Navigating rate risks: How bonds are better positioned in 2025

Market Update

U.S. equities are heading toward their second consecutive week of declines.

This week, Nvidia (-11%) exceeded earnings expectations but forecasted a decline in its gross margins, disappointing investors. Political news added to the sell-off as President Trump affirmed that 25% tariffs on Canada and Mexico will take effect on March 4, with an additional 10% tax to be imposed on Chinese imports.

The culmination of these factors is leading the S&P 500 to decline -2.5% this week, turning year-to-date performance negative. The largest companies in the index (Magnificent 7, -8.4%) and the largest sector (tech, -5.6%) have weighed on returns year-to-date.

Meanwhile, across the pond, Europe continues its outperformance. The Stoxx 50 is heading toward finishing the week up +1.1% as sentiment in the region has driven a valuation expansion.

Given the growth scares in the United States, fixed income is once again providing diversification. Yields on the 10-year are heading toward their seventh consecutive week of lower yields—the longest streak since 2019. The 10-year yield (4.26%) is 17 basis points lower this week, and the 2-year yield (4.05%) has declined 15 basis points.

As diversification has come back into focus, today’s note focuses on global equities and fixed income.

Spotlight

This year began with Wall Street in consensus. Slowing growth in Europe and China, contrasted by a release of animal spirits and deregulation in the United States, was expected to lead to a continuation of U.S. exceptionalism.

Two months into 2025, that consensus expectation hasn’t materialized. The United States is toward the bottom of the list in developed country equity performance, while Europe and China have rallied.

Chinese equities entered the year trading over two standard deviations below their average forward P/E over the last three years. A significant advancement in AI technology through Deepseek’s Mode-of-Experts method changed sentiment in the region. Equities rallied and valuations increased, leading to the forward P/E now trading about one standard deviation above its three-year average.

A similar story unfolded in Europe. The region typically trades at a 25%–30% P/E discount relative to the United States, but entered the year at about a 40% discount. In mid-January, earnings expectations troughed and saw a ~1% increase. Combined with a tailwind from increased defense spending as terms are being negotiated to potentially end the war in Ukraine, the region has rallied +12% year-to-date. Now, the region trades more closely in that typical 25%–30% discount to the United States.

What’s common in both stories is that we don’t believe anything in the fundamental drivers of the economy, or the earnings picture, has changed—the rally was driven by sentiment and a valuation catch-up.

Conversely, the underperformance in the United States was driven by a lag in the tech sector. Softer data in the United States and news that Microsoft may be canceling some of its data center leases caused a sell-off in the S&P’s largest sector (tech, at 30% of the index). Additionally, the largest names in the index have lagged their peers, with the Magnificent 7 declining -8.4% year-to-date, a change from the last two years, when they contributed 60% and 54% of index performance in 2023 and 2024, respectively.

The outperformance ex-U.S. is why we advocate for diversification in portfolios to capture those pockets of outperformance from other markets. We believe the 25% allocation to developed world ex-U.S. equities in the MSCI World Index serves as a good benchmark for investor portfolios.

We advocate for diversification not only across equity geographies, but also across asset classes. One such asset class, which was also an out-of-consensus call for 2025, is fixed income.

Investors have pushed back against fixed income because its correlation with equities has risen over the last two years, meaning that fixed income isn’t “zigging” when equities are “zagging,” as it has in the past. However, this is because the shock we experienced in markets over that period was an inflation shock. Fixed income doesn’t insulate portfolios from inflation. As the name suggests, your income is “fixed,” and if prices are rising simultaneously, then all else being equal, your purchasing power has eroded. This is why we have advocated for adding resilience to portfolios to hedge from inflation through assets such as real estate, infrastructure, structures and gold.

However, fixed income does still help to diversify portfolios; it hedges them specifically from growth shocks regardless of increasing correlations with equities. As such, we’re reminding investors of some of the fundamental principles of fixed income investing to guide their 2025 portfolio allocation decisions.

Bonds today are better positioned against a rate sell-off. A concern often raised by investors who held bonds through the rate sell-off of 2022 is the risk of adverse performance if rates increase again. The critical difference between a rate sell-off now and the rate sell-off that began in 2022 is that an investor today receives much more income because of the higher starting yield.

We can see an example of this if we compare the performance of the 10-year Treasury in early 2022 to late 2024. The 10-year Treasury yield increased by approximately 80 basis points over the first quarter of 2022 and the fourth quarter of 2024, but the starting yield at the start of Q1 2022 was only 1.5%, while the starting yield at the start of Q4 2024 was 3.8%. Performance was 200 basis points higher in 2024 because the starting yield was more than double that during 2022. In other words, investors received more than twice the income they had received two years earlier to offset a similar shift in rates. Higher yields can provide a cushion to adverse moves (rising) in rates, and compound on top of price appreciation in an advantageous scenario (falling rates).

Investors are once again compensated for interest rate risk. Fixed income markets passed a milestone on October 23, 2024, when the Bloomberg U.S. Aggregate Bond Index once again began to outyield the 3-month Treasury bill. For the first time since January 2023, investors were compensated for stepping out of cash and taking credit and duration risk. For those clients with excess cash, now may be the right time to consider an allocation to fixed income assets, not only for the pickup in yield but also for the hedging power in a traditional growth slowdown. The risk to this approach is that resurgent inflation and subsequent rate volatility lead to a sell-off, but our base case remains anchored in continued disinflation even if the Federal Reserve pauses for an extended period.

Rotating from cash to a short-duration municipal bond or investment grade corporate strategy pays a yield premium over cash and also offers hedging from slower growth. This wasn’t the case six months ago. Consider these dual advantages when allocating capital.

Curious as to how diversification can help you achieve your long-term goals? Reach out to your J.P. Morgan team.