Public Pensions Face a Cloudy Outlook for Growth

The macroeconomic outlook shifted swiftly in the first quarter. Following the election, markets focused on the potential for Trump administration policies to boost economic growth. But between January and March, investors increasingly focused on the risks associated with those policies. Risk markets reacted negatively, with equities falling and spreads widening across the fixed income spectrum.

The first quarter began with a continuation of the trend established at the end of 2024, as investors anticipated government policies that could increase both economic growth and inflation. The yield on the 10-year Treasury note rose 117 basis points from its September low through January 14, reaching 4.79%. Nearly half of that increase was reversed over the next eight weeks, as the 10-year Treasury yield fell 50 basis points.

This decline reflected a growing recognition that a variety of factors — including the escalating trade war, tighter immigration restrictions, federal government layoffs, and the US government’s fiscal situation — could weigh on economic growth. The possibility that some of these developments are also likely to be inflationary increased the potential for stagflation, which historically has been negative for both equities and fixed income.

Concerns about slowing growth and tariffs contributed to declines in US stocks. The S&P 500 fell nearly 9% between February 19 and March 12. Credit spreads widened as well after reaching their tightest levels in two decades. The ICE BofA High Yield Index Option-Adjusted Spread rose from 2.62 on February 18 to 3.20 on March 12, an increase of more than 20%.¹

While the environment deteriorated in the US, international equity markets experienced a bit of a renaissance. The MSCI EAFE Index gained nearly 8% year-to-date through March 12, compared to a roughly 5% year-to-date loss for the S&P 500. Although the economic outlook is not significantly better outside of the United States, valuations outside the US were much lower. In addition, some of the policies raising concerns in the US — such as a pullback from the international stage — could be supportive of opportunities abroad.

We saw similar themes in the international fixed income markets. The ECB continues to cut rates while the Federal Reserve (the fed) remains on hold, UK yields rose as US yields fell, and potential changes in Germany’s fiscal policy could lead to higher issuance and steepening yield curves. At the very least, a continuation of the deglobalization trend reinforces the benefits of international diversification.

Looking Ahead

The rising uncertainty around both economic growth and inflation has brought attention to the Fed's dual mandate to maintain stable prices and to pursue full employment. The Fed has focused on fighting inflation in recent years; this year we expect the Fed’s emphasis to shift to balancing the two goals. We continue to project three interest rate cuts, as inflation will continue to moderate over time, monetary policy remains restrictive, and the labor market could come under greater pressure. That said, our forecast for rate cuts could change as events unfold.

We anticipate that the US economy will continue to grow this year but may not accelerate the way many investors thought it might at the start of 2025. Likewise, we continue to hold a cautiously optimistic view for the equity and fixed income markets in 2025, tempered by an expectation for bouts of volatility in a period of policy transition. Although investor sentiment has retrenched, we have not seen signs of distress or panic. Selling has been orderly, and drawdowns have been moderate.

We expect yields on long-term government bonds to fluctuate as investors digest news related to inflation and growth. We continue to favor duration over credit spreads: US government bonds still benefit from safe haven status (which may be more attractive in a volatile world), while we believe that still-tight credit spreads limit upside. US corporations generally look healthy, with S&P 500 companies posting earnings growth of 18.3% in 2024.² That said, valuations are high in both the US stock and corporate bond markets, and analysts have been revising first-quarter earnings forecasts downward.³ Greater macroeconomic uncertainty and a moderating outlook for earnings growth could hold back stock gains and push credit spreads higher. Times like these demonstrate the value of diversifying assets, including international equities and alternatives such as private credit.

Implications for Public Defined Benefit Plans

Growth matters for public pension plans, which typically seek to improve funding ratios and meet growing future liabilities. Strong investment returns have been relatively easy to come by in the past two years, as US equities marched higher, driven by surging technology stocks. Plans have benefited, but now they may find themselves overexposed to these asset classes even as macroeconomic concerns weigh on their returns.

To navigate this challenging, fast-changing environment, public plans may want to seek ways to enhance the growth potential and diversification of their fixed income portfolios. A variety of sectors and styles offers a combination of potential excess return and low correlations to other fixed income strategies. They include:

• Systematic active fixed income (SAFI) strategies, which employ quantitative, factor-based approaches that offer potential alpha, low benchmark tracking error, and low correlations to fundamental active strategies
• Indexed leveraged loans, which offer relatively high yields and have effectively no duration risk
• Emerging markets debt, which can provide both attractive yield and exposure to a different set of economic risks and opportunities than the US debt markets

We anticipate periodic bouts of market volatility this year, as markets digest new policy and economic developments. Plans may want to adopt more dynamic investment approaches in order to capture opportunities and mitigate risks related to rapid changes in the markets. That may include opportunistically extending the duration of fixed income positions to lock in high yields if fears about inflation cause yields to rise to historically attractive levels.

Please contact our team if you have any questions about how to navigate an increasingly challenging macroeconomic environment.