The Fragmentation Era

Navigating trade wars and the future of the U.S. dollar

While legal challenges to U.S. tariffs, if successful, could ratchet down the developing trade war, we believe elevated trade-related conflict will persist. Uncertainty about the endgame for trade policy and global security alliances has increased downside risks to global growth.

Absent sustained retaliation against the U.S., the trade war mostly lowers export demand – a disinflationary impact – for much of the world. The reallocation of China’s trade surplus to the rest of the world is a clear source of disinflationary risk. In contrast, U.S. inflation risks have risen, at least in the short term, as has the likelihood of monetary policy divergence between the U.S. and other countries.

Despite the recent decline in the U.S. dollar, we believe it would be almost impossible for the dollar to lose its dominant global reserve currency status over our secular horizon, in part due to the lack of viable challengers in markets for foreign exchange, foreign currency debt, and bank lending. The U.S. Treasury still professes to want a strong dollar, and the U.S. administration appears to be backing off from the idea of a Mar-a-Lago accord aiming to weaken the dollar.

But dollar bear markets are possible, over both the short and long term, reflecting historical multiyear dollar cycles. Changing policy and security priorities may alter relative global demand for U.S. and other assets – especially as overseas investors reassess their tolerance for unhedged dollar exposure.

We expect the dollar to continue to lose market share in cross-border payments as regional currency arrangements (e.g., the “mBridge” payments platform developed by China) broaden and deepen in a more fragmented world. A gradual shift away from the U.S. dollar could continue as global portfolios rebalance at the margin to more diversified allocations in risk assets.

Debt looms large

Although it is near record highs, debt remains sustainable in most developed countries. Notable exceptions include Japan, the U.S., and France, where debt is on an unsustainable long-term trajectory, even more so than last year (see Figure 1). Deficits will likely stay above pre-pandemic levels, partly due to rising interest costs.

However, these issues appear chronic rather than acute. We do not foresee a sudden fiscal crisis but instead expect episodic market volatility – as seen in the U.S. in 2023 and 2025, and more sharply in the U.K. in 2022. In our baseline, U.S. Treasuries remain the cleanest dirty shirt in the sovereign closet over our secular timeline, underpinned by the dollar’s reserve currency status.

Fiscal policy in the U.S., Germany, and some advanced economies may be less restrictive than we forecasted a year ago. The Trump 2.0 fiscal package is likely to widen U.S. deficits and debt beyond prior policy projections. Yet overall fiscal space remains constrained, limiting room to respond to future downturns. That said, central banks have much more space to cut rates than in the decade before the pandemic.

Despite any short-term bump from tariffs, we expect inflation to return to Fed target levels over the secular horizon. We expect the Fed to cut rates to around neutral – roughly 3% – and well below neutral in the event of a recession, including to zero if necessary.

The historical likelihood of a recession in the U.S. over any five-year period is about two-thirds, but the probability appears higher over the next five years given the current backdrop.

Shifting global economic and inflation outlooks

Outside of the U.S., major DM economies face distinct growth challenges, while EM countries are bolstered by prudent debt management but also influenced by global trade shifts and DM policies.

Europe

Eurozone growth may decelerate from around 1% pre-pandemic to about 0.5% over the next five years, weighed down by weaker demographics and slower productivity growth. The region lags in the global tech race, faces stiff competition from China, and struggles with high energy costs amid a less favorable trade environment. Germany’s shift to higher defense and infrastructure spending is significant but unlikely to be matched elsewhere.

Inflation is unlikely to return to the pre-pandemic 1% norm, due to deglobalization and higher inflation expectations, but will likely settle below the European Central Bank’s 2% target. Equilibrium interest rates will likely stay low and below the current nominal level of about 2%.

China

China’s economy is shifting to a lower growth path amid rising debt and worsening demographics. Old growth drivers – property and infrastructure spending – are giving way to policies boosting consumption, manufacturing, and technology, signaling a deliberate pivot from debt-fueled booms to sustainable, innovation-led growth.

Yet deflationary pressures and structural constraints suggest growth will remain on a slower trajectory. China remains a global manufacturing hub, but trade and geopolitical tensions cast doubt on exports as a reliable growth engine.

