In early July, the yield on 10-year Treasuries fell to a record low. At the same time, the S&P 500 Index broke out to a new all-time high. This update will identify the drivers of this peculiar rally and discuss how the global business cycle may affect this dynamic going forward.
Ultra-low bond yields imply extreme valuations
Ten-year U.S. Treasury bond yields fell to 1.36% in July, the lowest level in history. Long-term Treasury yields are driven by three broad factors: expectations about the future pace of economic growth, expectations about the future pace of inflation, and something called a “term premium.” Term premium is essentially the additional compensation investors require over short-term interest rates (e.g., cash) to be willing to lend money for a longer period of time and bear a higher level of interest rate risk.
The chart shows the long-term history of the additional compensation of the U.S. 10-year Treasury over cash. The blue line plots the cumulative excess return through time, and the green line is a measure of the underlying trend. Bonds have dramatically outpaced cash, leaving little term premium.
However, in recent years bonds have outperformed cash by a historically extreme amount (the blue line vs. the green line). The result is that there is very little term premium (additional compensation) for investing in bonds instead of cash, which implies that investors have never gotten so little yield in exchange for the risks involved in holding longer term Treasuries. Sovereign bond yields in Europe and Japan are even lower, with more than $10 trillion of debt trading in negative yield territory.
Why are bond yields so low?
There are several fundamental reasons that help explain these ultra-low bond yields, and it’s important to remember that U.S. Treasuries are a global asset and not merely a reflection of the U.S. economy. The pace of global growth has been anemic, inflation has been subdued, and secular issues such as high debt and aging demographics are long-term headwinds for growth. In response, monetary policymakers have pushed down policy rates to ultra-low levels, including negative territory in Europe and Japan, and they have pledged to hold them there for a long time period.
Current yields also reflect formidable technical factors that have helped depress Treasury yields. On the supply side, quantitative easing programs by the four largest central banks have soaked up roughly the equivalent of $9 trillion in bonds. In addition, lower fiscal deficits have allowed new debt issuance by developed markets (DMs) to fall to an estimated equivalent of $1 trillion this year, just a third of the level issued in 2010 (see chart, below).
Meanwhile, demand for high-quality bonds has risen significantly. Regulatory changes have boosted demand among financial institutions in order to meet higher capital and liquidity requirements. Secular demand from pension plans and aging populations continues to rise. And zero and negative yields overseas have generated high foreign demand for comparatively high-yielding U.S. bonds.
Bond yields are priced for one scenario: low growth, low inflation
The bond market today appears to be pricing in a continuance of the global environment that we have experienced over the past couple of years: sluggish growth, nonexistent inflation, and indefinite monetary policy easing outside the U.S. According to the Treasury market, investors anticipate inflation to average just 1.5% a year for the next decade (see chart, below), the lowest at any point outside of the financial crisis.
Bond yields imply that the market is pricing bonds at a level indicating not only that the market technical factors will continue but also that the most likely cyclical scenario is a global recession followed by secular stagnation in the long term. Such a scenario would likely not only justify current bond yield levels but potentially push them even lower.
However, there are other scenarios for the U.S. and global economic outlook. In our opinion, the most likely alternative is that continued expansion in the U.S. and stabilization in the global economy leads to a growth and inflation environment that surpasses extremely subdued market expectations. One possibility within this context is that governments increase deficit spending to further stimulate growth, a trend already apparent in China, recently announced in Japan, and becoming increasingly likely in the U.K. and in the U.S.
Any improvement in macroeconomic trends would likely obviate the need for monetary policymakers to endlessly expand easing programs, particularly at a time when the limitations of ultra-low and negative policy rates are becoming more apparent (read Viewpoints: "Potential pitfalls of negative rates").
Such a scenario does not necessarily suggest a powerful global expansion, rampant inflation, or an overnight reversal in accommodative monetary policies. However, low yields and inflation expectations appear to be pricing in such a dire outcome that even a modest surprise in the other direction may have the ability to move asset valuations away from such a defensive-oriented outlook.
