Perspectives

"Separating the signal from the noise" feels like an apt description of what many investors have been focused on when making investment decisions in the first quarter of 2025. That holds even more true with the plethora of events in the last few weeks—and what it may all mean for the quarters and years ahead. The big debates now center around the shifting probabilities of a recession, broader uncertainty, inflation and interest rate expectations, along with where growth is going to come from.

Global economic aftershocks from “Liberation Day”

A near-final draft of our Q1 2025 Global Credit Monitor was completed on April 1, with a note saying: “Here is where we should put in the impact of Liberation Day news.” While much has happened since, it’s important to step back and properly assess where we are one week later, after the initial impact of the tariff announcements and the resultant aftershocks.

Needless to say, the latest U.S. trade policy moves and reactions are likely to have a lingering impact to credit globally, but unlike many of the biggest market dislocations over the past century, the global economy is relatively robust. What’s more, we have observed that this administration can shift policy decisions with short notice, depending on various factors, including a foreign government’s willingness to negotiate more favorable terms for the U.S. (Case in point: On April 9, U.S. President Donald J. Trump announced a 90-day halt on most of his tariffs and a lowering of the “reciprocal tariff” rate to 10%. The main exception to the pause was China.) Despite this shifting landscape, our latest Global Credit Monitor remains largely unchanged as a fundamentals-first approach to credit applies regardless of the broader economic backdrop. 

The probability of a global recession has increased in recent weeks, although this has been a risk since the start of the year. While the headlines imply a big jump in recession risk, different asset classes have shown varying levels of resilience. For instance, using JPMorgan’s methodology based off levels compared to recessionary levels and drawdowns, credit has proven to be more resilient than equities, rates, and commodities for reasons we will discuss.

JPM: Implied Recession Probability by Asset Class

Context is Everything

Equity markets have been more volatile than credit in the year-to-date, particularly recently, as markets have been weighing the daily news on trade policy, economic uncertainty and geopolitics. Trade policy and economic policy uncertainty are now arguably most in focus with indices produced by Baker, Bloom, and Davis now pushing above the highest levels they have seen in the last 25 years. As a result, consumer and CEO confidence softened in recent weeks after quite a positive start to the year. 

However, it is important to note that in the past those spikes in trade and economic policy uncertainty often lasted several months, not years, which could create opportunities for corporates and consumers alike.

Uncertainty Indices

In contrast to the equity markets, global credit markets have largely remained stable to start 2025, with defaults muted and the proportion of debt trading at stressed levels (debt trading at less than 80 cents on the dollar or credit spreads over 10%) remaining at low levels and spreads remaining near their long-term averages.

Context is everything, as we compare the historically tight spreads at the start of 2025 with the spreads today, it is easy to assume the worst given the noise in the market. In fact, the spreads across many of the broad credit indices remain at or below their historical average today, with spread expansion being most acute in the credit indices concentrated on the weakest credits.

For credit markets it will be important to monitor the increase in the amount of debt trading at distressed debt levels concentrated in certain industries. To date, we have yet to see a meaningful increase in the distressed portion of the leveraged finance markets. Only 6% of the high yield market and 3% of the loan market have reached those levels compared to peaks of 15-20% seen in past crises. Digging deeper into industry-specific stress will be important to assess the relative impact of trade policy based on the broader environment.

The size of the move in credit markets in the last week has been historically and statistically significant, with credit markets in U.S. and E.U. moving wider by 12-174 bps.

To put that into perspective, those moves represent two-day Z-scores of 2.0 - 7.6, which implies a probability of such an event (if you’re hazy on the details from your high school stats class back in the day, the Z-score represents how many standard deviations the event is from the average/mean). At a Z-score of 6 or 7 the probability becomes incredibly low, sometimes known as a Black Swan event. It’s crucial to watch how these market trends develop over the coming weeks.

Two-day Z-score moves following Liberation Day announcements

Stepping back, we are particularly focused on what trade policy decisions and "slightly less high for longer" base rates will have on the free cash flow generated by companies. Currently, in some cases, a material amount of a company’s free cash flow is going to service debt (i.e. paying cash interest expense), which companies have largely been able to do. This is why we haven’t seen a spike in defaults and why we haven’t seen non-accrual in credit portfolios go up meaningfully; that said, it does result in more challenging valuations of the equity in those companies.

On top of that, recent shifts in trade policy could result in material changes for certain companies at the revenue line if tariffs lead to more muted demand for goods, which could have a pronounced impact. This is likely one reason for the level of stress in the equity markets not translating back to credit.

Inflation expectations have increased since the start of the quarter, with inflation over the next two years surging to over 3% following uncertainty around trade and economic policy. Despite this, long-run market-based inflation expectations remain in the low 2% range, where it has been for the last few years despite larger movements in headline inflation – arguably a sign that markets view the current tariff-driven inflation potential as not having a long-term lasting impact.

