he market mood of the moment is whether bubbles are being blown in riskier markets by loose fiscal and monetary policies that lift the inflation horizon for years to come. Still compressed yields in gigantic global debt markets may give a glimpse of what’s happening.
With mounting fears for central bank independence from Washington to Tokyo and little appetite anywhere for unpopular budget cutting, the prospect of inflation rates returning sustainably back to long-standing 2 percent targets has dimmed.
That does not even have to mean another bout of runaway post-pandemic inflation but it could see 3-4 percent inflation for the world’s major economies start to get baked in. Already core inflation for the G7 economies as a whole is settling at 3 percent.
That may underpin nominal GDP growth and record high equities, goosing high-octane bets in tech, AI, private markets and even gold in the process. But it is a sour prospect for already clipped returns in global government and corporate fixed income that still houses the lion’s share of investment capital.
Apollo’s chief economist Torsten Slok pointed out late last week that almost 90 percent of all public fixed income outstanding now trades with a yield of less than 5 percent. With inflation running at 3 percent, that leaves a real return of just 2 percent.
It is a big universe of relatively meager long-term returns.
Every Thursday
According to the latest annual data from the Securities Industry and Financial Markets Association, global fixed income outstanding hit US$145.1 trillion through last year, up 75 percent over the past decade and still bigger than the entire global equity market capitalization of $126.7 trillion.
Of course big players in the private credit market like Apollo may have good reason to highlight the dearth of return in public markets, it is one of the big arguments for channeling investors into the less transparent but typically higher-yielding private credit space.
What is more, there are a host of reasons why investors hold government and public bonds at large, capital preservation for central banks, sovereign and pension funds, regulatory and liquidity demands for banks and insurers and steady long-term income in mixed portfolios.
But the marginal real return arguments may see more bond capital leak elsewhere if higher inflation is indeed now entrenched.
Even that private credit universe, while growing rapidly, is still only about $2 trillion in total size and the market cap of physical gold is a relatively modest $26 trillion. While tech stock market cap has ballooned over the past 10 years, it is concentrated in a relatively small number of mega firms.
So relatively small portfolio shifts from the bond universe may have outsize impacts in these areas.
Fixed-income fund managers talk of generating better returns through active management, playing yield curves, spread trades, selective company names and even riskier bets that enhance those returns as long as economic growth holds up.
While not seen as a major worry yet, recent jitters about credit accidents in the private debt world, surrounding the First Brands bust in particular, and creeping high-yield defaults may add headaches.
BlackRock’s credit team, for one, insists some of the jolts in credit are “idiosyncratic”, the peak in recent default activity is likely behind us and it remains positive on corporate credit as interest rates fall and growth continues.
But it has been hard station for aggregate bond holdings in recent years in any event.
The Bloomberg Multiverse of all global bonds is currently yielding 3.7 percent, with the government component just 3.2 percent, leaving the real yield on the latter barely positive. To be sure, that is marginally better than the negative real yields of much of the past decade, but it is still two percentage points below levels seen before the credit crash of 2007/2008.
Average annual total returns on that government index over the past decade have been about 0.5 percent.
Most risk-averse investors who hold these bonds may not be in them for relative yield. But a higher inflation world makes them more uncomfortable as a safety hedge, and even edging away may supercharge everything else.
—
The writer is a columnist for Reuters. The views expressed are personal.