Emerging markets

The question of whether new risks emanating from the U.S. automatically translate into higher risk premia for the rest of the world underscores how tight the historical link between DM policy rates and EM borrowing costs can be. While the risks are clear, encouragingly, many emerging economies have maintained manageable debt levels, positioning them to weather potential headwinds.

The rise of digital currencies – including stablecoin issuers that hold increasingly large portfolios of U.S. Treasuries – highlights how quickly capital flows can evolve. As this ecosystem matures, it could reshape EM capital flows and currency management.

Potential disruptions to the base case

We are alert to potential disruptions that – while low-probability events, in our view – could fundamentally shake up our baseline secular outlook. Among them:

• Accelerated AI-related disruption. AI advances could occur more quickly than expected and show up as faster growth in GDP and productivity data. Our base case remains that the full impact of new AI large language models manifests more gradually.
• A loss of Fed credibility – stemming from a Supreme Court ruling or a chair unwilling to uphold price stability – is unlikely but would be severe, likely sparking a surge in inflation expectations and bond yields, a sharp dollar decline, and a broad sell-off in risk assets.
• U.S exceptionalism 2.0. The narrative of U.S. economic and financial outperformance relative to the rest of the world has faded this year. Yet the U.S. entered 2025 with strong productivity, tech leadership, and deep capital markets fueling consistent profit growth. With GDP growth outpacing peers by at least a percentage point, these advantages can endure. If trade and fiscal uncertainties ease, U.S. exceptionalism could reemerge.

Investment implications: Fixed income for a fragmented era

In fixed income, investors are paid to build resilient portfolios. We continue to advocate seizing the yield advantage in high quality bonds rather than chasing equities at elevated valuations.

The equity risk premium – the difference between equity yields and bond yields – is likely the main ingredient in asset allocation as it gauges the relative value between stocks and bonds. The most straightforward way to compute the premium is to subtract the real (inflation-adjusted) bond yield from the cyclically adjusted earnings yield. The Figure 2 chart shows the U.S. equity risk premium stands at zero and is exceptionally low by historical standards.

A mean reversion to a higher equity risk premium typically involves a bond rally, an equity sell-off, or both. The same chart shows two prior times when the premium was zero or negative: in 1987 and in 1996–2001. Following the zero equity risk premium in September 1987, the stock market declined by almost 25%, while 30-year real bond yields fell by 80 basis points (bps). In December 1999, the equity risk premium reached its minimum level during the chart period, preceding an equity drawdown of almost 40% that ended in February 2003. In that same time, 30-year real bond yields fell by about 200 bps.

In addition, corporate profits relative to GDP are near historic highs. Rising tariffs and geopolitical tensions could all weigh on future profits.

Yield advantage remains compelling

Valuations point to a lower probability of equity outperformance over fixed income in part because the outlook for high quality fixed income is as good as it has been in a long time. After steep post-pandemic rate hikes, bond markets have made it to the other side: Investors can now benefit from higher yields plus potential price appreciation given central banks have ample room to cut rates.

Forecasting fixed income returns is relatively straightforward: Over a secular horizon, the starting yield on a bond portfolio can be a good guide to expected returns (see Figure 3). The yields on the Bloomberg U.S. Aggregate and the Global Aggregate (U.S.-dollar-hedged) Indexes, two common benchmarks for high quality bonds, are about 4.74% and 4.94%, respectively, as of 5 June 2025.

From there, active managers can seek to construct portfolios yielding about 5%–7% by capitalizing on attractive yields available in high grade investments. We anticipate maintaining an up-in-quality bias.

Harnessing global opportunities through active strategies

Powerful secular forces – local currency adoption, disciplined fiscal policies, and diversified funding – are converging to create durable opportunities. Active management, with the agility to exploit country-specific nuances and relative value differences, is crucial to navigating inevitable volatility.

The opportunity to generate alpha – returns exceeding market benchmarks – is as rich as it has ever been across global markets (see Figure 4).

