US inflation expectations (derived from Treasury Inflation-Protected Securities) are rock-solid and steady. Real rates have driven all of the rise in observed yields this year. That means that the ongoing weakness in bond markets is not a re-run of 2022, when fears of surging inflation led to simultaneous bear markets in bonds and stocks.
Stephen Dover, Head of Franklin Templeton Institute, says, “Given the fundamental shifts driving yields higher, we believe recent actions by US Treasury to cap long term interest rates via buybacks are unlikely to have lasting impact. The Federal Reserve, meanwhile, has adopt a tightening bias (readily detectable even if Chairman Kevin Warsh is dismayed by forward guidance), which also supports elevated yields.
“Of course, higher yields boost income streams for investors. But they can also increase financial risk for less creditworthy borrowers, crowd out certain forms of investment (e.g., US housing), crimp consumer spending, and lower stock market valuations via higher rates of discount. No wonder, therefore, that some commentators fret today about the risk posed by higher yields to global equity markets.
“And yet, higher yields also reflect a probable acceleration in trend economic growth courtesy of rapid innovation and rising capital expenditures. That’s not fanciful. Productivity growth is already picking up, and record high levels of return on capital and profit margins point to significant gains in economic efficiency.* Unambiguously, improving long-term growth is a positive for equity investors.
“So, taking all factors into consideration, what do we believe bewildering bond market moves mean for investors? There are three points to note:
- “Extend duration. Higher yields are likely to prevail over the rest of this year. That offers opportunities for income and diversification, particularly if risk assets dip. Real yields are also gravitating toward sustainable levels supported by the fundamentals. We therefore favor extending duration along the US curve to more neutral levels, alongside core holdings in corporate credit with sound fundamentals.
- “Position for broadening. Higher yields are driven by a combination of factors that are both negative and positive for growth and equity markets. Accordingly, investors should anticipate a greater dispersion of outcomes, as well as bouts of volatility. We think this is a good time to revisit portfolio resilience, but also to position for broader equity returns across market capitalisation sectors and countries.
- “And don’t count on a quick fix. Rising indebtedness of the government and corporate sectors is global and persistent. A combination of resilient global growth and elevated inflation means that central banks will likely tilt to tightening in the coming months. And if trend growth is improving, then higher real interest rates reflect a blessing in the making.”
*Source: US Bureau of Labor Statistics, Federal Reserve Economic Database
