Developed equity and bond market gyrations are primarily pricing in a continuation of macro uncertainty – a delayed economic recovery. Despite the dramatic surge in commodities prices over the past month led by the war in Ukraine and heavy economic sanctions imposed on Russia, long-term inflation expectations in developed economies still remain rather benign, as priced by their bond markets and our models. Going forward, long-term investors are well advised to focus on the (fiscal and monetary) policy responses to the crisis, and their perceived impact on the long-term drivers of real GDP growth - total factor productivity (TFP) and labor force growth - and inflation (government finances).
Exhibit 1 portrays the recent evolution of the US 10-year constant maturity nominal and real (TIPS) government bond yields, and their difference – the 10-year breakeven inflation rate, a market implied gauge of long-term inflation expectations. As depicted by the Exhibit, following Russia's intrusion into Ukraine, breakeven inflation increased from 254bps on February 25th to 294bps on March 11th. Since then, it has remained broadly unchanged. Interestingly, this 40bps increase incurred in the breakeven inflation rate was primarily driven by a decline in real yields. Indeed, over the same period, the 10-year TIPS yield decreased 37bps from -57bps to - 94bps, while the 10-year nominal treasury yield only increased 3bps, from 197bps to 200bps. The nominal yield even declined, to 174bps, through the first week following Russia's attack on Ukraine. As of March 25th, both the nominal and real yield have increased by about the same amount, reflecting the Federal Reserve decision and future plans to raise its refinancing rate. Real yields are now back at their pre-war level.
According to our models, the recent gyrations in US bond markets are consistent with markets’ pricing of high levels of US macro growth uncertainty, as Exhibit 2 illustrates. Long-term real GDP growth uncertainty increased significantly following the pandemic, and has remained stubbornly high compared to historical standards through 2021. As shown in the Exhibit, the recent, continued improvements in long-term growth trend led to a short-lived decline in macro uncertainty at the start of the year. However, the war in Ukraine has revived this uncertainty, casting renewed doubts about the speed of recovery in real economic growth.
Not surprisingly, Exhibit 3 shows that our model implied prior for long-term inflation continues to be low, at 2.2%, barely above the Federal Reserve long-term target rate. Our model implied prior is consistent with the trend in bond markets pricing and so far, unchanged levels of debt-to-gdp. Nonetheless, our models also indicate that even though long-term inflation expectations are balanced, inflation risk significantly increased through the pandemic and continues to remain elevated compared to historical standards.
Interestingly, these macro and market trends have not been specific to the US. According to our models, other major developed economies such as the UK, Eurozone, and Japan also experienced similar trends in real and nominal bond markets and continuation of high macro growth uncertainty.
What next for macro and markets trends? In the shorter term, the current geopolitical crisis is likely to weigh-in on both growth and inflation prospects. A recent study by the OECD projects that, relative to its baseline forecasts , global real GDP growth could decline as much as 100bps in the coming year, and inflation could increase 250bps, globally. In the longer run though, our models suggest investors are well advised to pay close attention to mitigating policies to help curb the impact of the crisis – fiscal and monetary – and their impact on the fundamental, long-term drivers of growth and inflation. In the case of real economic growth, our models indicate that these drivers are total factor productivity (TFP) and labor force growth. As for long-term inflation, what matters is how well balanced government finances are perceived to be in the long run. In turn, the government budget balance also depends on long-term growth prospects. In the particular case of the US, given the privileged status of USD denominated assets as world’s dominant reserve assets, expectations of long-term growth relative to the rest of the world also matter.
For example, suppose well targeted government policies, focused on alleviating the impact from higher key commodities prices (primarily oil, gas, wheat and maize), especially on lower income households, help lead a faster recovery in real economic growth with no changes to long-term inflation expectations. Under this scenario, assuming that in the next 10 years, global long-term real GDP growth reverts back to its pre-2008 global financial crisis level (i.e. about a 100bps increase in trend growth relative to our baseline), Exhibit 4 shows that global (nominal) equity returns would increase from 8% (our baseline) to 11.6% per year, on average over the next 10 years. Global (nominal) government bond returns would decline from 0.9% (our baseline) to -0.6% on average. On balance, nominal returns to a 65/35 global equities and bonds portfolio would increase from 5.5% (our baseline) to 7.3% per year on average.
Alternatively, should the policies prove insufficient to limit the impact on growth and prices, a worst case scenario could envision stagflation with persistently high uncertainty about the time to recovery. More precisely, under this scenario, long-term global economic growth expectations would deteriorate further for longer (a 100bps decline relative to our baseline over the next 10 years). At the same time, inflation expectations would increase significantly (about 450bps over the next 10 years), to compensate for persistently higher debt-to-GDP ratios due to inefficient expansionary measures. In turn, according to Exhibit 4, global (nominal) equity returns would barely decrease, from 8% (our baseline) to 7.7% per year on average. Global (nominal) government bond returns would take a much greater hit, declining from 0.9% (our baseline) to -1.5% per year on average. In turn, nominal returns to a 65/35 global equities and bonds portfolio would suffer significant losses, declining on average from 5.5% (our baseline) to 4.5% per year.
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