Many DM economies offer a combination of attractive bond yields and a challenged economic outlook, which can benefit bond investors. In addition, we see EM countries building upon their demonstrated resilience. Historically, global diversification has offered superior volatility-adjusted returns to single country portfolios. We believe that diversification is the one free lunch available to asset allocators.

The importance of duration and curve positioning

Given attractive starting valuations in fixed income, along with expected weaker growth and stabilizing inflation, we anticipate being biased to run more overweight duration positions in our portfolios than has been typical in recent years.

U.S. Treasuries have provided a hedging role for portfolios in every recession dating back to World War II, given the historical inverse correlation between stocks and bonds. High quality global bond markets have provided similar properties.

A core PIMCO thesis remains that yield curves will re-steepen over our secular horizon, as investors continue to demand more compensation to hold longer-term bonds relative to cash and short-term bills. Estimates of the Treasury term premium are positive and up substantially since the decade before the pandemic. There is potential for further steepening given the budget debate in the U.S.

Active management can enhance bonds’ role as a hedge through yield curve positioning. We anticipate maintaining a bias to be overweight in the 5- to 10-year part of global yield curves and to be underweight in the long end over time. That said, given rising long end real yields, we also see a limit to how much further the rise in term premia has to run.

Indeed, in the event of a sharp rise in longer-dated yields, we would anticipate significant damage to equity and credit markets – and, in turn, the foundations for a downward correction in real yields. We also expect central banks will step in and use their balance sheets if any market moves threaten broad financial market disruption.

Resilient opportunities beyond corporate credit

Credit markets offer abundant opportunities but also specific risks, demanding careful sector and asset selection and a value-driven investment approach.

The period since the global financial crisis (GFC) has been exceptional: a long expansion, fueled by massive government policy support in the wake of both the GFC and the pandemic, that rewarded aggressive lending. This contrasts sharply with the decades right before the GFC, which saw less support, greater volatility, and uneven returns in economically sensitive credit areas.

Credit spreads remain tight relative to historic averages, despite elevated secular recession potential, highlighting areas of complacency across public and private corporate credit markets. AI advances could stoke volatility, as leveraged loan and private direct lending markets feature large allocations to technology and other industries in the sights of AI disruptors. A correction in inflated U.S. equity valuations could also trigger broader risk asset repricing. Amid limited fiscal space, a genuine credit default cycle – unlike the recent “buy the dip” era – may unfold for the first time in years, catching many investors unprepared.

In a weaker growth environment, lower-quality, economically sensitive companies face risks. Elevated short-term interest rates could increasingly challenge midsize companies that borrow in floating-rate debt markets. We express caution in areas of corporate private credit where capital formation has outpaced investable opportunities, leading to potential disappointment. Stresses are becoming evident in private equity and private credit and could worsen sharply in a recession.

Some additional convergence between public and private markets appears likely over the secular horizon. However, there are meaningful barriers to stronger convergence, driven by liquidity, transparency, credit quality, and structural considerations. Active managers with broad, global capabilities spanning public and private markets can react to dislocations in value across different segments of public and private credit markets, while offering unbiased solutions that consider liquidity, true credit quality, and relative valuations to best serve investors.

Stricter bank capital and liquidity rules will likely continue to push many lending activities in the U.S. to the private credit market, especially asset-based finance. This opens opportunities for investors to act as senior lenders in areas once dominated by regional banks. We continue to see attractive opportunities in high quality areas including consumer, residential mortgage, real estate, and hard assets, where starting conditions and valuations appear favorable relative to corporate credit.

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. References to Agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. Structured products such as Collateralized Debt Obligations (CDOs), Constant Proportion Portfolio Insurance (CPPI), and Constant Proportion Debt Obligations (CPDOs) are complex instruments, typically involving a high degree of risk and intended for qualified investors only. Use of these instruments may involve derivative instruments that could lose more than the principal amount invested. The market value may also be affected by changes in economic, financial, and political environment (including, but not limited to spot and forward interest and exchange rates), maturity, market, and the credit quality of any issuer. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. Diversification does not ensure against loss.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

Correlation is a statistical measure of how two securities move in relation to each other. Duration is the measure of a bond's price sensitivity to interest rates and is expressed in years.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.

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