Perspective

 

Market Backdrop

Entering 2026, the U.S. economy reflects a complex mix of late-cycle resilience and meaningful strain. The Fed delivered three interest-rate cuts during 2025, bringing the federal funds rate into the 3.50–3.75% range. At the surface level, the macroeconomic picture remains respectable: unemployment hovered around 4.6%, real gross domestic product (GDP) growth reached 3.8% in the second quarter of 2025, and full-year 2025 GDP growth is projected near 1.8–2.0%.

However, those aggregates mask a widening gap across households. The post-COVID-19 pandemic expansion has been distinctly “K-shaped,” with higher-income consumers continuing to spend while the bottom 80–90% face mounting pressure from elevated living costs. The savings rate remains low (roughly 4.7%), and credit card balances rose approximately 6% year-over-year to a record ~$1.23 trillion, an indication that the marginal consumer is working harder to maintain lifestyle spending. Job creation has also slowed sharply, with the economy failing to produce 100,000 new jobs in six of the past seven months, alongside a notable drop in immigration.

Inflation is the other key piece of the macro puzzle. Real-time measures of rent inflation, such as private-market housing indices, have stabilized near the mid-2% range, while official Consumer Price Index (CPI) shelter inflation – well known for its lag – continues to show higher readings, around the high-3% area. We expect shelter inflation to continue drifting downward over the next several quarters, potentially reaching the mid-2% range by late 2026. Meanwhile, goods inflation has benefitted from lower oil prices (below $60 per barrel), but services inflation remains stubborn.

One measure we watch, the San Francisco Fed’s “acyclical” services-oriented inflation proxy, has risen from its 2023 lows, consistent with an environment where inflation is not collapsing back to 2%.

Trade policy adds another layer of complexity. Tariff increases in 2025 lifted the effective U.S. tariff rate sharply, from roughly 2.5% in 2024 to approximately 17% in 2025. While the inflationary pressure has been muted thus far – because companies have partially absorbed costs – there is a credible risk that more of that burden shifts to consumers in 2026. Such dynamics could place upward pressure on prices and limit the scope for sustained declines in long-term interest rates, which may struggle to fall materially below the roughly 4.0% level.

Importantly, the impact of higher tariffs is inherently transitory, persisting only as long as tariff changes continue to push prices higher. Once that adjustment is complete, the tariff-related contribution to inflation fades. Moreover, a reduction or removal of tariffs would exert downward pressure on inflation. For example, if the current legal challenge to the U.S. administration’s tariff policy is successful, this would have a significant cooling effect on inflation.

Against this backdrop, we continue to expect the Fed to cut interest rates in 2026. The policy path, however, may be shaped not only by inflation and employment, but also by broader financial and fiscal considerations. Federal debt-service costs have become an increasingly significant component of the U.S. government’s budget, whereas the U.S. Treasury has leaned heavily on short-term issuance while discussing longer-maturity buybacks – both of which implicitly benefit from lower short rates. The resulting environment points toward a 2026 regime in which short rates drift lower, long rates remain comparatively firm, and the yield curve modestly steepens.

Key themes for 2026

A bifurcated consumer supports “headline growth,” but raises tail risks in credit
A central theme entering 2026 is that macro resilience can coexist with pockets of real stress. For many households, elevated living costs and higher debt burdens are already translating into weaker cash flow. That does not automatically imply a broad recession, but it does suggest that credit outcomes may become increasingly dispersion-driven:

• “Prime” borrowers remain relatively healthy, supported by accumulated household equity and higher incomes.
• “Subprime” and lower-income cohorts are more exposed to inflation, depleted excess savings, and higher financing costs.

This dynamic matters most in sectors tied to the marginal borrower – particularly subprime auto ABS and certain unsecured consumer debt. In 2025, the liquidation of auto dealer Tricolor Holdings was a reminder that idiosyncratic platform and underwriting risks can overwhelm benign macro narratives. Even in markets where most bonds ultimately perform as expected due to structural credit support, the path can involve sharp price dislocations. That price volatility reinforces our focus on underwriting and position sizing, rather than simply “reaching” for yield.

Tight corporate spreads: fundamentals are stable, but compensation for volatility is thin
We view corporate credit fundamentals as broadly stable – but priced for a very smooth path. Investment-grade spreads have been supported by strong technicals, including heavy inflows and large money-market balances that could rotate into high-quality credit. High-yield spreads, however, appear less compelling on a loss-adjusted basis, with the HY/IG differential near the tightest percentiles of the past decade.

