Still climbing, just slower

Overview

Our outlook for the second half of 2025 is cautiously optimistic, with several key themes shaping our expectations.

We anticipate that US GDP growth will exceed consensus forecasts, though it will likely moderate compared to the robust expansion seen in 2024. The US labor market is beginning to show signs of softening; a decline of approximately one million foreign-born workers over the past two months has reduced labor force participation, which may weigh on payroll growth and broader population trends. While job openings persist, job seekers are experiencing longer searches, even as initial unemployment claims remain stable. From a policy perspective, we expect the Fed to hold interest rates steady in the near term. However, upcoming federal job cuts — which will be reflected in October’s labor data — could open the door for a 25-basis-point rate cut in the fourth quarter. On the fiscal front, the One Big Beautiful Bill Act (OBBBA) is delivering less savings than initially projected. As a result, we anticipate a pull-forward of tax-related revenues into 2025 and early 2026, which could influence both consumer behavior and corporate planning.

Inflation is trending higher, but we believe many companies may absorb rising input costs rather than pass them on to consumers. Our base case is that US inflation will settle around 3%. Meanwhile, the adoption of AI continues to accelerate, driving productivity gains and fostering the creation of new job categories.

The US consumer remains bifurcated. Prime consumers are benefiting from strong employment and asset appreciation, while subprime consumers face pressure from elevated inflation, higher interest rates, and rising delinquency rates. On the corporate front, US earnings growth expectations have moderated to approximately 6%, down from 10% – 11% in the first quarter. 

In Europe, sovereign risk has eased, but rising energy costs and increased military spending could challenge fiscal sustainability in select countries. The UK continues to grapple with persistent inflation, while broader European economic activity remains stable, albeit with subdued business and consumer confidence. Looking ahead, increased defense spending in Europe may present opportunities for US industries in 2026 and beyond, though the near-term impact is expected to be modest.

Geopolitical risks remain a key concern. Tariffs and trade tensions top our list of potential disruptors, followed closely by fiscal deficits and global political instability. Oil prices remain volatile, largely due to ongoing tensions in the Middle East.

Reserve fixed income: Keep calm and “carry” on 

Last quarter, we highlighted heightened market volatility in mid-April as a result of the “Liberation Day” announcement, which resulted in both rates and spreads widening considerably. Since that time, we have seen credit spreads “roundtrip,” to the point that they are once again very tight by historical standards. As a result of this valuation environment, we think insurers should seek to maintain their income advantage in portfolios to benefit from the positive carry of their reserve fixed income allocation, while not extending further on their risk budget since they are not being adequately compensated to do so. 

For insurers, we have gradually reduced our preferred top-line risk targets for both IG and HY corporates after incrementally lifting those targets in mid-April, with the primary catalyst being less appealing valuations. Despite some valuation concerns, we continue to think aggregate IG credit metrics, broadly speaking, are healthy and ratings momentum is very strong. While forward-looking earnings revisions have been negative since Liberation Day, they have stabilized for now. Spread valuations are poor relative to history, but momentum has improved as the market has gained comfort around the range of tariff outcomes. We think all-in yields are fair relative to recent history, while demand is robust and net supply and reinvestment trends are favorable. We would note that high hedging costs and more competitive local alternatives diminish the appeal of US-dollar credit for some overseas investors. 

We remain positive on structured finance due to generally strong fundamentals and attractive income profiles: 

• Within CMBS, valuations have cheapened recently, and we think insurers should consider maintaining a slight overweight position, primarily in conduit bonds over single-asset, single-borrower (SASB) structures.
• While CLOs have been a top idea for insurers’ portfolios in recent years, we favor decreasing exposure to high-quality CLOs in areas where market technicals are likely to weigh on spreads in the near term. We continue to believe the fundamental outlook for bank loans is well supported by private credit dry powder, which serves as a financing backstop in periods of elevated volatility. We expect an update this summer on the NAIC’s review of CLO tranches as it moves from a ratings-based approach to a more empirical methodology, but the project is not likely to be finalized until 2026.
• Agency MBS continues to look attractive relative to many other fixed income sectors, and we favor an overweight via passthroughs, CMOs, and agency CMBS. We think insurers should consider increasing their agency MBS exposure at the expense of IG corporate exposure. 

