Complacency over low-inflation world risks biting bond investors

As the US 10-year government bond yield again toys with the 3 per cent mark, the question of whether the bull market in fixed-income is ending is impossible to ignore.

Cyclical economic factors suggest yields should go higher. The US economy is booming, with fiscal stimulus from the White House and Congress fanning the expansion.

But structural forces, not cyclical ones, will ultimately determine the direction of the bond market. The underpinnings of the decades-long rally are being slowly chipped away at by political changes unfolding across many developed economies. That becomes clear when you consider the landmark changes that have contributed to the fall in developed world interest rates.

A breakdown of the trade unions and collective wage bargaining under Ronald Reagan and Margaret Thatcher in the 1980s was the first. This sharply reduced the ability of workers to hold on to real wage gains, allowing companies to bear down on wage costs while other expenses were rising.

The trend towards granting central banks independent authority to set monetary policy also helped in the process of anchoring low inflation. Then throw in the initial public offering of Amazon in 1997, an event that helped herald a world in which consumers are able to search an online marketplace for the cheapest price for products.

And four years later, the disinflationary forces in global goods markets were compounded when China joined the World Trade Organization. This, in effect, doubled the global capacity of the goods producing sector.

All of these factors served not only to reduce the average rate of inflation, but also the distribution around that average. It was less likely that a cost shock to the economy would spiral into a broad-based inflation concern. As a result, investors in fixed income products did not need to insulate themselves from inflation risk in the way they previously had to. Nominal interest rates steadily declined.

There is, however, a risk that these structural factors could reverse incrementally in the coming decades. The populist surge across the developed world has common roots. An increasingly large section of western societies are worried about their job security and how they will provide for their families.

In the face of migration, outsourcing and automation they are not certain that their skills and abilities will still be needed in the future.

Many analysts in the City and Wall Street are finding it hard to incorporate this into their forecasts. As political outcomes continue to surprise, economic and market forecasts fall wide of the mark.

The bond market, in particular, may be underestimating how this shift in public sentiment threatens to undermine the pillars of the low-inflation environment that we have become accustomed to.

As populist demands are translated into policies, left-leaning governments will increasingly play the role of traditional trade unions. Voters may be tempted by the manifesto promises of minimum wages, universal incomes and job guarantees.

But policies designed to help the real wages of low-income workers are also likely to end up raising overall inflationary pressures, particularly in the face of a broader shock to costs from either commodities or movements in exchange rates.

At the same time, the pressure on central banks is building. In recent weeks President Donald Trump has said he is “not thrilled” that the Federal Reserve is increasing interest rates. More generally, governments burdened by high levels of debt will find the interest much easier to service with an obliging central bank.

While the disinflationary influence of technological change seems to have further to run, populism may curtail its growth. The temptation to tax the profits created by the fast-growing tech companies is likely to grow, which in turn will hinder their growth.

On top of all this, the risks posed by a possible escalation in the global trade war cannot be ignored. The White House is questioning the benefits of being able to import “cheap” goods from the emerging world, while the concept of “national security” is being rewritten to focus as much on the economic threat as the physical one. In a world of sluggish demand, nations will continue to fight to protect their share of the global output pie.

We should think carefully about how this populist shift will affect the investment landscape. It is unlikely to prove transitory. It calls into question the low and stable inflation of recent decades and it threatens to expose government bond markets in particular — vulnerable as they are to a shift in perceptions of inflation risk.

If political developments ultimately lead to a significant rise in inflation, government bonds are unlikely to be the asset that will protect portfolios. The rise in yields has further room to run.