Market Based Inflation Expectations

U.S.

The recent view of the economy can be split into two distinct periods. Even before the Liberation Day announcement, the economy was on a slower trajectory than 2024. Weakness in “soft data” like business and consumer surveys indicated expectations of a slowing economy, while “hard data” like jobs and inflation kept beating expectations. Goalposts for 1st quarter growth were set between -0.8% from the Atlanta Fed’s GDPNow model and +1% from economist surveys. Going forward, labor market weakness was a consideration with 279k of government cuts expected from Elon Musk’s Department of Government Efficiency (DOGE). Overall, a slowing, yet measured, economy was expected.

April 2’s "reciprocal tariff" announcements surprised even the most bearish of forecasters. The effective average tariff rate has been computed to be in the low/mid 20% range, compared to downside-case forecasts guessing a 16-20% range. The economic impact is impossible to know at this point, but early estimates are converging around a -1% hit to growth, +1-1.5% spike in inflation, and 0.5% increase in the unemployment rate. Economists surveyed by Bloomberg had already increased their probability of recession to 30% from 20% going into April.

Europe

The European liquid credit markets saw strong demand from investors to start the year which helped grind spreads to multi-year tights. For example, CLO formation – a key source of demand for loans – has been tracking at a record pace, while high yield was supported by consistently positive fund flows. There has been no shortage of high yield bond and leveraged loan issuance, but this has mainly been in the form of A&E/Re-Pricing/Refinancing activity rather than new money deals. As a result, net supply has been manageable, thus supporting the technical backdrop. The asset class has not been immune to the recent tariff related volatility, leaving year-to-date total returns in negative territory as spreads moved materially wider in the space of a few days following the recent “reciprocal tariff” announcement. Despite the sharp moves wider, spreads have moved from tight levels and are some way off the wides witnessed in 2020 and 2022.

Looking ahead, while we expect defaults to increase modestly, we do not view this as a trend driven by sector dynamics, but rather idiosyncratic single name credits unable to weather the confluence of current conditions. The corporate environment is broadly underpinned by strong corporate balance sheets and healthy interest coverage ratios. The main driver of potential upcoming defaults is expected to come from issuers that are unable to service their debt maturities and industries that are more heavily impacted by tariffs should those remain in place (e.g. automotive and chemicals). Whilst the tariff announcements do create some element of concern over the near term, an offset is the expectation of increased defense spending and economic activity generated from an EU looking to a future with less global dependence.

APAC

Last year finished with a flurry of credit activity across Asia which continued into the start of 2025. Commercial banks delivered most of the volume across the region with 60-90%+ market share depending on which country you were looking at. Private credit was active, stepping up its market share while the broadly syndicated institutional loan market had another quiet year with limited volumes in all countries. Overall credit volumes remained more muted relative to the period from 2019-2022. The key themes outlined above are being considered by market participants, but each country has materially different circumstances to grapple with in recent weeks (e.g. Vietnam, China, India, Australia, Japan).

Consistent with previous cycles recent global volatility has been slower in permeating into credit spreads in Asia versus other regions. Across the region credit metrics have largely remained resilient with strong outlooks. However there have been some high-profile credit defaults taking up headlines across Asia, but the actual number of those remains low. The recent market backdrop will be a real test for the market that is not anywhere as deep and liquid as the US and European markets.

Conclusion

After a risk-on start to broader markets in 2025, trade policy, geopolitical turmoil, sticky inflation and broader uncertainty in the outlook have tested equity investors’ will. Credit markets are on edge but have generally healthy credit metrics across countries and industries outside of a few small pockets to date. Material changes in trade policy that remain unresolved are likely to drive dispersion and further decompression in the credit market.

It’s paramount to assess whether trade policy changes are likely to be temporary or permanent shocks to the global financial system. In terms of lead indicators, we will be keeping a close eye on the path of credit spreads, distressed debt levels by industry, trends in business and consumer confidence, policy decisions by the U.S. executive, legislative and judicial branches and the path of inflation and interest rates. Though at times daunting, volatility and uncertainty will create more opportunities for credit with attractive spreads also benefiting from base rates that continue to remain elevated.

As always, when noise reverberates through global markets, we remain focused on deciphering the signals from the static.

For this quarter’s Global Credit Monitor, we interviewed Jana Markowicz, a Partner and Chief Operating Officer for U.S. Direct Lending in the Ares Credit Group. She also serves as Chief Operating Officer of Ares Capital Corporation and Ares Strategic Income Fund. 

This interview took place on April 3, 2025, the day after U.S. President Donald J. Trump announced sweeping global tariffs.