Municipals: Still presenting strong potential for crossover investors

As noted in our last outlook, tax-exempt municipal bond valuations have widened this year, making them more attractive than Treasuries and generally fair versus corporate bonds at the corporate tax rate, particularly relative to their recent history and at longer maturities. Figure 1 illustrates the income pickup potential. AAA municipals (dark-blue line) are less attractive than Treasuries (light-blue line) at shorter maturities (10 years and under) but more attractive further out on the curve. In addition, A rated municipals (purple line) offer a noticeable yield pickup over similarly rated corporates (yellow line) at 20-year-plus maturities.

Figure 1

Given this enticing valuation picture and generally healthy market fundamentals, we think crossover investors should consider increasing their municipal allocations, particularly at longer maturities. 

Equities: It’s all relative

We retain our slight overweight view on global equities. We still expect positive earnings growth across all major regions and believe downward earnings revisions have likely bottomed out, but we are cautious on valuations. The current tight equity risk premium suggests excessive optimism, in our view, and implies that tail risks are underpriced. While there are reasons for optimism, as noted earlier, the market seems to assume that tariffs and other policies will avoid causing any economic damage, and it is incorporating little geopolitical risk premium as well.

We maintain an overweight view on Japan relative to the US, thanks in part to the valuation gap between the two. Governance reforms in Japan are gaining momentum, boosting both return on equity (ROE) and corporate balance sheets. Japan has historically lagged in ROE compared to global peers, but this is changing and strengthening the argument for higher price-to-earnings multiples (Figure 2). Along with Europe, Japan has one of the highest levels of cash return to shareholders, through both dividends and buybacks. Policy — and specifically the potential for yen strength — could be a headwind, however, preventing us from taking a larger overweight stance against the US.

Figure 2

High valuations and the post-Liberation Day performance reversal reflect a skew to the most positive scenarios for US equities and contribute to our underweight view. Moreover, US market gains continue to be driven by the outperformance of a narrow group of the largest companies. We would prefer to see broader earnings growth and price trends, but expectations for that broadening have been pushed out as companies have less flexibility to pass through all the tariffs and may choose to absorb some of the higher costs, denting margins.

We have a neutral view on European equities. We are positive on prospects for economic multipliers from the fiscal expansion underway in Germany, which provides some support for European equity valuations. However, earnings-per-share (EPS) growth may take time to materialize, particularly with currency strength weighing on foreign earnings, and key uncertainties remain, including progress in trade negotiations.

We also have a neutral view on emerging markets. The US dollar remains soft, which typically supports EM assets. The likely peak of US-China trade headwinds, coupled with additional Chinese stimulus, provides upside. Inflation is largely under control in many EM economies, giving central banks room to ease policy and cut rates. However, we would want to gain more conviction on global growth developments, tariffs, and geopolitical developments before we turn positive here. 

Within sectors, we have an overweight view on utilities, financials, industrials, and consumer discretionary, against underweight views on information technology, materials, and energy. Utilities and financials are our highest-conviction overweight views, driven by fundamental tailwinds including infrastructure spending and a more favorable regulatory environment for banks. On the other hand, macro headwinds to materials and energy equities persist, with our energy sector underweight view complementing our new underweight view on oil. 

One last point related to equities: In 2024, the American Academy of Actuaries (AAA) conducted a study of correlation factors in life risk-based capital charges. The Life RBC Working Group and the Investment Risk and Evaluation Working Group are currently working on the technical analysis. The most direct impact of this effort will likely be a change to the correlation factors between equity, credit, and interest rates from the current binary approach. Depending on the outcome and the starting point for insurers, this could increase the capital charge for equity-related C-1cs risk. However, the work may not be completed until 2026.

Government bonds: Central banks go their own way

Pity the central bankers who must figure out how fiscal and trade policy moves will impact their economies! The consensus appears to be that tariffs will drive growth lower and inflation higher in the coming months. While we await definitive evidence of these outcomes, we don’t see a big opportunity in being long or short overall duration. Fed Chair Jerome Powell has articulated a similar case for patience on interest rates, arguing that as long as the US economy is solid, the right thing to do is stick with the current policy stance and learn more over the summer. Signs of labor market weakness are surfacing, and we think the Fed is more likely to tilt in favor of its employment mandate and cut rates sometime this year, trusting that above-target inflation will ease. This expectation is priced in by markets.

