The 10-year U.S. Treasury bond yield hit a cyclical peak of just over 3.2% last November, driven higher by two factors: the fleeting growth spurt that resulted from the U.S. Tax Cuts and Jobs Act passed in late 2017 and the U.S. Federal Reserve’s (Fed’s) valiant attempt to normalize interest-rate policy.
However, the prospect of higher rates had a surprisingly swift and adverse impact on the growth trajectory—particularly housing, automobiles, and capital spending—reflecting the massive economywide buildup of leverage that has occurred over the last decade or so.
At the same time, downside risks to the economy increased as trade tensions came to the fore and economic momentum rolled over outside the United States. Moreover, despite the record-setting U.S. economic expansion and tight labor market, inflation failed to accelerate. This set the backdrop for the “Powell Pivot,” in which a vacillating and unmoored Fed led by Chairman Jerome Powell signaled its intention to implement multiple rate cuts as a sort of insurance policy, just in case downside economic risks materialized. As a result, the 10-year Treasury bond yield dropped by over 100 basis points and managed to slip below 2.0% in early July and again in early August, while the S&P 500 Index1 charged ahead—its performance in the first six months of this year was the best since 1997.2
The decline in Treasury bond yields over the last couple quarters has provided a strong boost to equity markets and has been the subject of a great many headlines. However, we believe the longer-term picture is arguably even more important, although it has received much less attention. In particular, note that the average U.S. 10-year Treasury bond yield during the current recovery has been only 2.4%—far below that experienced in previous expansions.3 Moreover, according to the consensus of economists surveyed by Bloomberg Inc. the 10-year yield is expected to remain low; it is forecast to end 2019 at 2.3% and 2020 at 2.5%.
What has caused the dramatic decline in nominal bond yields over the last four decades? While lower inflation accounted for the majority of the decline from the 1980s to the 1990s, we believe it has played only a minor role since then. A more important factor has been the decline in the inflation-adjusted real yield, which has averaged only 0.9% during the current economic expansion dating to 2009—down conspicuously from a mean of 4.2% in the 1990s and 2.5% the following decade.
It’s crucial to keep in mind that the decline in bond yields is a global phenomenon and has been even more severe in many European countries than in the United States. Partially due to the European Central Bank’s quantitative easing policies,4 10-year nominal bond yields have recently been negative in Germany, France, Switzerland, and six other European countries. Globally, there now exists over US$13 trillion of negative-yielding bonds, representing 45% of global sovereign issuances.5
To a large extent, we believe the decline in bond yields over recent decades reflects a more modest growth outlook. For example, U.S. real GDP growth averaged over 4% in the 1950s and 1960s, followed by just over 3% in the 1970s, 1980s and 1990s.6 However, over the last two decades, growth has decelerated to roughly 2%, which also happens to be the post-1870 mean.
Moreover, the U.S. Federal Reserve Bank of San Francisco estimates that the new normal pace for U.S. GDP growth is somewhere between 1.50% and 1.75%—noticeably slower than the typical pace experienced since World War II. The slowdown stems mainly from two developments: demographic trends that have reduced labor force growth, about which there is relatively little uncertainty; and declining productivity growth, which is more difficult to comprehend and poses a larger challenge.
In our view, achieving GDP growth consistently above 1.75% will require much faster productivity growth than the United States has typically experienced since the 1970s.7 This is true even if we agree with the Fed that output and productivity are being underestimated by at least 0.3 percentage points per year, because of difficulties in measuring the impact of new technologies (including “free” digital goods).
Demographic headwinds for growth
Although demographic trends and labor force growth are much more predictable than productivity, the prevailing direction is equally troubling, at least in terms of its impact on economic growth. Recently the U.S. population has been increasing at a rate of about 0.7% per year, down dramatically from its post-1950 mean of 1.1%.8 However, according to the United Nations’ latest population projections, this is expected to decline even further, to 0.3% to 0.4%, by 2050.9
The demographic headwind is even more pronounced for the developed world outside the United States, where the population has recently been growing by only 0.2% per year and is forecast to turn negative during the next decade or two.9 The populations of Japan and Italy are already shrinking. Last year, fewer than 440,000 children were born in Italy, a 4% decline from 2017, and the lowest number since the country’s creation in 1861.10 This development is also a challenge for many emerging-market countries, such as China, where population growth is forecast to turn negative by 2030.11 At that point we believe China’s trend economic growth rate will be close to 3%, down dramatically from that experienced over the last decade or two.
Lower for longer: investment implications of 2% Treasury bond yields
While there are many ramifications of the low-growth, low-rate environment discussed above, this note touched on just two of them. First, if trend nominal U.S. GDP growth is now 4% to 5%, it might prove unrealistic to expect S&P 500 earnings to grow at 8%+ on a sustainable basis. That said, in today’s capital-light world, we expect many companies to return a large and possibly growing proportion of their free cash flow to shareholders, either through dividends or share buybacks. This strongly suggests to us that shareholder yield strategies—those that seek to capture dividends, share buybacks, and debt repayments—are likely to become more important over the medium to long term.
Second, in most markets, the equity yield is far superior to bond yields. A U.S. equity index, the S&P 500, had a dividend yield12 of just above 2.0% as of late July 2019; factoring in the value of stock buybacks, the yield was 3.5%.13 The corresponding numbers for Europe’s MSCI Europe Index were 3.7% and 1.4%, while those for Japan’s Tokyo Price Index were 2.5% and 2.0%.14 These equity yield numbers are very powerful and make a strong case for owning equities, especially where the shareholder yield total is both sustainable and likely to grow.
As a result of the above points, we believe it’s even more important to favor companies with a demonstrated ability to produce free cash flow and allocate that cash flow wisely between reinvestment/acquisition opportunities and return of capital options.
1 The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. 2 S&P Dow Jones Indices, July 2019. 3 Bloomberg Inc., Epoch Investment Partners, July 2019. 4 Quantitative easing (QE) is a monetary policy in which a central bank purchases government debt or other fixed-income securities in an effort to lower interest rates, increase the money supply, and stimulate economic growth. 5 Bloomberg Inc., Epoch Investment Partners, July 2019. 6 U.S. Federal Reserve Bank of St. Louis, July 2019. 7 The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War, Robert J. Gordon, Princeton University Press, 2015. 8 International Monetary Fund, Bloomberg Inc., Epoch Investment Partners, 2019. 9 “World Population Prospects: The 2015 Revision,” United Nations, July 2015. 10 Italian National Institute of Statistics, July 2019. 11 Chinese Academy of Social Sciences, January 2019. 12 A dividend yield is a dividend expressed as a percentage of a current share price. 13 Epoch Investment Partners, July 2019. 14 The MSCI Europe Index tracks the performance of large- and mid-cap stocks of developed-market companies in Europe. The Tokyo Price Index (TOPIX) is a capitalization-weighted index that tracks stock prices on the Tokyo Stock Exchange. It is not possible to invest directly in an index.