Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 406

Real yields, inflation and risk assets in a transition

The fixed income world is beginning to undergo a multiyear transition as monetary accommodation and government spending across key economies drive higher near-term economic growth rates. The result could be a shift to higher real rates as output gaps narrow, as well as moderately higher but stable inflation.

In our opinion, this bodes well for risky assets, but will likely be accompanied by increased volatility and changing correlations.

Investment implications are quickly changing

For the past dozen years since the GFC, the overall environment for fixed income investors has been largely unchanged. Global growth has been sluggish across the developed and emerging markets. Central banks have unleashed a range of programmes aimed at supporting growth and financial assets. And fixed income investors have been persistently rewarded for positioning for low nominal yields, low real yields and a low-inflation (or even disinflationary) environment.

Whether it’s government bonds, credit instruments or even trends in the equity markets, these powerful trends in yields and inflation have significantly influenced the return outcomes of a vast swath of financial instruments.

This backdrop, to which investors have grown accustomed, is quickly changing, and we think investors need to position for a different and more complex environment. In our view, this is not a one-quarter or two-quarter shift, but likely the beginning of a multiyear transition to a different fixed income world.

What characterises this new environment?

It’s continued aggressive monetary accommodation, coordinated with remarkably high fiscal spending across a range of key economies, that will drive substantially higher growth rates over the near term. For fixed income investors, it means a transition to higher real yields as output gaps narrow globally.

We expect significantly more volatility around real yields in the coming quarters and years than we’ve experienced in the recent past. Intuitively, that’s due to uncertainty about whether this higher fiscal spending will drive quasi-permanent higher growth rates, or whether growth fades as fiscal stimulus eventually fades.

Real yields in perspective

As the chart below highlights, developed market real yields have been in a constant decline over the past 20 years, with acceleration lower after the financial crisis and then again in response to the COVID crisis. Relatively weak growth across the global economy has been the primary driver.

Markets currently appreciate that the growth outlook for 2021 will be strong given the reopening of economies and pent-up demand in many services sectors. However, we think investors under-appreciate how strong the growth trajectory could be after this year. Although declining, fiscal stimulus should support major economies well into 2023. Household savings rates are relatively high and will drive continued consumer spending. And, as consumption patterns change as some forms of work-from-home become permanent, we expect multiyear adjustments toward higher goods spending.

As the chart below highlights, this should all result in significantly above-trend growth in the three major economies not only this year, but over the next three years.

What does a multiyear period of higher growth rates imply for markets?

We are entering a 'period of transition', where strong growth will help close output gaps across the world, and where very accommodative central bank policies will increasingly feel different given these higher growth rates.

For fixed income investors, this should translate into a period of structurally higher and/or rising real yields, reflecting the more persistent and stronger economic backdrop.

We have three key conclusions about the emerging transition to higher real yields.

First, of all the factors that can impact the appropriate level of real rates, we expect that output gaps - or realised growth relative to potential growth - will be the main driver of equilibrium levels. As highlighted in the chart below, this analysis points to continued and sustained upward pressure on real yields in the coming quarters as aggressive policies continue to drive above-trend growth rates.

Second, based on our expected evolution of fiscal policy, monetary policy and expected growth, our 'fair value' view for U.S. and German 10-year real yields at the end of 2021 is -0.20% and -1.45%, respectively or approximately 30 basis points higher than current levels (see chart below).

Third, we expect risk assets to perform well in the intermediate term despite rising real rates. If a rise in real yields is exogenous and driven by a one-off tightening of financial conditions, like the taper tantrum of 2013, risk assets have tended to fare poorly. But if real yields are going up because of stronger growth and closing output gaps, it is generally supportive environment for risk assets.

In addition, just as we are transitioning to a higher real-yield environment, we are also transitioning to a higher realised and expected inflation environment. Perhaps the most significant recent change is credible central bank shifts toward conducting policy explicitly to achieve this outcome. Referencing the chart below, we expect inflation rates to return to levels seen in some of the stronger years since the GFC.

This transition to higher real yields and higher inflation rates poses two main risks to markets and economies. We don’t think these issues surface in 2021, but believe it’s not too early for investor consideration.