That said, central banks around the world are dealing with varied regional dynamics that require different policies (Figure 3). In the euro area, as noted, markets expect the European Central Bank to cut rates beyond the 175 bps already delivered. We see upside risks to longer-term yields, including tentative signs that euro-area demand is picking up from looser financial conditions and fiscal policy and that inflation assumptions are too low. The details of a US-European trade deal will be important as well, and we think the risk skew favors a hawkish scenario in which growth and inflation pick up and 10-year yields rise. 

Figure 3

In Japan, inflation is becoming a problem. First-quarter nominal GDP was running above 5% year over year, so 10 times the policy rate of 0.5%. Business conditions are strong, especially among domestically oriented sectors, while labor markets are tight and inflation expectations are accelerating. The BOJ should be hiking rates, but tariffs, which could cut into GDP and reduce confidence, remain a concern. Politics have also muddied the picture: Heading into the July 20 Upper House elections, the candidates were effectively competing on who could loosen fiscal policy more. Poor demographics are always pulling real yields in the other direction, yet we think the combination of inflation and fiscal risks will bias longer-term yields higher. 

Where do we see opportunities relative to these concerns about Europe and Japan? We think yields could decline in the UK, where worries about fiscal slippage caused a spike in the term premium that we believe is overdone, while the employment picture appears to be weakening.

Private investments: Rain, rain, go away, IPOs please come back in play

As companies stay private longer and IPO activity remains muted, we recognize there may be concerns about liquidity, especially for insurance companies. However, we remain positive on the opportunity set. As our colleagues argued recently, the leading private companies will eventually go public because they need three things that the public market provides: liquidity, access to low-cost capital and efficiency, and, ultimately, brand recognition. 

Given this value proposition, we think IPOs are bound to happen, and in the meantime, investors can potentially capitalize on several advantages the private market may offer over the public market, including higher growth profiles, sector diversification, and value creation. That said, it is crucial that investors fully understand the dynamics leading companies to stay private longer and consider the full spectrum of opportunities across public and private markets.

Commodities: Weighing geopolitical opportunities and concerns

We maintain our neutral view on commodities. Structural tailwinds remain favorable for gold, including the geopolitical environment and flows from EM central banks and retail investors. The prospect of an acceleration in central bank efforts to diversify their reserves may provide an additional kicker. That said, we see a case for pausing to wait for a more favorable entry point for a long position in gold, within what we acknowledge is a strong uptrend (albeit with some volatility). A recent geopolitical premium has provided what we believe is a short-term boost to prices, and structural tailwinds remain, but valuations are extreme (the highest since 1980).

We moved to a small underweight view on oil following the recent spike in geopolitical concerns. While the situation in the Middle East is fluid, there is already a significant geopolitical risk premium in the oil market despite the fact that prices have come down since the US strikes on Iran. Given that we see a low probability of a significant supply disruption, we think higher prices give producers the opportunity to hedge 2026 production, which could reverse the trend of capex and production discipline. We agree with the consensus view that there will be oversupply by the end of the year, creating a potentially attractive entry point for shorting crude, with the primary risk being the substantial negative carry drag.

Investment implications 

Consider maintaining a slight pro-risk stance — We believe we are past peak uncertainty, but trade policy uncertainty remains relatively high. Given our base case of no recession, we see a case for insurers maintaining some risk in both their reserve assets and in surplus portfolios. Within global equities, we favor utilities and financials. Against those, we have underweight views on materials and energy, with the latter reflecting our expectation that oil supply will lead to lower prices. 

Watch for fixed income opportunities resulting from divergent policies — While we do not currently have a strong overweight/underweight view on global duration, we see regional duration opportunities that can potentially add alpha to portfolios. In particular, yields in the euro area and Japan look expensive relative to the UK given our expectation that fiscal stimulus, improving growth, and rising inflation expectations will push yields higher in the former markets. 

Stay steady in spreads — Given a no-recession base case, we maintain our slight overweight view on credit spreads, specifically in securitized credit where valuations are generally more appealing versus IG corporates.