Investing around Policy Shifts, Market Volatility, and AI

After a dizzying April in markets, we take a step back to assess what has changed—and, just as importantly, what hasn’t—in the investing landscape.

Tariffs, Government Spending, and Immigration

The softening of the Liberation Day announcements has removed some of the worst-case scenarios from the outlook for growth and inflation. However, the world is still markedly different than it was on April 1^st. The effective tariff rate jumped from under 3% to nearly 30% at the peak of reciprocal tariffs and has since settled in the mid-teens, following the suspension of the most punitive levies on China. A fivefold increase in such a short time remains unprecedented and can continue to dominate market attention.

Markets have rightly cheered the de-escalation with China, but with the final outcome still unknown, it's crucial to monitor ongoing disruptions. The real-world impact is starting to surface: import prices are rising and shipping container volumes are plunging as companies await clarity. While sentiment indicators have offered little insight in recent years, we still recognize that sustained low confidence and elevated inflation expectations can become self-fulfilling.

The recent ruling by the federal trade court blocking most of the new tariffs adds another layer of uncertainty, with the potential for an appeal or other legal avenues to reinstate them keeping markets in limbo. For now, lower growth expectations are fair, but their magnitude will remain uncertain until policies are finalized.

Government spending cuts have been entering the spotlight in recent weeks. Coupled with the slowing in immigration, the most immediate impact of these policies is likely to be felt in the labor market. Proposed cuts to Medicaid and federal funding to universities would put real pressure on hiring in the Education & Health Services sector. This sector, combined with Leisure & Hospitality, has accounted for a massive 71% of all private employment growth in the last three years. They also tend to hire a greater proportion of immigrants as compared to the rest of the economy; a dynamic that kept US employment remarkably strong during the Fed’s hiking cycle. As the new policies work their way through the system, softer employment figures are a very real possibility that could move the Fed to restart the cutting cycle.

The growth machine is made in the USA

It’s notable that there has been little sign of slowing growth in the consumption data. As we’ve covered numerous times in the past, services consumption is the engine of U.S. GDP. This makes the economy significantly more insulated from global trade shocks than a more manufacturing or export-heavy country.

The bright spots in Q1’s distorted GDP numbers were consumption and investment, both of which have strong long-term tailwinds largely independent of changes in trade. Households came into this episode in a uniquely strong position with debt as a proportion of net worth at a seven-decade low and wealth and income at the highs. Of course, this is not an even distribution, lower-income households were and still are feeling the pinch of higher rates and inflation.

Inflation had already stalled above target and has been trending higher in the past three and six months on an annualized basis. Continued stubbornness or an outright acceleration here will further complicate the path for the Fed.

A considerable portion of the market recovery from the lows was in the hegemonic tech stocks attached to the AI theme. We see this as a very sensible realization that the AI investment cycle, and the productivity gains it has already begun to deliver are one of the most significant technological and economic advances the world has seen. The U.S. remains at the forefront of developments here—and as the global hub of innovation, it’s unlikely to be displaced.

The short-term picture may be bumpy, but over the intermediate term, the U.S. economy is positioned to remain resilient—as it so often has.

The end of U.S. exceptionalism? Not quite

The dollar’s status as the world’s reserve currency has come under renewed scrutiny amid the trade turmoil. Unlike the dollar’s strength through the tariff announcements in the first Trump administration, it just experienced its second-weakest two-month period since the financial crisis.

For non-U.S. investors, this created a double blow—equity drawdowns of over 30% in some cases, amplified by currency losses. Notably, much of the selling occurred in overnight markets, suggesting a wave of foreign-led risk reduction. This marks the first time since 2002 that a weakening dollar has coincided with a major risk-off event, prompting institutions to question traditional correlations and reconsider reliance on U.S. assets.

That said, speculation about the dollar losing its reserve currency status remains far-fetched. No viable alternative currently meets the scale and systemic requirements to underpin global trade. For perspective, consider that the U.S. BBB-rated corporate debt market alone is double the size of Germany’s entire bond market.

The dollar taking a marginally less prominent share of foreign reserves, especially relative to the rising share of gold, is possible. However, full-scale de-dollarization is still a long way away - but there is one dynamic playing out that could significantly raise this risk…

We need to talk about the debt

We have been highlighting the precarious position of the government’s indebtedness for close to a year now. This issue has been brought back into the spotlight with the news of Moody’s downgrading the government’s credit rating. If left unchecked, we view this issue as the single biggest risk to the U.S.’ special status in financial markets.