We believe growth is stabilizing and inflation is accelerating
What matters most is whether the outlook justifies the pessimism implied by record-low bond yields. To us, steadying trends in China and continued expansion in the U.S. make a modest positive surprise in both growth and inflation expectations the most likely scenario over the next 6-12 months. Trends in most of the recent economic data support this outlook:
- U.S. wage pressures are accelerating (see U.S. consumer section).
- Despite recent weakness, oil prices have significantly rebounded off their Q1 trough (see U.S. inflation section).
- The global manufacturing and trade recession is receding (see Global section).
Modest upward surprises to both growth and inflation expectations would likely put upward pressure on interest rates. It’s important to note, however, that many of the strong secular and technical factors outlined above may serve to moderate the magnitude and pace of any increase in yields.
Stock valuations helped by yields; bond proxies at extremes
As Treasury yields have fallen to such low levels, it has spurred investors to search for higher-yielding assets in other markets. One area in particular that has benefitted has been bond-proxy, or high-dividend yielding equities, including stocks in the utilities, REITs, and consumer staples sectors. During the past year, bond-proxy sectors such as REITs and utilities have attracted a net $11 billion in inflows, while the overall equity market has seen a net outflow of $96 billion.1 The surge in demand has pushed high-dividend-yielding stock valuations to historically high levels relative to their own past, as well as to the broader equity market (see chart, below).
Low bond yields have also contributed to rising valuations for the equity market as a whole, as they provide lower interest rates to discount the present value of future corporate earnings. However, the somewhat above-average market valuations are still within a historically reasonable range.
Moreover, equities in general may benefit from a modest surprise in growth. As we’ve highlighted the past several months, the U.S. economy continues to experience a mix of mid- and late-cycle indicators (see U.S. macro section), with our expectation that late-cycle indicators will continue to rise in the coming months.
Inflation-resistant sectors, such as energy and materials—which are trading at historically low relative valuations—tend to benefit from the inflationary dynamics of late cycles. Stretched valuations may make utilities and other bond proxies less helpful than usual in a late-cycle environment, particularly if interest rates rise.
Business cycle: macro update
Though post-Brexit data remain sparse, the U.S. and global economies appear to have gained momentum in recent months. The U.S. continues to experience a mix of mid- and late-cycle dynamics with low odds of recession, while the global economic expansion continues at a slow but steady pace.
United States: late-cycle indicators elevated, recession odds remain low
Consumer supports continued expansion
Favorable employment conditions have helped soak up a significant amount of excess slack in the labor markets. As the cycle continues to mature, wage growth has begun to pick up and job gains have moderated, as is consistent with historical late-cycle dynamics. Better wage growth has helped consumer spending inflect higher in the first half of the year, as evidenced by improved core retail sales and improved growth in spending on services.2 Tight labor markets and rising income suggest that the U.S. consumer is providing a solid foundation for continued U.S. expansion.
Inflation firm, likely to rise from higher crude oil
We expect inflation to remain firm as oil prices stabilize and continued labor-market tightening supports wage growth and service prices. During the past year, headline CPI has accelerated from 0.2% to 1.0%, while core inflation (ex-food and energy) has expanded from 1.8% to 2.3% despite a stronger dollar keeping a lid on import prices. With core inflation firm and oil prices poised to rise above late 2015’s subdued levels, headline inflation will likely rise to at least 2% by the end of the year.
Earnings and industrial activity moving off bottom
Stabilizing external conditions have helped the U.S. business sector regain footing from a recent slowdown. All components of the ISM manufacturing index outside of inventories have accelerated during the first six months of this year and are now signaling a solid expansion. Energy-led earnings declines have weighed on market sentiment in recent quarters, but earnings expectations stabilized during Q2, and the earnings reporting season thus far has suggested a better tone of positive surprises. Late-cycle trends such as rising wages may cap profit growth, but fewer headwinds from oil prices and the dollar suggest an opportunity for earnings to surprise to the upside.
