Real rates of economic growth, inflation, interest rates and valuations are all interrelated.
Long-term government bond yields are largely determined by expectations for economic growth and stability (opportunity costs and associated economic risk) and inflation (reduction in the purchasing power of money). The return from long-dated government bonds represents the rate of return relating to overall economic growth in nominal terms. In other words, there are two key components of a government bond yield: 1) an opportunity cost component that relates to expected economic growth and stability levels that theoretically everyone can enjoy and benefit from, and 2) an inflation compensation component.
Long-dated government bond yields have increased over the past year as the economic outlook has improved and inflation expectations have increased. Recently, the 10-year U.S. government bond yield has risen sharply and is now approximately 136bps, compared to a low of 50bps last year. It is worth noting that this yield is still considerably lower than the average since the GFC of approximately 230bps.
Given the poor outlook for economic demand growth and the technology-based disruption the world faces, we continue to believe that any pickup in inflation over the next year is temporary and unlikely to be sustained over the long term.
High levels of inflation increase uncertainty for both consumers and businesses. High inflation is particularly damaging for holders of long-term bonds. This is because the return of the bond is set in nominal terms at the time of purchase, and a sustained increase in inflation will result in the real (inflation-adjusted) returns declining.
Equity holders are generally in a better position, because businesses have some potential to lift the prices they charge customers to help protect the real value of their future revenue and free cash flows. However, there will be many businesses that cannot pass on the cost of inflation and maintain their revenues and free cash flows in real terms. These stocks are likely to suffer materially from any sustained return to high inflation.
We continue to believe that inflation will remain lower for longer, with our base assumption of 10-year U.S. bond yields to average 250bps over the next 10 years.
Figure 1: U.S. 10-Year Treasury constant maturity rate over time