Monetizing the New Macro

Investors aren’t rotating away from the US so much as repricing what matters in a world of risks. After years of overweighting US assets, market participants are rethinking exposures amidst what Prime Minister Mark Carney has called a “new world order” of shifting alliances and trade. Bottom line: it’s difficult for US assets to behave like safe havens when the source of global uncertainty is made in America. Tariff shocks are complicated to resolve and carry greater upside risks to inflation. That’s particularly true against a global backdrop of persistent deficit spending spurred by infrastructure and rearmament needs. In this environment, fixed income is having a harder time hedging equity risk, and investors continue to hunt for linkages to commodities, both direct and indirect, to manage portfolio volatility. These shifts are less about “Selling America” and more about monetizing the new macro.

Fixed income with an asterisk. Bond vigilantes are monitoring debt sustainability metrics, pushing long-end rates higher when faced with unwelcome fiscal developments. Macroeconomic data is also contributing to volatility. Many central banks have ostensibly ended their easing cycles, and market participants are looking to incoming data to inform the direction of their next moves. As an asset class, fixed income carries more apparent risk given this uncertainty and the debt dynamics. As a result, diversification within fixed income is becoming more important.

Investors are currently overweight US debt markets, but look for that to gradually change. The US makes up just over 40% of total global debt outstanding, but most international investors own a disproportionately large share of US fixed income. For example, in Canada, foreign allocations to US debt are greater than 70% (graph 1).

Fundamental factors should become more pronounced drivers of fixed income returns this year. Last year, fixed income returns were shaped by a market coming to terms with a changing global order—a recalibration that created a dominant common factor that moved returns in unison (graph 2). This year, as that adjustment is better understood, fundamental factors like debt trajectories and credit ratings should begin to play a larger role in bond returns.

Government of Canada bonds (GoCs) should benefit in this environment, especially in the long end. Term premium—the additional compensation investors require to own fixed income above expectations for the overnight rate—has stabilized at elevated levels in Canada, and we see scope for this to move lower (graph 3). That comes even as we expect Canadian central bankers to remain on the sidelines until the second half of 2027.

The decline in longer-term rates should also help lower mortgage rates by year-end. While mortgage originations continue to skew towards 3‑ to 4‑year fixed-rate terms and variable-rate products, we see the bulk of originations returning to the 5‑year fixed-rate sector over the next few years (graph 4).

Longer-duration US Treasuries (USTs) will likely underperform GoCs this year. The buyer base of USTs is shifting towards investors who are more price sensitive. Official accounts, which include central banks, some sovereign wealth funds and some international pensions, have been reducing their ownership share of US Treasuries (graph 5). That should make US rates more volatile and could put upward pressure on long-end yields. While Fed officials have been leaning more hawkish this year, policymakers are likely to ease policy further before the end of the year. That should provide a tailwind to shorter-dated USTs.

Fixed income’s role in portfolios is evolving but remains essential. Higher interest rates have restored bonds as a source of income, but that has come alongside higher volatility. Investors can no longer rely on fixed income to remain a stable hedge to their equity risk. That may seem like a radical structural shift, but it’s more consistent with what has been seen many times in history (graph 6). High inflation—and inflation uncertainty—tends to be associated with positive stock–bond correlations and higher bond volatility. Today’s environment is trending in that direction.

The US dollar has come under acute pressure in recent weeks. While initially the weakness was tied to strength in the Japanese yen, the decline is now broad-based (graph 7). The “Sell America” theme has once again circulated in what seems like a Liberation Day Lite-type price action. This is yet another wake-up call for investors buying US dollar assets unhedged.

Investing in US assets unhedged has become extremely risky. The graph below shows the return on the S&P 500 for a European investor assuming no currency hedging program. We can see that the double-digit return posted by US large cap equities essentially vanishes once converted back into euros (graph 8).

The Canadian dollar has appreciated notably this year. Our year-end forecast points to USDCAD at 1.34, but it’s possible the Canadian dollar could see even more strength. Interest rate differentials should become more supportive for the loonie in the second half of the year with the FOMC expected to resume easing. That said, CUSMA negotiations cloud the outlook for the Canadian economy and could inject more volatility over the coming months.

US equity markets appear fully priced, and this continues to encourage a rotation toward other regions. Fund flow data from ETFs and mutual funds shows US funds increasingly falling behind their global counterparts, while Canadian funds are experiencing unusually strong inflows (graph 9).

Equity price performance mirrors these flows, although volatility in metals has dragged Canadian equities lower. Nonetheless, this still reinforces the picture of investors reallocating across jurisdictions (graph 10).

The hurdle for overweighting US equities remains high. The AI trade is moving from a phase of broad enthusiasm to one of execution, prompting investors to trim exposures ahead of what could be more volatility. From here, either AI‑linked firms must deliver on already elevated expectations, or the rest of the market—particularly non‑tech—must play catch‑up. While earnings growth should broaden in 2026, such an improvement would largely reflect the high starting point concentration and fewer downgrades rather than a surge in underlying growth momentum.

Against this backdrop, shifting some exposure into rest‑of‑world equities looks both natural and prudent. US valuations have risen far above those of their global peers post-pandemic (graph 11). Starting valuations matter: higher multiples tend to compress forward returns, and with such a high bar for overweighting US equities, investors are understandably exploring opportunities elsewhere.

Still, US equities retain an important strategic role in portfolios. American companies continue to exhibit superior margins and stronger cost discipline, providing better downside protection when growth softens. Even from elevated valuation levels, the S&P 500 is still expected to deliver returns approaching 10% this year.

Meanwhile Canadian equities are positioned to outperform. Domestic investors continue to buy Canadian equities, and there are early indications that foreigners may be turning more constructive. With tighter linkages to commodities, the TSX has seen its correlation with other major equity indices decline (graph 12). Energy—still structurally under‑owned—is beginning to benefit from improving fundamentals and shifting sentiment, as evidenced by the pickup in fund flows within the sector. The recent correction in precious metals aside, we still see gold prices finishing the year higher than current levels, which should further support the TSX.

Strong demand for Canadian risk assets means that we’re not expecting a material widening of spreads. Foreign flows into Canadian corporate credit remain strong, corroborating the fund flow data (graph 13). Those factors, coupled with coupon reinvestment flows, are keeping spreads at historically tight levels. CUSMA negotiations are likely to inject some volatility, but our base case assumes a sanguine outcome for the trade negotiations.