The U.S. has the highest financing needs as a percentage of GDP among the G7, coupled with the shortest average debt maturity. Despite proposed spending cuts, deficits are still climbing—and more of that spending is now going toward interest payments. Net interest expense is set to exceed all non-defense discretionary spending for the first time in decades. In simple terms, the government could soon be spending more on debt servicing than on education, transportation, housing, research, agriculture, and labor programs combined.

With foreign investors stepping back, and the government issuing more than half a trillion dollars of debt weekly, the risk of private markets being unable to absorb this debt and pushing the cost of borrowing for the government even higher is tangible. A breakdown in Treasury markets may still be a few years off, but decisive policy action is needed now to preserve the many benefits of reserve currency status.

Taking stock

When it comes to equity investing, the U.S. continues to stand out. As we've noted, the U.S. is uniquely positioned to lead the AI revolution—already translating into tangible gains in productivity and profitability. Even with the recent rise in tariffs, the disparity in cash flow generation across regions remains striking. The defining story of 21^st-century equity markets has been the U.S. stock market’s growing concentration in fast-growing, highly innovative, cash-generating tech companies. In contrast, Europe’s equity landscape has evolved in the opposite direction: tech’s share of European indices has declined over the past two decades, leaving them heavily weighted toward slower-growth, old-economy industrials. Simply put, no other major asset class rivals the scale and consistency of cash-flow growth that U.S. equities continue to deliver.

That growth premium helps justify the U.S. market’s higher valuation, but with Price/Earnings ratios near the top of historical ranges and shifting currency dynamics, now is a good time to revisit diversification. We still favor a U.S.-centric portfolio but with selective exposure abroad—focusing on businesses with durable models and strong future cash flows.

Trade policy will remain a source of volatility until a more settled framework emerges. Still, equities have shown resilience. Even with some earnings downgrades, markets bounced back quickly. While we remain cautious on stretched valuations, the S&P 500’s return on equity—now over 30% in the tech sector—continues to offer strong long-term support.

Income Income Income

Turning to fixed income: duration is no longer the reliable hedge it once was. In April, the U.S. 10-year Treasury experienced a deeper drawdown than BB-rated high-yield corporate bonds. Given today’s macro backdrop, we don’t expect that to change. With the Fed likely to keep rates above neutral for longer, debt markets are still offering historically high income.

In this environment, we believe investors should prioritize income over duration. Yields across the board have rarely been this high, especially in the front-end, giving investors the chance to earn very attractive returns from high-quality borrowers with little duration risk. Even with inflation running higher than historically, these nominal yields dramatically eclipse run-rate inflation, something rarely seen over the prior few decades. When optimizing for income in this way, a steady stream of coupon payments helps to offset near-term price volatility.

We continue to see strong convexity at the front end of the Treasury curve, making it an attractive place to hold some duration. Meanwhile, the global rate-cutting cycle is likely to continue—and could even be accelerated by deflationary pressures from the rerouting of global trade in goods. In this context, lending opportunities in Europe and parts of Asia offer compelling ways to gain longer-duration exposure.

In a market environment marked by heightened uncertainty and unreliable correlations, the case for a larger allocation to more stable, income-generating investments has never been stronger. While equities continue to hold long-term appeal—supported by strong fundamentals and ongoing innovation in areas like AI and data—the relative volatility and stretched valuations suggest a need for balance. Income-oriented Fixed Income, with its compelling yields, lower volatility, and shorter duration, offers an anchor that can help steady portfolios through market turbulence. As we look ahead, embracing a more prominent role for income strategies can offer greater stability and comfort, allowing investors to stay the course while selectively taking stock in new opportunities as they appear.

To obtain more information on the fund(s) including the Morningstar time period ratings and standardized average annual total returns as of the most recent calendar quarter and current month end, please click on the fund tile. The Morningstar Rating for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure (excluding any applicable sales charges) that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.

The performance quoted represents past performance and does not guarantee future results. Investment returns and principal values may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. All returns assume reinvestment of all dividend and capital gain distributions. Refer to www.blackrock.com or www.ishares.com to obtain performance data current to the most recent month-end.

Access exclusive tools and content

Obtain exclusive insights, CE courses, events, model allocations and portfolio analytics powered by Aladdin® technology.

Get access now