Keeping bonds as a buffer

By Richard Turnill

Key points

  1. We see US government bonds offering more diversification benefits in 2019 against a backdrop where economic growth is a key market driver.
  2. Global equities gained, as dovish Fed minutes helped fuel further positive momentum. German economic data missed expectations. Oil rallied.
  3. We see a low likelihood that the UK Parliament will pass Theresa May’s Brexit deal this week in its current form. The magnitude of a defeat is key.

Keeping bonds as a buffer

Last year was unusual: US equities and 10-year Treasuries both finished down, as heightened economic and geopolitical uncertainty and expectations for higher short-term rates drove markets. We see growth as the key market driver in 2019. This suggests Treasuries may offer more diversification benefits as a buffer to bouts of equity weakness.

Chart of the week

Correlation between US equity and 10-year Treasury returns, 2004-2019

Chart of the week

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. 
Sources: BlackRock Investment Institute, with data from Thomson Reuters, January 2019.

Notes: The line shows the correlation of daily returns between the MSCI USA Index (representing US equities) and the benchmark 10-year US Treasury over a one-year rolling period (256 trading days). The dot shows the correlation of returns over the last 90 days.

The correlation between US equity and US government bond returns has been negative since the early 2000s, meaning the two asset classes generally move in opposite directions. Yet the magnitude of the negative correlation varies over time. It has recently turned more negative, as shown in the chart above. We see this relationship being sustained as economic growth becomes a key driver of market returns. One corollary: bonds may offer a more formidable ballast to equity exposures. These diversification benefits were particularly evident in December, a gruelling month for risk assets: US equities sold off by 9.2%, while 10-year US Treasury yields fell below 2.7% from around 3%, sending 10-year Treasury prices up.

Staying neutral

We see the correlation between equity and bond returns remaining significantly negative in 2019 as the economic cycle enters its latter stages. Growth, not Federal Reserve policy, is now the dominant market driver, in our view. A scenario where both US stocks and 10-year Treasuries sell off, as in 2018, requires a big pickup in inflation leading to a more hawkish Fed. We see this as unlikely in 2019.

Fears of a sharp economic slowdown over the past couple of months have spurred a rally in US Treasury prices and caused markets to dial down their expectations of potential Fed rate increases this year. Markets have moved from pricing in two 2019 Fed rate increases as of November to now flirting with the possibility of a rate cut. Yet market fears about economic weakness may have overshot, in our view. We see global growth slowing in 2019, and the US economy entering a late-cycle phase, but view the risk of a recession this year as low. We see core inflation in the US hovering near the Fed’s target, and the absence of meaningful inflationary pressures giving the Fed flexibility. We expect a pause in the Fed’s tightening cycle in the first half of 2019. 

Against this backdrop, we maintain our neutral stance on US government bonds. Increasing macro uncertainty is likely to stoke volatility in risk assets, pointing to the need for quality bonds when targeting portfolio resilience. We advocate flanking Treasury exposures with high-conviction allocations in areas that offer attractive compensation for risk, as part of our barbell approach for 2019. We would wait for a rise in yields before adding to US government bond positions. One potential catalyst that could send US yields higher in the short-term: an outcome from the latest US-China trade negotiations that lowers trade tensions. Yet we see a full resolution of this trade dispute as unlikely in 2019 and, therefore, do not see a sustained rise in global yields this year. Also likely to suppress bond yields: We view the European Central Bank’s growth estimates as optimistic, and see a 2019 rate rise from the ECB as unlikely. We do, however, see yields gradually moving higher over the medium term as policy and the yield curve eventually normalise.

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  • Equities extended the prior week’s positive momentum with a broad-based rally, as investors digested dovish Fed minutes, new fiscal stimulus in China and US-China trade talks. The Fed’s December meeting minutes suggested many Fed officials could take a “patient” approach on rates and see the future path of hikes as “less clear.” Government bond yields rose modestly.
  • German industrial production for November came in well below expectations, putting Germany on track for a potential second consecutive quarter of negative gross domestic product (GDP) growth and raising the possibility that Europe’s second-largest economy is in a technical recession. 
  • Oil prices surged after Saudi Arabia’s energy minister said the kingdom aimed to “stabilise” the oil market. China’s inflation data came in lower than expected, while US consumer inflation data were in line with expectations with annual core inflation at 2.2%.



  Date: Event
Jan. 14 China balance of trade; eurozone industrial production; fourth-quarter 2018 earnings reporting season kicks off
Jan. 15 UK Parliament vote on Brexit deal
Jan. 16 US retail sales, business inventories (both could be delayed due to government shutdown)
Jan. 17 OPEC Monthly Oil Market Report; US housing starts (could be delayed due to government shutdown)
Jan. 18 Japan Consumer Price Index; US consumer sentiment index, industrial production

The UK Parliament is set to vote Tuesday on Prime Minister Theresa May’s Brexit withdrawal deal. We see a low likelihood of the deal passing in its current form, given deep divisions within the government. May appears to be hoping that fears of a “no-deal” or a second referendum might be enough to get an amended deal through Parliament. If the vote does not pass this week, the magnitude of defeat will be important to determine the government’s next move. A second referendum or a general election may yet be required to break the deadlock. See our BlackRock geopolitical risk dashboard for more on the risk of European fragmentation. 

Global Chief Investment Strategist, BlackRock Investment Institute
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active Equit

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Sources: Bloomberg unless otherwise specified.

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