The rise in bond volatility is evidence of new macro and market mechanisms at work and confirms the benefits of remaining agile in our five-year or longer strategic view.
We upgrade sovereign bonds Developed Markets (DM) is rated Neutral, but this masks two stories – we continue to be underweight long-term bonds, but have moved to overweight short- and medium-term bonds. We also trimmed our preference for inflation-linked bonds, although this remains our largest overweight, and downgraded developed market equities to neutral.
1) Yields further rise
Our 3.5-year underweight position in all developed market government bonds has ended as rising market yields are consistent with our positioning. Overall, we have moved to neutral, but this is driven by a preference for short-term and medium-term bonds – more notably we have not changed. We remain underweight long-dated bonds.
We believe long-term yields will resume their climb as investors demand more of the term premium (compensating for the risk of holding long-term bonds).
2) Inflation continues to be at a high level
We believe rising inflation, combined with higher fiscal and climate-related spending, could mean policy rates will be significantly higher than before the outbreak.
Our latest view on rising long-term neutral rates prompts us to reassess equity valuations. Our strategic Overweight position on developed market equities – a holding since before the end of Western lockdowns – has now been reduced to Neutral. Long-term equity valuations look fair to us, rather than warranting a higher-than-usual allocation. Despite the downgrade to Neutral, U.S. equities remain our largest portfolio allocation.
We believe that the new turbulent economic regime requires a more flexible and dynamic strategic perspective.
We believe granularity is key as government bond yields hit multi-year highs. We are more bullish on short- and medium-term developed market bonds as we factor in longer periods of higher interest rates in our five-year and above strategic view. We continue to be underweight long-dated bonds and in our latest quarterly update we remained neutral on developed market bonds overall. We like inflation-linked bonds and downgrade developed market equities to neutral. We remain underweight credit and prefer private market earnings.
Long-term bonds are riskier
Forward-looking estimates may not materialize. Note: Chart shows historical and estimated term premium ranges. The scope covers three regions: the United States, Germany and the United Kingdom. The term premium is defined as the compensation investors require for the risk of holding long-term bonds. Our historical estimates of the term premium are based on the Adrian, Crump, and Moench (2013) “ACM” model, detailed below: Our estimate range represents a five-year view from 2023 to 2028.
We have been underweight developed market government bonds since March 2020 as we expect yields to rise. As our views have been reflected, we have gradually reduced our holdings and increasingly favored shorter-term bonds. Now, with yields higher, we are clearly overweight developed market short- and medium-term government bonds. We continue to be underweight long-dated bonds as we believe there is room for long-term yields to rise again. Why? We believe investors will demand more term premium, or compensation for the risk of holding these bonds in developed markets. See chart. This is due to increased bond market volatility due to more uncertain and volatile inflation. We’ve also seen weaker demand for bonds amid rising debt levels. Central banks are no longer reinvesting proceeds from maturing bonds as part of quantitative tightening, while investors are struggling to digest a flood of new debt.
The path to higher long-term yields over the next five years is unlikely to be smooth. In fact, we have recently been neutral on long-dated Treasuries from a 6- to 12-month tactical perspective, as we see the potential for yields to move more evenly in either direction. Inflation-linked bonds remain our most committed overweight at a strategic level. Of course, inflation is falling in the near term as pandemic-era mismatches ease and consumer spending shifts from goods to services. But in the long term, we believe inflation is well above the central bank’s 2% policy target. The reason is that huge structural shifts are constraining supply: slower labor force growth, geopolitical fragmentation and the low-carbon transition. This is why we see central banks keeping interest rates high for longer. Our updated strategic view also reflects the impact of this.
Be flexible and selective
We also moved to neutral on developed market equities, with U.S. equities remaining our largest portfolio allocation. We have been overweight on attractive valuations since the end of pandemic lockdowns in the West. The bond and stock markets have been moving intermittently toward our long-term view of high rates, while long-term valuations for stocks now appear fair to us. That’s why we are neutral on a broad range of asset classes and look for opportunities within them. The new system creates uncertainty and results in greater fragmentation of sectoral and individual security returns. How can these potential opportunities be captured to generate returns above the benchmark? We believe that flexible portfolios, refinement and investment techniques are part of the answer.
These changes illustrate why we believe it is important to maintain an agile strategic perspective. This new, more unstable system means that the relative attractiveness of different assets changes faster than our generation is used to. Credit is a good example. Just a year ago, we were overweight investment-grade credit because spreads looked attractive compared to our long-term expectations. Then spreads tightened significantly and we started reducing our holdings as we expected spreads to widen in the longer term. We believe higher rates over the longer term could erode corporate profits and earnings, particularly as companies refinance debt. We see private lenders benefiting from refinancing activity as high interest rates reshape the financial sector and banks limit lending. That said, private markets are complex and not suitable for all investors. Private credit is not immune to the tough economic backdrop, but we believe current yields compensate investors for the risk.
High interest rates were a core tenet of the new regime. We are strategically overweight short-dated developed market bonds and maintain our preference for inflation-linked bonds. We are neutral on developed market equities but see granular opportunities.
The S&P 500 hit a four-month high and was up about 11% from its October lows in the holiday-shortened trading week. The tech-heavy Nasdaq 100 index hit its highest level since January 2022. The yield on the 10-year U.S. Treasury note edged back up to 4.5%, but is still about 50 basis points below its October peak. We believe yields will remain volatile but will return to growth as investors begin to demand more term premiums – a key part of our tactical and strategic view.
We are monitoring this week’s US PCE inflation data, the Fed’s preferred inflation gauge, to gauge whether inflation is on track to fall to 2%. We believe U.S. inflation will approach the Fed’s 2% policy target in the second half of 2024, but will not remain at that level for long. We believe euro area inflation will also return to target next year as economic activity stalls.