The downturn caused by COVID-19 and the subsequent V-shaped recovery contrasts with prior cycles that were marked by slow rebounds in output and the labour market, and by persistently low inflation. Several factors have driven the accelerated recovery with higher inflation than observed over the past few decades. These factors include massive coordinated global fiscal and monetary stimulus, a COVID-restriction-driven shift in consumer spending towards goods, and subsequent capacity constraints and disruptions to supply chains.

We believe investors need to balance their understanding of this recovery and near-term cyclical pressures on the global economy with a long-term view. To that end, we examine the evolution of real interest rates – nominal interest rates adjusted for the effects of inflation – to assess the long-term economic outlook as the economic cycle transitions from early to late phase. We also use historical correlations seen in similar economic environments to help investors frame return expectations across specific asset classes in scenarios where real interest rates rise rapidly.^Footnote[i]

No material change to secular drivers of low real interest rates

In recent years, the concept of “secular stagnation” has become a popular way to describe a chronic demand shortfall. PIMCO articulated these themes under our broad concepts of the “New Normal” (a multi-year period of deleveraging and low economic growth, inflation, and asset returns across developed markets) and the “New Neutral” (in which the real central bank policy rate remains close to zero).

In this context, natural interest rates^Footnote[ii] have fallen relatively steadily over the past two decades. The main drivers have been aging populations, slowing productivity growth and lower investment demand – along with increasing demand for safe-haven assets, unconventional monetary and fiscal policy, inequality, and global shifts that have depressed prices of investment goods and increased perceptions of macroeconomic risk. A reversal of these slow-moving yet persistent macroeconomic trends may be unlikely: The natural real interest rate might therefore be expected to remain anchored at low levels in the medium to long term.

Figure 1 shows real interest rates trending lower in both the U.S. and Australia over the past 20 years.^{Footnote[iii]} Before the financial crisis of 2008–2009, longer-run real yields tended to fluctuate in the 2%–3% range, with an average of 2.5%. After the financial crisis, real yields fluctuated in a new range of 0.25%–1.25%, with an average of about 0.90%.

Interestingly, after 2018 but well before COVID, there appears to have been another step-change lower, with real yields ranging between -0.7% and 0.50% with an average of about zero.

Given the V-shaped recovery from the COVID recession, cyclical pressures on the global economy should drive real yields higher. In fact, ahead of the escalation of the Ukraine-Russia conflict, real yields have already risen by 20 and 38 basis points (bps) in the first two months of 2022 in the U.S. and Australia, respectively. This short-term trend reversed in March as inflation expectations continued to climb in light of soaring commodity prices.

We believe that the longer-run range in real yields is unlikely to have changed. Notably, productive capacity in the U.S. has fallen amid tight labour market conditions, causing inflation to accelerate despite prime-age employment and real gross domestic product (GDP) being only at the levels projected pre-COVID.

Therefore, we expect the current low range in real yields to persist. In our view, a reasonable hypothesis would be for real yields to rise towards the top end of the recent range to around 0.5%. Real yields are unlikely to reach or hover about the 1% average seen in 2011–2018 because we consider that the longer-term structural dynamics discussed above have not dissipated.

What does this mean for returns?

Looking at the historical relationship between the changes in real yields and other risk factors helps frame a reasonable set of return expectations for various asset classes.

In general, investors expect asset values to decline when the discount rate increases. This is consistent with finance models, such as the Gordon Growth Model, in which the price of an asset is derived from the real cash flow (e.g., the inflation-adjusted element of dividends and coupons) divided by the real interest rate minus the growth rate. However, in practice, due to the complex dynamics between macroeconomic variables, real rate shocks rarely occur in isolation: The impact on other risk factors must be considered to determine the likely impact on returns.

Generally, there is a strong positive correlation between real rates and nominal rates, with an estimated beta of 0.76, based on U.S. data (that is, every 1% rise in nominal rates is associated with real rates rising 0.76%).

The relationship between real rates, GDP, and inflation surprises is somewhat weaker. This is because there are two main scenarios for rising interest rates: First, real rates may climb because economic growth is high and drives up nominal rates. Second, real rates could rise because inflation expectations collapse in a recessionary shock. This makes the modelling of real rate shocks less straightforward and calls for a conditional approach.

