PORTFOLIO PERSPECTIVES

Weathering shocks

A fierce drawdown in risky assets is underway, driven by fears of the economic cost of the coronavirus outbreaks and containment measures. The impact is likely to be sharp and deep, yet we do not see this as a repeat of 2008 as the economy and, importantly, the financial system, is on a firmer footing. Our view is conditional on a comprehensive, sizeable and coordinated fiscal and monetary policy response. In this paper – a precursor to our regular, comprehensive review of our capital market assumptions (CMAs) in coming weeks - we show why we lean towards adding exposure to risk assets at the expense of government bonds in strategic portfolios.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

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Global markets have swiftly moved to price in a grim outlook – a significant turnaround from a relatively benign view of the world at the start of the year. The impact of the coronavirus outbreak is likely to be sharp and deep. Yet we do not see this as a repeat of 2008 as the economy and, more importantly, the financial system, are on a firmer footing this time. Our view is conditional on a pre-emptive, comprehensive and sizeable policy response. We laid out the need for a joint and decisive effort between fiscal and monetary policy in Time to go direct. The key will be policies that assuage sentiment, ease financial conditions and prevent any liquidity or cashflow crunches for households and small businesses. We are starting to see increasing evidence of such stimulus – such as the $2 trillion* U.S. fiscal package alongside extraordinary measures from the Federal Reserve to cushion the impact of the coronavirus shock - coming through. These measures set the stage for an eventual recovery in our view, yet macroeconomic uncertainty is still elevated.

*All amounts given in USD. Source: White House and Democratic lawmakers, March 2020.

We also questioned the traditional role of government bonds as portfolio ballast – an example of looking beyond historical observations. We tilted our government bond exposure in strategic portfolios away from lower-yielding euro area and Japanese government bonds and toward the U.S. and China. Why? We believed that government bonds in markets close to the lower bound of interest rates would have diminished ability to act as ballasts during equity sell offs as historic negative bond-equity correlations could break down. See chart above. U.S. government bonds have once again shown their robust ballast properties over lower-yielding counterparts, as seen in the chart below. Yet even they started to have their diversification benefits questioned on some of the worst days of the market turmoil, as prices fell alongside equities.

Our strategic views

What is the impact on our hypothetical SAA? We show this in the simplified graphic below. In the first, we use the CMAs re-estimated for recent asset price moves (left table below). On the second, we add the impact of the alternative economic scenario we laid out earlier and assume a floor on yields in the range of potential return outcomes we consider for bonds (right table below). We believe it is important to capture the asymmetry of return outcomes for government bonds when yields are significantly lower, and the typical negative bond-equity correlation breaks down. These two analyses inform our strategic views.

Quantifying the impact of market events on strategic asset preferences
Potential change in asset allocations relative to hypothetical portfolio under different assumptions, March 2020

Quantifying the impact of market events on strategic asset preferences

Forward looking estimates may not come to pass. Indexes do not include fees. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, March 2020. Notes: The tables show potential changes in preference relative to the hypothetical stock-bond asset allocation built pre-coronavirus shock. We use the alternative sets of CMAs shown earlier to derive these preferences. The left table shows the change in preferences as a result of market price moves between Dec. 31, 2019 and March 10, 2020. The right table shows the change in preferences as a result of market price moves and assuming persisting effects of the economic and market shock year-to-date, resulting in an alternative medium-term scenario. The details of the alternative scenario are laid out on the following page and in the Appendix on pg. 7. Index proxies are mentioned in the Appendix. “Sub-investment grade credit” refers to global high yield and emerging market debt. Global equity combines developed and emerging market equities.

Philipp Hildebrand
Vice Chairman, BlackRock
Jean Boivin
Head of BlackRock Investment Institute
Anthony Chan
Portfolio Research – BlackRock Investment Institute
Natalie Gill
Portfolio Research - BlackRock Investment Institute
Paul Henderson
Portfolio Research – BlackRock Investment Institute
Christian Olinger
Portfolio Strategist - BlackRock Investment Institute
Vivek Paul
Senior Portfolio Strategist, BlackRock Investment Institute