We think they could.
On the one hand, now that quantitative easing is behind us, it’s unlikely that real yields will turn negative again; real yields were so low on average over the past 10 years that they failed to keep up with the rate of GDP growth. On the other hand, real yields should be capped over the long term by (more modest) real economic growth. Thus, in our analysis, real yields could trend in line with realized real yields of the previous decade, prior to the global financial crisis.
While higher inflation implies higher nominal yields, higher inflation volatility implies steeper yield curves. Over the past decade, term premiums have mostly evaporated. In the next decade, we think term premiums will increase to compensate investors for the risk of holding longer-maturity bonds in an environment of less-certain inflation expectations. Supply constraints also may keep the long end of the yield curve more elevated than in the recent past.
Active Management May See a Resurgence
Higher rates are typically associated with higher rate volatility. In turn, higher volatility equates to greater dispersion and disruption—more variation in return patterns among regions, sectors and industries, as well as bigger challenges and more idiosyncratic opportunities.
While both active and passive strategies play a role in investors’ portfolios, a more volatile landscape works in favor of active managers, who can take advantage of new avenues for diversification, increased opportunities to add alpha, and the ability to maneuver to avoid trouble spots.
As a result, we expect to see a resurgence of active strategies over the coming decade.
Explicit Inflation Protection Needed
In the face of both higher inflation and more frequent inflation spikes, we anticipate that investors will also make bigger allocations to inflation strategies. This includes explicit inflation protection in the form of inflation-linked securities, known as “linkers” outside the United States and as Treasury Inflation-Protected Securities (TIPS) in the US.
This may be an especially opportune time to buy TIPS. TIPS, like other Treasuries, are backed by the full faith and credit of the US government. They are designed to fully compensate the investor for inflation and, if newly issued, also provide protection against deflation—that is, inflation compensation will not be negative.
And today, investors can buy TIPS whose annual return may approximate the growth of the US economy over the next decade. In the 27 years since TIPS first came to market, TIPS yielded an average 90 basis points below GDP growth.
That’s not the only measure by which TIPS look attractively priced. The current 10-year breakeven rate—the yield difference between 10-year nominal Treasuries and 10-year TIPS, and thus the implied market forecast for CPI over the next 10 years—is 2.30%. Our analysis of historical inflation measures since TIPS first came to market 27 years ago suggests a fair breakeven should be 2.51%.
In other words, TIPS are abnormally cheap by multiple measures, and investors should consider increasing their allocations now.
Investors May Return to Their Natural Habitats
After more than two decades of exceptionally low rates and under-allocations to fixed income, a new regime of higher equilibrium inflation, higher nominal yields and higher volatility could reshape how investors allocate capital over the long run.
Institutional investors will want to rethink the long-term assumptions they’re using for asset allocation. Even the mindset around risk will likely change; many investors have devoted mindshare to hedging against 2008-style credit distress, but inflation is likely to be the biggest risk to guard against in the years ahead—just as it’s been in the past.
In our view, that’s no reason to shun fixed income. If anything, with allocations to active fixed income and explicit inflation strategies playing a bigger role than in recent years, many investors may find themselves back in familiar territory when it comes to allocating to bonds.