  • Rising government bond supply versus growth sustainability. Expanded deficit spending in the U.S., Europe and China is driven by the premise that accelerated fiscal stimulus can kickstart economies into higher and more sustainable growth rates. If this spending has low or negative multipliers to growth, the risk is an environment of upward pressure on yields without higher growth.
  • Rising term premiums. Central bank purchase programs, primarily in the U.S. and Europe, have helped push government bond term premiums to low or even negative yields. Whenever these programs begin unwinding—we do not expect this in 2021—balancing the positives of a stronger growth environment with rising term premiums will likely introduce a different type of volatility into fixed income markets.

Finally, it’s worth highlighting the risk of increasing global divergences. Europe and certain emerging markets may lag in the coming global recovery, particularly versus the U.S. and China. This may result in a more disjointed yield environment globally than has been typical over the past few years, and create opportunities for global investors.


Register here to receive the Firstlinks weekly newsletter for free

Revisiting our 2021 fixed income themes

Key market themes we identified at the start of 2021 remain intact. With the market movements in the first quarter, we slightly update our views.

  • Earn income without duration. This theme was a key driver of relative returns in the first quarter, as short-duration income sectors such as high yield, bank loans and collateralised assets delivered higher returns than other fixed income markets. We expect continued outperformance on both a relative and absolute basis from these areas. However, with the rise in interest rates in the first quarter, tactical opportunities have emerged in intermediate- or longer-duration sectors, such as fallen angels and rising starts in the non-investment grade markets, BBB rated securities in the investment grade market, and emerging market sovereigns.
  • Position for rising inflation. We expect continued increases in inflation breakeven rates, driven by the U.S. markets. We continue to believe that emerging market currencies are also attractive expressions of a higher inflation theme, although volatility will remain relatively high as U.S. growth expectations rise.
  • Sector and issue selection will drive returns. With relatively tight credit spreads across markets, sector and issue selection will remain key drivers of returns across fixed income. We continue to construct portfolios with an emphasis on secular winners (sectors like telecommunications and media), but are finding attractive opportunities in more cyclical exposures such as commodity-focused companies or countries.

 

Ashok Bhatia is Deputy Chief Investment Officer for Fixed Income at Neuberger Berman, a sponsor of Firstlinks. This material is general information and does not constitute investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. You should consult your accountant or tax adviser concerning your own circumstances.

For more articles and papers from Neuberger Berman, click here.

 


 

Leave a Comment:

     
banner

Most viewed in recent weeks

10 little-known pension traps prove the value of advice

Most people entering retirement do not see a financial adviser, mainly due to cost. It's a major problem because there are small mistakes a retiree can make which are expensive and avoidable if a few tips were known.

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Hamish Douglass on why the movie hasn’t ended yet

The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out. Vindication is always long term.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Latest Updates

Investment strategies

Three ways index investing masks extra risk

There are thousands of different indexes, and they are not all diversified and broadly-based. Watch for concentration risk in sectors and companies, and know the underlying assets in case liquidity is needed.

Investment strategies

Will 2022 be the year for quality companies?

It is easy to feel like an investing genius over the last 10 years, with most asset classes making wonderful gains. But if there's a setback, companies like Reece, ARB, Cochlear, REA Group and CSL will recover best.

Shares

2022 outlook: buy a raincoat but don't put it on yet

In the 11th year of a bull market, near the end of the cycle, some type of correction is likely. Underneath is solid, healthy and underpinned by strong earnings growth, but there's less room for mistakes.

Gold

Time to give up on gold?

In 2021, the gold price failed to sustain its strong rise since 2018, although it recovered after early losses. But where does gold sit in a world of inflation, rising rates and a competitor like Bitcoin?

Investment strategies

Global leaders reveal surprises of 2021, challenges for 2022

In a sentence or two, global experts across many fields are asked to summarise the biggest surprise of 2021, and enduring challenges into 2022. It's a short and sweet view of the changes we are all facing.

Shares

2021 was a standout year for stockmarket listings

In 2021, sharemarket gains supported record levels of capital raisings and IPOs in Australia. The range of deals listed here shows the maturity of the local market in providing equity capital.

Economy

Let 'er rip: how high can debt-to-GDP ratios soar?

Governments and investors have been complacent about the build up of debt, but at some level, a ceiling exists. Are we near yet? Trouble is brewing, especially in the eurozone and emerging countries.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.