A 60/40 equity and fixed income investors at the beginning of 2020 would have seen their portfolio today resembling more of an 80/20 allocation, without rebalancing, due to the unstoppable bull market in equities and structurally higher yields. Since January 2020, the S&P 500 has delivered 155% total return while U.S. corporate bond benchmark returned just 9.4% (both numbers are not annualized). The gap between the two asset classes is the largest since the late 1990s. Historically, such massive underperformance for fixed income bodes well for its future returns (Figure 1), but as we argued before we are in a very different world today. Inflation is structurally higher, global trade integration is stagnating, and aging population is translating to fiscal pressure for governments across the developed and developing world.
Is it time for investors to trim equities and rebalance? If the answer is yes, then is fixed income still the appropriate asset class to put capital to work? Can real assets and alternative strategies be a substitute for bond allocations?
Figure 1. Equity performance has left fixed income investors in the dust
One common macro theme across both the developed and developing world today is that central banks are again on the path of a rate hike cycle. However, mid-cycle policy rate hike is more about fine-tuning monetary policy rather than full blown tightening. We continue to expect headwinds from higher rates for fixed income returns in the coming months, but the impact should be relatively milder compared to the 2022-2023 episode. The European Central Bank, Bank of Japan, and Reserve Bank of Australia already increasing their respective policy rate over the past twelve months. The Federal Reserve is expected to do the same in the coming months. Our global policy rate diffusion index – measuring the percentage of central banks that increased policy rate minus those that decreased it over the past twelve months across 25 countries – is now turning higher (Figure 2). Historically, policy rate hike cycles tend to coincide with periods of strong economic growth and/or rising inflation, which are often associated with the trend of higher bond yields and strong earnings growth.
Figure 2. We are on global policy rate hike cycle, which is not uncommon given decent global growth backdrop
Fixed-income returns are primarily driven by two factors. The first is the additional compensation investors receive for holding riskier securities, generally measured by the yield spread over U.S. Treasury bonds. Corporate bond spreads are currently relatively tight, at approximately 80 basis points for investment-grade (IG) bonds and 270 basis points for high-yield (HY) bonds. When economic activity is accelerating, HY bonds typically outperform IG bonds because they offer wider spreads while default rates remain relatively low. This has broadly been the market environment since early 2023. The second driver is a bond’s sensitivity to changes in interest rates, known as duration. The longer the duration, the more sensitive the bond is to rate movements. Investment-grade bonds generally have a longer duration than high-yield bonds—about 6.7 years compared with 3.2 years. As a result, the higher interest-rate environment of recent years has been a greater headwind for IG bonds, contributing to their weaker performance relative to HY bonds (Figure 3).
Figure 3. U.S. IG bonds have underperformed HY bonds, partly due to higher duration
Higher Yields, So What?
The stabilization in U.S. labour market and strong investment growth skew the odds for another Fed rate hike cycle higher. This would bring U.S. government interest burden higher and tamp down demand for private sector borrowing – a negative for industries that are more sensitive to higher yields and potentially arresting the upswing in manufacturing activity. The yield curve should bear flatten in this scenario. Note that this is not a solely U.S. phenomenon, meaning that the impact of higher yield could apply to international and EM equities as well. This increases the probability of late cycle behaviour for the financial market.
This could already be seen in the slower expansion of U.S. manufacturing activity, which decline to 54.6 in August from 55.6 in July. The softening in manufacturing outlook is perhaps not surprising given the macro headwinds faced by cyclical industries of late, including the increase in long-term yields, tariffs volatility, and higher energy prices. Figure 3 shows that change in yields tends to be loosely correlated with the direction of ISM Manufacturing PMI, which currently is pointing downward. The details point to some loss of momentum in August with strong production and low customer inventories remained supportive but weaker new orders, backlogs and imports suggest growth is likely to moderate in the near term. Respondents commented on factors disrupting their business, with several commented on supply chain challenges, including one who said the “supply chain situation… is going through another crisis”.
Figure 3. Higher yields could mean slowdown in cyclical activities
Fortunately, the U.S. service sector is more resilient and much less sensitive to the change in rates. U.S. ISM Services PMI rose to 55.4 in August from 54.1 in July, a 26 consecutive month of expansion. Activity and new orders both accelerated strongly, and strong backlogs, trade flows, and inventories suggest demand carried solid momentum during the quarter. On the negative side, price pressure rose further and employment remained in contraction – highlighting the cautious approach on hiring by private businesses. The latter is interesting given that historically stronger demand translates to more hiring for the sector (Figure 4). The optimist could read this as businesses seeing higher productivity from their workers, whereas the pessimist could point to executives doubting the durability of this expansion.
Figure 4. U.S. Service sector is more resilient and less rate sensitive
With this backdrop in mind, we are becoming less constructive in our overweight position on industrials, which have underperformed since the end of June amid higher oil prices, yields, and tariffs-related volatility. Historically, however, a global rate hike cycle is not necessarily a bad thing for the industrial sector. In fact, a hiking cycle tends to coincide with acceleration in economic growth and is positive for cyclicals including energy, industrials, financials, and consumer discretionary (Figure 5). From asset class perspective, the outlook for commodity remains favourable while fixed income could continue to underperform.
Figure 5. Sector and asset class performance during global rate hike and cut cycle
This trend of rising yields has been a constant headwind for rate-sensitive sectors, which include real estate, utilities, consumer staples, and healthcare – all of which has significantly underperformed post-pandemic (Figure 6). Fundamentally, revenue and EPS growth for these sectors remain lower than the S&P 500 benchmark; we are looking for positive inflection in the fundamental of these sectors before upgrading them to neutral or overweight position.
Figure 6. Higher yields post-pandemic have been constant headwinds for defensive sectors
How About the Greenback?
Investors have demanded higher risk premium for investing in U.S. treasuries to reflect the deterioration in U.S. fiscal outlook, but the greenback is still at a relatively strong level today. There are reasons why the U.S. dollar may not weaken compared to other currencies, especially the Euro, even if the currency debasement thesis plays out, due to even worse fiscal/monetary constraints for the Eurozone. For example, French government also ran 5.2% of GDP fiscal deficit this year and unlike the U.S., French government does not have independent monetary policy. Whereas the Fed could print money to buy U.S. treasury issuance, the ECB is unlikely to do so barring a fiscal crisis. The bottom line is that in the longer term the value of real assets should increase when measured in fiat currency. In the near term, however, speculative positioning on the U.S. dollar is stretched, which historically marked the peak in the dollar index (Figure 7).
Figure 7. The greenback could resume its decline once the Fed rate hike overhang passes
Bottom Line
In short, this is a mid-cycle recalibration rather than a replay of 2022: resilient growth – especially in services – and persistent inflation are allowing central banks to lean hawkish, while heavy sovereign issuance keeps pressure on longer-term yields. Large treasury issuance is also crowding out capital to both the investment grade and high yield market. That backdrop argues for caution on duration and other rate-sensitive assets, even as still-solid activity supports selective exposure to cyclicals, commodities, and real assets. We are therefore becoming more measured on industrials after their recent underperformance, remain cautious on defensive sectors until fundamentals improve, and expect the U.S. dollar to stay supported near term before the Fed overhang eventually fades. For investors rebalancing equity-heavy portfolios, the opportunity in bonds is improving as yields rise, but the return of structurally higher inflation and fiscal risk means diversification, not a simple return to the traditional 60/40 playbook, should remain the priority.
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