Goodbye, negative-yielding debt: Three-minute macro

Negative-yielding debt is a thing of the past

The global phenomenon of negative interest rates is nearing its end. Having peaked in December 2020 at over US$18 trillion, the value of negative-yielding debt globally recently hit zero for the first time in over a decade. At the peak, about 64% of this index was European-originated debt and 28% Japanese–driven by super accommodative monetary policies by the European Central Bank (ECB) and Bank of Japan. The level of negative-yielding debt remained elevated until the end of 2021 when rate markets started pricing in one of the most aggressive tightening cycles in decades, forcefully driving yields up.

While central banks are raising rates to combat inflation, there is an important consideration for sovereigns: debt sustainability. Developed- and emerging-market governments issued historic amounts of debt throughout the pandemic to finance accommodative fiscal policies, and higher rates have made refinancing increasingly costly. Forecasts from the U.S. Congressional Budget Office suggest that interest costs on federal debt that currently total roughly $400 billion per year are expected to reach almost $1.2 trillion in 2032 due to a growth in the deficit. In other words, debt service costs could lead to potential crowding out in productive investment that could fuel growth. In some countries, particularly in Europe, debt has continued to be issued as fiscal policy is being used to assist households and corporates with surging energy costs.

Outside of debt sustainability, there are implications (and possible opportunities) for multi-asset investors as rising yields have profound implications on asset allocation. With a U.S. Treasury yield of 3.5% and the dividend yield on the S&P 500 Index being just 1.7%, the relative total return profile for bonds has improved. And the same effect is being felt across fixed income’s risk spectrum, with the U.S. Aggregate Bond Index’s yield climbing to over 4.0%, eclipsing the approximate 1.5% yield in 2020 and 2021. Effectively, the concept of TINA (there is no alternative) is being reconsidered as equities are no longer the only game in town. A look at the depressed equity risk premium is also a result of this dynamic—and another reason why we’re cautious on equities in 2023. 

Source: Bloomberg, Manulife Investment Management, as of January 17, 2023. It is not possible to invest directly in an index. 

European sentiment—cautiously optimistic

Between October 1, 2022, and January 19, 2023, European equities returned 24%, outperforming the S&P 500 Index by 15%.¹ Similarly, the euro is up over 10%, with EUR/USD rising from 0.98 to 1.08. European sentiment has improved so markedly that forward earnings per share growth estimates have started to improve, defying the widely held consensus view that the earnings picture in 2023 will deteriorate.

What are the tailwinds that have contributed to recent strength in European equities?

1. Significantly warmer than average winter temperatures have reduced the risk of a 2023 energy crisis as natural gas inventories have accumulated. 
2. The largest EU countries provided material fiscal support specifically targeting gas, providing a cushion to households.
3. Mainland China’s reopening has lifted the global demand outlook. Many of Europe’s mega caps have a large share of geographical revenue exposure to Asia and the reopening will drive expectations up.
4. Macro data coming in ahead of expectations, albeit still in deeply negative or recessionary territory.
5. Valuations are cheap relative to the United States (and most other developed-market equity peers) and despite recent outperformance, valuations remain much below their long-term averages.

While many risks for the region over the short term (three to six months) have subsided, a looming macro risk ahead for all European assets is the hawkishness of the ECB. Markets are currently pricing another 125 basis points of hikes for a terminal rate of 3.25%. This will present clear headwinds to growth, and we’re unsure how the real economy will absorb the aggressiveness of the tightening cycle with rates the most restrictive they’ve been in over 20 years. The slowing of growth is an obvious headwind to European assets and will increase financial stability risks, so we’ll be watching the labor market and real-time activity indexes closely.

A resurgence of any of the aforementioned risks (in addition to the lagged impacts of restrictive monetary policy) could pull down sentiment on European equities, but for now, there are both fundamental and technical reasons that support European equity outperformance over the coming months. Longer term, we remain neutral on European equities due to the structural headwinds at hand.

Source: Bloomberg, Manulife Investment Management, as of January 17, 2023. It is not possible to invest directly in an index. 

History suggests bonds should have a better year

One of the most notable market moves of 2022 was the sell-off in bonds, driven by the aggressive policy tightening of global central banks. The Bloomberg U.S. Aggregate Bond Index returned -13.3% last year, the worst return for the index in decades. In fact, if we look at just the U.S. 10-year Treasury over the past century, it has never recorded three consecutive years of negative returns, and after losses in 2021 and 2022, it’s statistically very unlikely for Treasuries to post a third year of losses.

With markets pricing just two more 0.25% hikes for the U.S. Federal Reserve and just 0.25% for the Bank of Canada, we believe that the pain in fixed income has been felt and the worst is behind us. For one, we expect that with a return to trend growth, yields are likely to stay at lower levels going forward. As such, investors with a medium to longer term horizon could find fixed income to be a compelling space in the coming months.