What happens to inflation is key for investors. If inflation fails to fall further, bond yields are
likely to rise further.
The collapse of the Middle East truce threatens to push inflation up again. Long duration
bonds remain a difficult place to invest.
Meanwhile, in a growth environment, equity dividend growth has consistently outpaced
inflation in most markets. For the moment, the macroeconomic outlook favours equities.
• Key macro themes – resurgent tensions in the Middle East pose inflation risks
• Key market themes – bull market earnings showing up again for the second quarter
Failing to beat inflation
Renewed Middle East hostilities have sent energy prices higher again, threatening to
exacerbate the inflation environment. This comes despite recently improved inflation data.
June’s US consumer prices report was market friendly; headline consumer prices fell 0.4%
while core prices were flat on the month.
Both the headline and core annual inflation rates fell from 4.2% and 2.9% in May, to 3.5%
and 2.6%, respectively. But already in July, oil prices are up around 20%.
Another upturn in inflationary expectations would not be good for bond investors.
Government bond returns have struggled to keep pace with inflation for most of the last
decade. Even short-duration and inflation-linked bonds have struggled to match, let alone
beat inflation.
It really has been a torrid time. Credit has done a little better, but this has been much more
the case in high yield rather than in investment grade. Having exposure to a strong corporate
sector (equities and high yield) has delivered better real returns, than exposure to the
eroding effects of inflation.
Exceeding forecasts
Despite the sharp rise in bond yields between 2021 and 2023, and the gradual increase
since then, the problem is inflation has continued to exceed forecasts.
At the start of 2026, the Bloomberg consensus forecast for US headline consumer price
inflation was 2.8%. As of the end of June, the headline inflation index had already risen 3%
with the core consumer price index up 1.7%. The ICE/BofA US Treasury total return index
was up just 0.43% over the same period.
For current yields in the US Treasury market to provide enough return to match inflation,
monthly increases in the CPI index cannot exceed 0.35% to 0.40%. The average this year
has been 0.5% per month (the average since 2016 was 0.27%).
For there to be positive real returns, either inflation needs to be lower, or yields need to be
higher. Current yield levels do not provide satisfactory cover for the inflation risks.
The inflation gap
The big question is whether we are entering a period where inflation will continue to be
biased higher? There are arguments to suggest we are. Geopolitical disruptions to trade,
investment, and supply chains seem to have become more frequent.
Climate change, protectionism, and the need to spend on artificial intelligence can all
contribute to upside inflation risks.
That risk should be sufficient for investors to demand higher yields and therefore, better
returns from bonds. Until then, investors will likely continue to prefer short-duration bonds
and bonds with a significant credit return.
In the case of the former, short duration strategies offer a potential defence against central
banks raising interest rates to combat persistently higher inflation. The latter case, for credit,
relies on corporate cash-flows being resistant to inflation (companies can raise prices to
offset higher costs if the economy is doing well).
Yields on credit are higher than current inflation rates – US investment grade credit yields at
5.3% against that June headline inflation rate of 3.5%. European investment grade credit
yields are 3.6% against a preliminary June inflation rate of 2.8%. The potential for positive
real returns is there.
It is understood that equities remain the best hedge against inflation with the return driven by
earnings growth – and despite a low yield, US dividend growth has consistently outpaced
inflation, as it has in other major markets.
Indeed, equities have benefitted from higher-than-expected inflation, giving them pricing
power. Because bond yields have not risen more, maybe because of the belief that inflation
above target is transient, equity valuations have remained rich.
The worst case for all markets is a sharp rise in inflation and yields, triggering a derating
across equity markets.
Inflation and fiscal considerations
I think the inflation impact on bond yields is more important than fiscal considerations.
Governments can at least try to control borrowing, but central banks have found it hard to
control inflation and monetary policy has been compromised since the global financial crisis.
This is not to minimise deficit and debt considerations. Profligate fiscal policies always run
the risk of upsetting the bond vigilantes. But not getting a real return from investing in bonds
is also important.
Inflation credibility key
Market participants can still make money in bond markets. There remain attractive spreads
in the credit markets. Short-term volatility is always creating trading opportunities. Yield
curve shapes will evolve.
Active fixed income management should potentially be able to outperform passive bond
indices. Short-duration high yield strategies remain one of the more attractive options. As do
short-duration inflation-linked strategies which should at least match realised inflation.
But longer-term investors who buy bonds to fund government deficits, or corporate
investment needs, must be convinced there is potential for a real positive return. Investors
that want real returns in their pension plans without being 100% in equities also need to think
hard about where in fixed income to be invested.
Central banks are committed to bringing inflation down. It was encouraging to hear new
Federal Reserve Chair, Kevin Warsh, saying he would “double down on the Fed’s 2%
inflation target” in his Congressional testimony this week.
There are not many developed economies that do not have a worrying fiscal outlook and,
tempting as it may be to inflate away the debt, keeping borrowing costs under control must
play a part in managing the debt trajectory.
That means lower inflation and that may mean central banks having to raise interest rates if
inflation does not moderate. Watch this space and be prepared for inflation-adjusted bond
returns to be lackluster, at least in the short term!
Performance data/data sources: LSEG Workspace DataStream, ICE Data Services,
Bloomberg, BNP Paribas AM, as of 16 July 2026, unless otherwise stated. Past
performance should not be seen as a guide to future returns.
