Global bond yields have become exceptionally low. The yield of the 10-year U.K. gilt recently fell to 0.41%, and that of its German bund counterpart sank to –0.61%—both record lows. Japanese 10-year government bonds, which had positive yields earlier this year, are now part of the more than $16.8 trillion in negative-yielding global debt. And the U.S. 10-year Treasury yield dropped by more than half since November 2018 to under 1.50% in August, lower than it was even during the 2008 global financial crisis.
Bond yields seem to be flashing red, and yet global equity markets are not far from record highs. Three Vanguard experts—Gemma Wright-Casparius, senior portfolio manager in Vanguard’s Fixed Income Group; Qian Wang, Asia-Pacific chief economist in Vanguard Investment Strategy Group; and Joshua Hirt, Americas economist in that group—explain why this is happening and the potential implications for investors.
10-year government yields are down across the globe
Note: Data are for the Group of Seven advanced economies (all but Italy) and cover August 2009 through August 2019.
Sources: Vanguard calculations, based on data from Thomson Reuters Datastream.
Why the wide divergence in outlook between the equity and bond markets?
Mr. Hirt: If you rewound to 12 months ago, the global economy looked to be in good shape. Consumer and business confidence were solid, labor markets were robust, business investment was decent, and inflation seemed to be moving healthily higher. Since then, we’ve seen a clear softening in all those data points, and outside the U.S., the deterioration has been even sharper.
The equity markets were actually the first to respond to the deterioration. We saw that in their sharp decline toward the end of December 2018. And the bond market reacted as well. Since then, however, the equity market has adopted more of a glass-half-full assessment, but the bond market isn’t buying it.
Ms. Wang: I agree that equities seem to be looking on the bright side, and not without reason. Global GDP in the first half of this year slowed but was still running close to trend. There’s been some weakness in manufacturing, affecting the Asia-Pacific region and Germany far more than the United States where manufacturing is a much smaller part of the economy. And so far we’ve seen little spillover from manufacturing to other sectors. Consumption is holding up, unemployment is low, wages are rising, and corporate profits have been decent.
Global growth has fallen below trend amid manufacturing downturn
Notes: The figure shows global growth as derived by the Vanguard Leading Economic Indicators Index series. This proprietary model comprises more than 70 economic indicators covering all sectors of the global economy. It is designed to anticipate turning points in the business cycle and slowdowns in payroll growth. Data cover January 1990 through August 2019.
Sources: Vanguard calculations, based on data from Thomson Reuters Datastream.
The bond markets, on the other hand, seem to be looking a little further out. Slowing growth is sooner or later likely to weigh on business hiring. That, in turn, could create a downdraft on labor markets, wages, household income, and eventually consumption. On top of that, there’s the risk of a protracted trade war to factor in.
Ms. Wright-Casparius: I think there’s a bifurcation, too, in thinking about how the global slowdown could play out. It could happen in a predictable, linear way with, say, Europe entering a recession, the European Central Bank responding with sufficient monetary policy stimulus, and the economy moving back into positive territory. Equities seem to be subscribing to such controlled deceleration scenarios.
Other scenarios, though, could evolve in a more unexpected, nonlinear way.
Ms. Wang: Yes, central banks might find they don’t have enough firepower to counteract a downturn, the U.S.-China trade spat could devolve into something much uglier and more damaging, or businesses and consumers could begin to expect the worst and sharply curtail their spending. Bonds seem to be pricing in these more dire outcomes.
Where do you see interest rates going from here?
Ms. Wright-Casparius: All the uncertainty makes it a hard call. You would think they wouldn’t go lower, right? But if the bond market’s pessimism proves correct, the Federal Reserve and the ECB could try to “out-dove” the markets—that is, cut more than the markets are expecting, to show they’ve got control of interest rates again—pushing yields even lower and prices even higher.
On the other hand, if equities’ sunnier outlook materializes and the global economy chugs along, inflation and yields could rise.
Ms. Wang: For now, our base-case scenario is for the global economy to slow in this second half of 2019 but not slip into a recession. That’s predicated, though, on current trade tensions not escalating into full-blown trade wars and on some further monetary policy accommodation from central banks, including the Fed and the ECB.
Let’s turn to the implications for investors. With bond yields so low and even negative, would investors be better off sitting on the sidelines in cash?
Mr. Hirt: Money market returns relative to those of bonds are more attractive than we’re used to seeing, which could make being in cash seem like a good idea given all the uncertainty. But keep in mind that high-quality bonds are in a portfolio not only for their yield, but also as ballast against the riskier assets you hold. So you’d miss out on the cushion that high-quality bonds can provide when equity markets hit significant turbulence. Being in cash would also mean missing out on capital returns if yields end up falling further.
One last question: We know that a globally diversified bond allocation can help reduce volatility through exposure to more securities, markets, and economic and inflation environments than you’d have if you invested only in your home fixed income market. But if it means investing in bond markets where rates are negative, is the diversification benefit worth it?
Ms. Wright-Casparius: If you’re hedging your international bond allocation so that currency volatility doesn’t overwhelm the diversification advantage that international bonds can bring, you’ll actually have two return streams: the income return from the underlying bonds and a hedge return.1 As the hedge return adjusts for fundamental differences across markets, mainly interest rates and inflation, it effectively pushes total return on hedged international bonds closer to what investors would earn in their domestic bond market.
A quick example: The return of negative-yielding German 1- to 3-year bunds from January through August 2019 was roughly zero.2 That’s what German investors would have earned, but U.S. investors with a hedged position would have earned a little more than 2%—a performance much closer to what they would have earned from U.S. Treasuries of comparable maturities.
In short, negative yields in some markets shouldn’t deter investors from holding a global bond allocation: Hedged long-term international bonds tend to produce returns in line with those of local bonds but come with the benefits of broader diversification.
Mr. Hirt: I would just add that, in times like this when there’s high uncertainty as to how things will evolve—in the bond market as well as the equity market—sticking with a well-diversified portfolio that matches the level of risk you’re willing to take on is probably more prudent than trying to make tactical bets one way or the other. After all, your investment plan is meant to serve you well in both good markets and bad.
1 For a deeper discussion about hedging international bonds, see the Vanguard research paper Going Global With Bonds: The Benefits of a More Global Fixed Income Allocation, available at vanguard.com.
2 Total returns according to the Bloomberg Barclays Global Treasury Index.