Figure 2 shows estimated instantaneous returns across asset classes when the real rate rises by 50 bps, while the nominal rate only increases by 30 bps.^Footnote[iv] Our stress-testing approach forces other risk factors to move in tandem with our macroeconomic hypothesis of slower, but above-trend growth coupled with above-target but moderating inflation. For a more pronounced real rates shock, we include a scenario where the real rate jumps by 1% to the 2011-2018 average. We compare this scenario to a regular +50 bps shock to nominal rates while all other risk factors move in a “covariance consistent” fashion to the nominal rates shock.^Footnote[v]

This stress test shows returns across asset classes are expected to be low when we apply an instantaneous shock of 50 bps and 30bps to the real and nominal rates, respectively. Government bonds are expected to suffer a loss of 1.62%, driven by duration exposure, while convexity and yield curve factors dampen the loss. Investment grade (IG) credit and high yield (HY) credit are expected to return -2.86% and -2.55%, respectively. For IG, rates and credit spreads are expected to detract equally. In the HY market, where exposure to interest rate duration is modest and exposure to credit risk is high, the loss is primarily driven by the expectation of widening credit spreads in this scenario.

Consistent with the widening of HY credit spreads, our modelling suggests that equities suffer a loss of 1.92%. Alternative assets such as commercial real estate are also unlikely to perform well in our shock scenario due to their inherent equity exposure, real interest rate sensitivity, credit exposure, and the pro-cyclical nature of liquidity risk.

A 1% shock to real rates and a 0.6% jump in nominal rates is expected to approximately double losses across all asset classes relative to the shock of 50 bps and 30 bps to the real and nominal rates, respectively. However, losses for government bonds and IG credit may be slightly narrower than double, as these asset classes offer marginal diversification benefits from interest rate convexity as yields rise. Overall, these results are intuitive as most assets are expected to suffer in an environment of rising rates coupled with slowing economic growth. This is consistent with the expectation that real yield and inflation shocks may be associated with a positive correlation between equity and bond markets, while shocks emerging from the equity market are generally associated with a negative relationship.^Footnote[vi]

Is the worst over for government bonds?

A nominal rate shock – more consistent with an early stage economic recovery of rising nominal rates amid accelerating inflation expectations – may weaken returns for government bonds and strengthen returns for equities. In that scenario, stocks may benefit from high economic growth coupled with stable real yields, while the performance of credit may be mediocre and hinge on the magnitude of interest rate and credit exposures.

It is worth noting that in our scenario of real rates rising more than nominal rates, government bonds may outperform stocks and credit. In addition, based on the last five Fed hiking cycles, we note that rate-sensitive sectors tend to underperform credit and equities before hiking cycles. However, during hiking cycles such as the one the Fed has just embarked on, front-end rates may move more than longer-end rates, potentially causing the yield curve to flatten, and returns for core bonds to be modestly positive.^{Footnote[vii]} We believe government bonds may be able to weather modest increases in real rates and offer an attractive yield compared to cash. And while government bond returns may remain low, the worst may be behind us, with valuations now providing a better buffer of protection under extreme scenarios.

Asset allocation implications

In conclusion, as a late-cycle increase in real rates looms, PIMCO remains optimistic on the economic outlook in 2022. However, we acknowledge headwinds from mature valuations, receding policy support, elevated levels of volatility, and persistent inflationary pressure. In addition, a further escalation in geopolitical tensions increases the risk of a meaningful economic slowdown coupled with higher inflation.

As our stress test suggests, a rising real rate environment does not necessarily imply significant losses. In contrast to earlier stages of the cycle where most assets benefit, investors may be well-advised to remain nimble amid this period of volatility, focusing on relative value opportunities while staying neutral on risk assets. Within equities, we emphasize regions, sectors, and companies that we view to be higher quality, and which may exhibit greater resiliency amid economic uncertainty. Given the recent back-up in nominal yields, it may be beneficial to have exposure to interest rate risk as a defensive anchor in multi-asset portfolios. Some investors may consider inflation-hedging strategies and we note that longer-term inflation expectations remain subdued as most repricing has occurred at the front end of the inflation curve. This may imply that it is still reasonably cheap to hedge long-term inflation risk with inflation-linked bonds. A modest allocation to commodities may hedge inflation risks as the Russia-Ukraine conflict is likely to have lasting effects on commodity markets, in particular energy, which may not have been priced into the forward curves. Within credit markets, we are constructive on certain sectors. Securitised debt may offer more resilience to interest rate and growth shocks than IG credit. As credit spreads have moved from very tight levels closer towards long-term averages, there are now some opportunities in higher yielding, resilient, default-remote names.