when risks are flagged in advance, their realization can still surprise. That surprise often stems from the hope — implicit in market pricing — that policymakers might defer, dilute, or delay action. When that hope is dashed, price adjustments tend to be swift.

Still, we know enough to draw one conclusion: tariffs raise the probability of policy error. Whether through misjudged central bank responses, misaligned inflation forecasts, or increased term premiums, the uncertainty they introduce is inflationary in nature, even if growth-sapping in effect.

Positioning: Balanced, but Fragile

Perhaps most intriguing today is what the market isn’t doing. More relevant is the strong appetite for risk assets seen at the start of 2025—reflected in tight credit spreads, elevated equity valuations, and hedge fund gains across equity and macro strategies.

This positioning backdrop helps explain why some weakness has crept into risk markets more recently. When markets lean heavily into one direction—such as the long-risk positioning in credit and equities earlier this year—even a modest change in the narrative can prompt price action, as flows begin to unwind or pause.

At present, positioning looks more balanced, but not deeply defensive. There’s no crowding in either direction—but that also means conviction is low. In such environments, the market may absorb surprises more gradually, with fewer forced flows. But the absence of conviction also implies the potential for swift sentiment shifts, particularly if the narrative around growth, policy, or inflation meaningfully evolves.

Technical Distortions: Where Value May Be Hiding

Away from the headlines, certain parts of the bond market offer value born not from macro forecasts but from market structure. For example:

• Some short-dated investment-grade corporate bonds now offer income profiles not far below high yield—but with far better fundamentals.

• European mortgage-backed and structured products have cheapened due to issuance and liquidity mismatches, not credit deterioration.

• Maturity-specific distortions around benchmark rebalancing and fund flows have created pockets of inefficiency that active managers can exploit.

None of these require a precise forecast on inflation or central bank timing. What they require is an eye for dislocation and the discipline to step in when others hesitate.

Final Thoughts

At Cavalen, we don’t invest based on single-outcome scenarios. We invest where the probability of a mispricing outweighs the risk of being wrong. Today’s bond market is shaped as much by politics and psychology as it is by fundamentals. But therein lies the opportunity.

Conviction, in times of uncertainty, isn’t about being loud. It’s about being prepared when the crowd isn’t.

Craig Veysey 
Cavalen Asset Management