We have long argued that structural forces, such as aging labor forces at a time of ever-rising debt, would keep inflation and interest rates higher for longer. This view is now consensus. Surging global yields show shifting market narratives, from deep rate cuts to almost no cuts, keep driving sharp volatility. These moves go beyond market expectations of higher inflation: real yields on inflation-linked bonds have been the main driver of the recent surge. We think some of the volatility is driven by expecting the Federal Reserve to respond in a typical way to a business cycle. This is the wrong lens at a time of structural transformation and when the government debt backdrop is very different. Investors are demanding more compensation for the risk of holding long-term bonds, driving the term premium to a decade high. See the chart. That shows the market coming around to our higher-for-longer view.
Yet this is not a business cycle. We are in an economic transformation – with structural shifts driving activity. We have never before seen today’s combination of sticky inflation, higher policy rates and high and rising debt levels. This combination represents a fragile equilibrium supporting investor demand for long-term bonds. Yet investor sentiment and risk appetite can shift quickly in this environment – threatening to throw this equilibrium off-kilter. We have seen that in the UK recently, where fiscal concerns helped drive 10-year gilt yields to 17-year highs. We stay overweight gilts for income – yet monitor the UK’s outlook as it faces the sharpest trade-off between growth and inflation among developed markets, in our view.
Our fixed income and credit views
In the U.S., large and persistent deficits were expected even before the new administration makes any changes to fiscal policy – like the proposed extension of tax cuts. As bond markets absorb record Treasury issuance, we think long-term yields can rise further – though they have come a long way in a short period of time. That keeps us underweight U.S. 10-year Treasuries as we think yields could pass 5%. We prefer earning income in short-dated Treasuries and credit. Even with the recent jump in bond yields, credit spreads have stayed tight. Investment grade corporates have stronger balance sheets after the pandemic, even as they start to refinance at higher interest rates – a reason we prefer short-dated investment grade credit over government bonds. Within investment grade, solid corporate earnings momentum supports tighter spreads, in our view.
Even in a higher-rate environment, we still think stocks can keep pushing higher as long as fundamentals stay strong. The magnificent seven companies driving corporate earnings growth have strong balance sheets, are cash rich and have negative net debt. This makes them more resilient to the bite of higher rates. Early signs are positive that earnings momentum can persist: consensus forecasts call for overall U.S. earnings to grow 13% in 2025, up from 10% last year, LSEG Datastream data show. We watch Q4 earnings season for signs of this strength persisting and broadening to sectors beyond tech. We stay risk-on for now as we expect AI beneficiaries to broaden out yet eye triggers that could cause us to change our view.
Our bottom line
We think bond yields can keep climbing over the long term, so we stay underweight long-dated U.S. Treasuries. We prefer short-term bonds for income and euro area over U.S. credit. We stay risk-on and expect earnings to fuel equities.