Global: stabilization continues despite Brexit headwinds
Europe: headwinds from Brexit, Italian banks, but expansion likely to continue
Pre-Brexit data indicate that much of Europe remained in a mid-cycle expansion phase, benefiting from a recovering manufacturing sector and improving credit conditions, particularly in Germany. Post-Brexit data show a drop in German business sentiment, but eurozone industrial expansion continued. While it will take at least several more weeks of data to gauge the negative impact of Brexit on sentiment and activity, we do think the uncertainty will serve as more of a headwind than a force strong enough to derail Europe’s expansion. Additionally, concerns about under-capitalized Italian banks represent another sentiment overhang, but we believe these risks are not systemic and that European bank fundamentals in general are notably stronger than prior years. We expect Europe’s domestic economy is strong enough to continue its tepid cyclical expansion despite rising political uncertainty.
U.K. sentiment falls, recession risk rises post Brexit
Brexit is already weighing on cyclical growth. In the near term, uncertainty surrounding the time frame and substance of the negotiations with the EU are likely weighing on sentiment, business investment, and hiring. This has already begun to be reflected in the data, with the Lloyds Bank survey of current and forward-looking business expectations declining sharply in July. Brexit substantially raises the risk of recession in the U.K., with political uncertainty a big wild card.
Japan slipped into modest recession, but new stimulus may provide a positive impact on economy
As a slow-growing economy heavily reliant on trade, Japan’s business cycle is particularly susceptible to changes in the external growth environment. Japan has slipped into a mild recession on the back of a stronger yen hurting the export sector’s competitiveness and profitability. Responding to this weakness, policymakers announced a large stimulus package at the end of July, though the impact will depend on the structure of the package. We believe fiscal expansion will be more meaningful for the real economy, as monetary policy has begun to show its limits. Fiscal expansion and continued stabilization in China could potentially provide tailwinds for Japan to move back into positive growth territory.
China stabilization continues amid policy support
A downshift in growth at the end of an overextended credit boom has caused China to remain in a growth recession for the past year, but the economy appears to have steadied over the past several months. Stabilization is largely due to monetary and especially fiscal stimulus, as policymakers ramp up infrastructure projects, leading to stabilization in the industrial and property sectors. Rising fiscal support and improved global financial conditions have stabilized growth in the near term, although greater structural reforms will be needed for a sustainable reacceleration.
Global summary: tentative improvement in PMIs, EMs, and commodity-exporting countries
Most pre-Brexit data show a global economy that was exhibiting tentative signs of reacceleration across a variety of metrics. More than 75% of countries’ manufacturing sectors were in expansionary territory during June, featuring a dramatic improvement in emerging markets, rising from 50% of countries in expansion in May to more than 70% in June (see chart, right). Global export growth recovering notably after dropping more than 20% in 2015. Raw industrials prices—a proxy for global growth—are positive year-over-year for the first time in nearly two years. Several commodity- exporting countries such as Brazil, Canada, and Australia are improving on the margins. Despite Brexit headwinds, the tepid global economy appears to be gaining cyclical traction.
Outlook/asset allocation implications
The slow-growth, low-inflation business cycle has been weak enough to justify low bond yields but not bad enough to disrupt the multiyear bull market in U.S. stocks. Perhaps the abundance of cheap money worldwide has allowed everyone to be right for a moment in time. However, if Brexit uncertainty is not enough to dislodge the trend toward global stabilization—which is our base case—then growth measures, inflationary pressures, and late-cycle indicators are likely to rise. Historically high valuations for bonds and bond proxies offer little support for this scenario.
If that’s the case, the investment question is not about whether activity will become vibrant or inflation-rampant, but simply whether they will outpace beaten-down expectations. High-quality bonds are still a necessary component of a diversified portfolio, but at these yield levels, there are cyclical and secular risks that suggest a difficult return profile ahead. From an asset allocation perspective, we still favor global equities, though smaller cyclical tilts may be warranted at this phase of the cycle. Inflation-resistant assets may help diversify against the rise in U.S. late-cycle dynamics.
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Past performance is no guarantee of future results.
A Purchasing Managers’ Index (PMI) is a survey of purchasing managers in a certain economic sector. A PMI over 50 represents expansion of the sector compared to the previous month, while a reading under 50 represents a contraction, and a reading of 50 indicates no change. The Institute for Supply Management® reports the U.S. manufacturing PMI®. Markit compiles non-U.S. PMIs.
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