Strategic implications of the yield spike

We reduce our long-running underweight to government bonds in strategic portfolios as short-dated debt is more attractive after this year’s surge in yields - and keep our overweight to equities.

Summary

Equities over bonds

• This year’s surge in bond yields has spurred changes in our strategic – or long-term – asset views. Most notably, we have reduced our long-running underweight to government bonds, in large part due to less unattractive valuations and better income on offer at the short-end of the curve. We stay firmly underweight long-dated bonds as we see yields rising further as investors demand greater compensation for holding them in an inflationary backdrop. Developed market (DM) equities remain one of our largest overweights - underpinned by still appealing expected returns on a long-term view.
• Both equities and bonds have seen sharp selloffs this year. The drawdown in equities reflects, in our view, investors grappling with the difficult trade-off confronting central banks on growth and inflation. Central banks have turned increasingly hawkish to counter elevated inflationary pressures, sparking a sharp repricing higher of expected policy rate paths. The near-term risk of a renewed hawkish repricing in markets amid persistent inflation pressures spurred us to cut risk in our tactical views last month.
• Yet we expect this the excessive hawkishness to subside over a strategic horizon as central banks ultimately choose to live with inflation that we see persisting over the medium term rather than slamming the policy brakes and choking off growth. That scenario favors equities over bonds, in our view, underscoring our broad asset preference. Our expected returns for equities have risen modestly as the lift from cheaper valuations after the selloff is offset by the drag from a higher projected path for short term rates in the near term.

Adjusting our strategic views

• In fixed income, the rise in long-term yields is consistent with the underweight to DM nominal government bonds we have held in our strategic positioning since April 2020. We still see higher long-term yields over the next five years, driven by investors demanding a higher term premium for the risk of holding long-term bonds. We also cut Chinese government bonds to neutral as their previous yield advantage over DM yields has disappeared.
• We still favor inflation-linked bonds in this environment due to higher real rates and our expectation that inflation will settle at levels above pre-pandemic levels. Breakeven inflation rates – a market proxy for market inflation expectations – remain well below our estimates of where inflation is likely to be in five years’ time.
• In private markets – as in public – the higher path of short-term rates brings down our expected returns on the asset class. In our last Portfolio perspectives we highlighted the increased attractiveness of public equities over private markets to get exposure to growth. That relative appeal persists. We prefer private credit over public credit on a strategic horizon due to our higher expected returns on a risk-adjusted basis.

Time horizon is key

The current environment reinforces the importance of having investment views on a tactical (6-12 months) and strategic (five years and beyond) horizon. Over a strategic horizon, we believe the regime we flagged in our 2022 Global Outlook – one driven by investors demanding greater compensation, or term premium, for the risk of holding government bonds amid inflation higher than pre-Covid levels – as reasserting itself. Such a regime favors equities over nominal government bonds, in our view. Yet risk assets face a volatile few months amid worsening macro conditions.

Our latest strategic views

We prefer equities and inflation-linked bonds over nominal government bonds in our strategic views and portfolios. The key change this quarter is to trim the size of these views as the surge in yields alters the relative appeal of equities vs. bonds.

Our base case

Over a strategic horizon of five years and beyond, we believe the core framing underpinning our 2022 Global Outlook will reassert itself. To recap: we see inflation as largely supply driven due to abnormally low supply due to the pandemic and the war in Ukraine rather than due to exuberant demand in the restart. We see inflation easing from current elevated levels as supply disruptions, yet staying higher than pre-Covid levels. Central banks will choose to live with some inflation rather than destroy growth and employment in a bid to fight supply-driven inflation, in our view. In other words, they will likely pause after an accelerated return to neutral policy rates rather than slamming the brakes by going beyond and tipping economies into a recession. Over a strategic horizon, this scenario favors equities over nominal government bonds, in our view. Our strategic views shown in the chart on the left below reflect this.

Higher long-term government bond yields have been in line with our strategic asset positioning in fixed income where we have been maximum underweight developed market (DM) nominal government bonds since April 2020. Since then the Bloomberg U.S. Treasury bond index is down 18%, according to Refinitiv data. We are now trimming this underweight. This is driven in large part by the increased appeal of shorter-dated bonds over longer-dated maturities. The outlook for longer-dated bonds remains challenged, in our view, as we see the term premium – the extra compensation investors demand for holding longer-term bonds rising and pushing bond yields higher.

Relative appeal

The relative attractiveness of equities over bonds has diminished – but only marginally. We trim our overweight to +2 from +3. In other words, the asset remains a large overweight. Declining equity prices have offset the drag on expected returns from the higher policy rate paths. Our risk-adjusted expected returns for DM equities have risen less than for shorter-maturity DM government bonds (see chart on the right). We also cut our overweight to inflation-linked bonds slightly to +2 from +3 as breakeven inflation rates have moved higher in line with our views – but we still see more room for higher pricing. We cut Chinese government bonds to neutral as their yield differential over DM bonds has been erased.

Short- over long-dated bonds

We expect bond yields to climb higher over a strategic horizon even after this year’s surge. The key driver: higher term premium over the medium term due to ballooning sovereign debt burdens and the shift to a higher inflation regime – two fallouts of the pandemic. See chart on the left below. We expect inflation over the strategic horizon to be higher and more uncertain than over the decades preceding the pandemic. This should drive investors to demand greater premium for holding longer-dated bonds - this has started but we see further to go. The expectation of higher yields over the medium term keeps us broadly underweight nominal government bonds. But within this underweight we see a brightening backdrop for shorter-date bonds. This appeal has spurred a reduction in our overall underweight to -1 from the maximum of -3 we have had in place since March 2020.

Yields have spiked higher since our last update. Yet the spot yield curve (red line in the right chart) is still below our estimate of what the yield curve will look like by then (purple line). The other key observation: the gap between two gets greater as you go further out the yield curve. That means in the our CMAs we expect a bigger valuation drag for yields backing up for longer-dated assets - both on account of their duration and our yield estimates – than at the short end.

Heightened uncertainty

There is a high level of uncertainty around the path forward for interest rates. We believe it prudent in such a volatile environment to test the our views. We do this by studying two hypothetical scenarios and test how our views – and the changes we made this quarter – would change if the term premium itself were to rise even more than we expect and if the entire yield curve shifts higher – perhaps because short-term interest rates rise to levels beyond our current expectations.

The chart on the right below illustrates the first of these hypothetical scenarios where the term premium rises more than our current estimates. In this instance too our view on nominal DM government bonds would remain at -1. Why? An increase in term premium is negative only for long duration bonds – an asset class on which we are already have a high conviction underweight. A worse outlook doesn’t change that view. Short-duration bonds don’t suffer from increased term premium.

Shifting yield curve

The second scenario – a parallel shift higher in the yield curve – has more meaningful asset allocation implications, beyond just bonds. In this scenario, our underweight to nominal DM government bonds would be at -2. Why? Short-duration bonds suffer from the increase in the front-end of the curve. Importantly, in this scenario our view on DM equities would also reduce to a +1 from +2. Higher cash rates mean higher discount rates for equities, diminishing our expected return and driving a smaller preference for the asset class. A higher term premium will be particularly bad for long-term bonds and not necessarily so for equities, while a higher curve is bad for both equities and bonds, in our view.

Yields could surge significantly, yet given the jump in yields over the last two years, we believe the balance of risks to yields is now less skewed to the upside - one reason the relative attractiveness of equities over bonds has narrowed. Our sensitivity analysis shows that an expected overshoot of term premium versus our forecast would not make us more underweight bonds today. Only an overshoot of the whole curve would make us more underweight government bonds and this would be detrimental to equities too.

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