By Chris Iggo, Chair of the Investment Institute and CIO for AXA IM Core, BNP Paribas Asset Management
What happens to inflation is key for investors. If inflation fails to fall further, bond yields are likely to rise further.
The collapse of the Middle East truce threatens to push inflation up again. Long duration bonds remain a difficult place to invest.
Meanwhile, in a growth environment, equity dividend growth has consistently outpaced inflation in most markets. For the moment, the macroeconomic outlook favours equities.
- Key macro themes – resurgent tensions in the Middle East pose inflation risks
- Key market themes – bull market earnings showing up again for the second quarter
Failing to beat inflation
Renewed Middle East hostilities have sent energy prices higher again, threatening to exacerbate the inflation environment. This comes despite recently improved inflation data.
June’s US consumer prices report was market friendly; headline consumer prices fell 0.4% while core prices were flat on the month.
Both the headline and core annual inflation rates fell from 4.2% and 2.9% in May, to 3.5% and 2.6%, respectively. Eurozone inflation data for June was also encouraging. But already in July, oil prices are up around 20%.
Another upturn in inflationary expectations would not be good for bond investors. Government bond returns have struggled to keep pace with inflation for most of the last decade. Even short-duration and inflation-linked bonds have struggled to match, let alone beat inflation.
It really has been a torrid time. Credit has done a little better, but this has been much more the case in high yield rather than in investment grade. Having exposure to a strong corporate sector (equities and high yield) has delivered better real returns, than exposure to the eroding effects of inflation.
From its peak in September 2020, the UK gilt total return index is more than 40% lower in real terms.
Exceeding forecasts
Despite the sharp rise in bond yields between 2021 and 2023, and the gradual increase since then, the problem is inflation has continued to exceed forecasts. Yields had to adjust higher after a decade of financial repression, and inflation accelerated because of the pandemic’s impact on supply chains. This combination caused real returns in bond markets to plummet. Since then, realised inflation has been higher than suggested by inflation swap or break-even inflation rates – the difference between yields on conventional government bonds relative to inflation-linked.
At the start of 2026, the Bloomberg consensus forecast for US headline consumer price inflation was 2.8%. As of the end of June, the headline inflation index had already risen 3% with the core consumer price index up 1.7%. The ICE/BofA US Treasury total return index was up just 0.43% over the same period.
For current yields in the US Treasury market to provide enough return to match inflation, monthly increases in the CPI index cannot exceed 0.35% to 0.40%. The average this year has been 0.5% per month (the average since 2016 was 0.27%).
For there to be positive real returns, either inflation needs to be lower, or yields need to be higher. Current yield levels do not provide satisfactory cover for the inflation risks.
The inflation gap
The big question is whether we are entering a period where inflation will continue to be biased higher? There are arguments to suggest we are. Geopolitical disruptions to trade, investment, and supply chains seem to have become more frequent.
Climate change, protectionism, and the need to spend on artificial intelligence can all contribute to upside inflation risks.
That risk should be sufficient for investors to demand higher yields and therefore, better returns from bonds. Until then, investors will likely continue to prefer short-duration bonds and bonds with a significant credit return.
In the case of the former, short duration strategies offer a potential defence against central banks raising interest rates to combat persistently higher inflation. The latter case, for credit, relies on corporate cash-flows being resistant to inflation (companies can raise prices to offset higher costs if the economy is doing well).
Yields on credit are higher than current inflation rates – US investment grade credit yields at 5.3% against that June headline inflation rate of 3.5%. European investment grade credit yields are 3.6% against a preliminary June inflation rate of 2.8%. The potential for positive real returns is there.
It is understood that equities remain the best hedge against inflation with the return driven by earnings growth – and despite a low yield, US dividend growth has consistently outpaced inflation, as it has in other major markets.
Indeed, equities have benefitted from higher-than-expected inflation, giving them pricing power. Because bond yields have not risen more, maybe because of the belief that inflation above target is transient, equity valuations have remained rich. The worst case for all markets is a sharp rise in inflation and yields, triggering a derating across equity markets.
Inflation and fiscal considerations
I think the inflation impact on bond yields is more important than fiscal considerations. Governments can at least try to control borrowing, but central banks have found it hard to control inflation and monetary policy has been compromised since the global financial crisis.
This is not to minimise deficit and debt considerations. Profligate fiscal policies always run the risk of upsetting the bond vigilantes. But not getting a real return from investing in bonds is also important.
Elevated levels of government bond supply will be more easily absorbed if investors buying the bonds are confident of maintaining the real value of their investments. Sadly, that has not been the case now for the best part of a decade.
Inflation credibility key
Market participants can still make money in bond markets. There remain attractive spreads in the credit markets. Short-term volatility is always creating trading opportunities. Yield curve shapes will evolve.
Active fixed income management should potentially be able to outperform passive bond indices. Short-duration high yield strategies remain one of the more attractive options. As do short-duration inflation-linked strategies which should at least match realised inflation.
But longer-term investors who buy bonds to fund government deficits, or corporate investment needs, must be convinced there is potential for a real positive return. Investors that want real returns in their pension plans without being 100% in equities also need to think hard about where in fixed income to be invested.
Central banks are committed to bringing inflation down. It was encouraging to hear new Federal Reserve Chair, Kevin Warsh, saying he would “double down on the Fed’s 2% inflation target” in his Congressional testimony this week.
There are not many developed economies that do not have a worrying fiscal outlook and, tempting as it may be to inflate away the debt, keeping borrowing costs under control must play a part in managing the debt trajectory.
That means lower inflation and that may mean central banks having to raise interest rates if inflation does not moderate. Watch this space and be prepared for inflation-adjusted bond returns to be lacklustre, at least in the short term!
