The structural slowdown in global economic growth and dramatic drop in bond yields represent a paradigm shift that is forcing a rethink of portfolio allocations. Ageing societies and weak productivity growth have led to a persistent decline in economic growth. What is now considered a neutral policy rate for a central bank – one that neither stimulates nor restrains growth – has experienced a likely medium-term decline in the United States and other major economies.
This low neutral rate and large central bank ownership of government bonds are why we see long-term bond yields staying low on a five- to 10-year horizon. Investors should not expect bond yields to revert to historical averages, notwithstanding likely short-term swings. Low risk-free rates – the fundamental basis for gauging asset valuations – represent an underappreciated sea change in assessing future returns, in our view. Asset valuations need to be seen through a different lens.
- Investors need to reassess how to achieve return and diversification goals: perceived “safe” assets are looking less safe due to a variety of near-term risks (valuations, political and central bank uncertainty), while equities can generate more income in a diversified portfolio.
- Structural forces imply the U.S. neutral real short-term rate (known as natural rate or r*) is now just 0.5%, suggesting nominal short-term rates should be anchored around 3.0%. That limits how high central banks will likely lift rates and thus how high long-dated bond yields are likely to go, in our view.
- Low discount rates suggest that asset valuations should not fall back to historical means and thus relative valuations matter more, we believe. So take risk where you are most rewarded.
- We see U.S. 10-year yields gently rising to average about 2.4% on a five-year horizon. We also see risks of occasional government bond sell-offs that may result in reduced portfolio diversification benefits.
- Our bottom line: Investors are still getting paid for holding certain risk assets, even as we expect subdued overall returns. Investors with fewer liability constraints should consider reducing government bonds and holding a bigger share of alternatives, global equities and emerging market (EM) assets, in our view.
Lower growth and interest rates here to stay
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