Several factors reinforce the late-cycle feel:

• Valuations are tight: both IG and HY spreads sit near the low (tight) end of 5- and 10-year ranges.
• Risk has migrated: some weaker credits have shifted into private credit structures, which can reduce visible stress in public HY – until it doesn’t.
• Potential catalysts for volatility exist: Catalysts include a wave of issuance tied to AI capex, renewed merger and acquisition/leveraged buyout dynamics, an equity-driven risk-off episode, and/or a high-profile private credit event.

Our base case is not “persistent blowout widening,” but rather episodic volatility – periods where spreads abruptly widen and then retrace as buyers step in. That outlook underpins our emphasis on patience: when spreads are very tight, the upside is limited while the downside can emerge quickly.

 
Structured credit: improving risk-adjusted carry in a steepening-curve world
We continue to prefer structured credit – RMBS, CMBS, and select ABS, and we keep CLO exposure more tactical – because these sectors often offer:

• Higher carry per unit of duration
• Lower correlation to equities and traditional corporate credit
• More idiosyncratic pricing opportunities driven by structure, prepayment and call dynamics, and collateral-specific factors

A steepening yield curve is an important tailwind. If the Fed cuts interest rates while long rates remain anchored around roughly 4.00–4.50% due to sticky services inflation and tariff pass-through, short-duration structured credit can compare favorably with longer-duration corporate credit.

Within structured credit, our emphasis remains on areas where we believe compensation for risk is most attractive:

• Non-Agency RMBS (non-qualified mortgages/prime-like): Underwriting quality has remained strong, with high average FICO (Fair Isaac Corp.) credit scores and generally low loan-to-value ratios. Delinquencies have inched up but remain contained, and many distressed loans resolve without REO (property owned by a bank or lender after a borrower defaults and it doesn’t sell at auction) due to equity cushions. We continue to see demand for well-underwritten, high-carry tranches – particularly vintages where call behavior and issuer efficiency can create upside.
• CMBS: Credit performance is mixed. We continue to monitor office and multifamily deterioration and expect office delinquencies to rise further as maturities approach and more loans pursue extensions or modifications. At the same time, certain seasoned, de-levered cash flows, including select conduit mezzanine and Small-Balance Commercial shelves, can offer attractive outcomes if refinancing and liquidity improve as interest rates drift lower.
• ABS: 2025 reminded investors that “platform risk” and operational risk can matter as much as borrower credit risk. We remain cautious in subprime auto, where delinquencies are elevated and recoveries have weakened. We are more interested in areas where spreads compensate for uncertainty, including select solar ABS structures that have already widened alongside other segments experiencing actual credit deterioration, and in areas where fundamentals are improving.
• CLOs (selective): CLOs can provide diversification and floating-rate exposure, but above-par pricing and heavy refinancing/reset activity can create negative convexity. We prefer scaling exposure when leveraged loan prices are meaningfully distressed and spreads better compensate investors for structural complexity and illiquidity.

Conclusion and positioning summary

Our practical message going into 2026 is straightforward: don’t chase.

When spreads are near cycle tights, investors are often tempted to add leverage, extend duration, or move down in quality to maintain yield. We believe this is the wrong playbook in the current environment. The macroeconomic backdrop, including sticky services inflation, tariff uncertainty, and a bifurcated consumer, argues for a portfolio that can withstand volatility while retaining the flexibility, or “dry powder,” to take advantage of more attractive entry points if spreads widen.

How this translates into our positioning:

• Stay disciplined in corporate credit. We don’t need a recession for IG/HY spreads to widen; we just need a volatility event, heavier issuance, or a sentiment shift. At current spread levels, we prefer to keep exposure measured and focus on quality. Currently, our only corporate credit exposure is in the form of corporate structured notes, which can benefit from curve steepening.
• Lean into structured credit where underwriting is strong and structure is defensive. We continue to favor the top of the capital structure within RMBS, CMBS, and ABS, where we believe carry is attractive relative to spread volatility and duration. We also focus on areas in which structural features, including call dynamics, refinancing assumptions, and seasoning, which we believe can enhance returns beyond carry.
• Keep liquidity as a feature, not a bug. Short Treasuries, cash, and high-quality short-duration bonds are not merely parking places; they represent “dry powder.” In periods of episodic widening, which is our base case, liquidity enables us to add risk at materially better levels, with minimal bid-ask friction.
• Position for steepening, not a parallel rally. Our base case is that the Fed can cut interest rates, but inflation and policy dynamics may limit declines in long rates. That environment tends to favor shorter-duration, higher-carry credit exposures and bonds with a steepening bias, such as corporate structured notes, over long-duration assets.

 
In sum, we are positioning for a 2026 environment in which the U.S. economy can remain resilient at the headline level, but where pricing is unforgiving in the event of shocks. The portfolio is positioned to earn income without taking uncompensated risk and to capitalize opportunistically if volatility creates more attractive entry points.

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