A Month of Rapid Change

The past month has been a whirlwind for financial markets. Expectations for U.S. economic growth have taken a sharp turn downward, shifting from a "Goldilocks" scenario to fears of an economic downturn. This shift has led to heightened volatility in risk assets, with the S&P 500 Index returning -5.0% year-to-date at the time of writing and down 9% from its February 19 peak.

However, corporate credit has shown relative resilience. Since mid-February, the largest U.S. high-yield debt ETF (HYG) has only declined by 1%, while credit spreads for single-B rated bonds have widened by 60 basis points to +353bp over Treasuries, resulting in a yield of 7.6% (source: ICE BofA).

Bond Market Support Amid Slowdown Fears

With economic slowdown concerns rising, Treasury yields have responded accordingly. The 10-year U.S. Treasury yield has dropped to 4.3% from its mid-January high of 4.8%, as yields move inversely to bond prices.

The root of these slowdown fears is clear: Donald Trump’s fluctuating stance on punitive tariffs has created uncertainty for U.S. businesses and consumers. Key confidence indicators – including CEO sentiment, small business optimism, homebuilder confidence, and consumer sentiment – declined in February. Meanwhile, the widely followed Atlanta Fed’s GDPNow Forecast Index turned negative, further fuelling recession concerns. The much-discussed "Trump Bump" appears to have given way to a "Trump Slump."

Is a Recession Imminent?

The big question now is whether the U.S. is heading for a full-blown recession or experiencing a natural economic slowdown after four years of 2%+ real GDP growth. Since the post-Covid period, markets have witnessed multiple "false alarms" where recession fears did not materialize. In those instances, market volatility and negative sentiment—often seen as contrarian indicators—provided buying opportunities.

Liquidity as a Market Buffer

We believe the U.S. economy’s resilience can largely be attributed to the massive fiscal stimulus and monetary expansion from the pandemic era. Record-high money market mutual fund balances, all-time high home equity values, and an M2 money supply that remains above its long-term trend suggest ample liquidity in the system.

This excess liquidity helps cushion markets, making the recent downturn look more like a standard business cycle correction rather than a prelude to a major market dislocation.

Uncertainty Looms Over Policy and Economic Sentiment

Despite these mitigating factors, uncertainty remains high due to the unpredictability of the Trump Administration's economic policies. Some of these policies – such as large-scale government layoffs – could have counter-cyclical effects, further dampening sentiment indicators that often lead economic activity.

Additionally, a growing theory among market watchers suggests that the Trump Administration may be indifferent to short-term economic weakness given its massive Treasury bond financing needs of $7-$8 trillion over the next year. A weaker economy typically leads to lower interest rates, which could ease the burden of such financing. New Treasury Secretary Scott Bessent, a former hedge fund manager, has even been quoted as saying that the 10-year Treasury bond yield is more important to the Administration than stock market performance.

Tariff Risks and the U.S. Economy

It is important to note that U.S. fund credit risk is primarily domestic and not significantly exposed to material tariff risks, aside from general economic malaise. The U.S. is largely a closed economy, with approximately 85%-90% of its economic activity occurring domestically. As a result, while tariffs may impact global trade partners more significantly, their direct effect on the broader U.S. economy is relatively muted.

Final Thoughts

The current market environment is marked by increased volatility, policy uncertainty, and shifting economic expectations. However, strong liquidity buffers and past resilience suggest that this downturn may be more of a natural market cycle adjustment than a harbinger of a severe recession. Investors will need to navigate these conditions carefully, keeping a close eye on economic data, sentiment indicators, and policy decisions in the months ahead.

—Sandy Liang, CFA, is the Head of Fixed Income at Purpose Investments

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