Upgrading U.S. government bonds

Dec 10, 2018

Key points

  • We have upgraded our call on U.S. government bonds to neutral on the view they should play a bigger role in balancing portfolio risk and reward.
  • Financials led developed market equities down. The minimum-volatility factor outperformed and the U.S. yield curve further flattened.
  • We see low probability of the UK parliament passing the government’s Brexit withdrawal arrangement, but still view a “no-deal” exit as unlikely.

Markets are becoming increasingly sensitive to any hints of an economic slowdown as we approach a late-cycle phase. The upshot for investors: a need for extra diligence in balancing risk and reward. We see U.S. government bonds playing a bigger role as portfolio ballast and have upgraded our view to neutral.

Chart of the week
Average 12-month returns in periods preceding U.S. recessions, 1978-2018

Average 12-month returns in periods preceding U.S. recessions, 1978-2018


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 Bloomberg and NBER, December 2018. Notes: The bars show average returns in selected assets in periods before U.S. recessions. The left-hand bars show the average returns in calendar years before the year in which a recession started. The right-hand bars show the average returns in the four quarters preceding the quarter in which a recession started. Recessions are as defined by NBER, with five recorded over the 40-year period. U.S. stocks are represented by the S&P 500 Index, DM stocks by the MSCI World Index, U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Total Return Index. 60/40 refers to a hypothetical portfolio of 60% S&P 500 and 40% Bloomberg Barclays U.S. Treasury Total Return Index, weighted monthly. Equities reflect price returns and bonds total returns, all in U.S. dollar terms.

A U.S. recession is not imminent, in our view, yet trade-related uncertainty and fears of a slowdown challenging for risk assets. Our analysis puts recession probabilities as low for 2019 but rising to just above 50% by the end of 2021. We find equities have historically done well in late-cycle slowdowns. This includes even the calendar year preceding an economic downturn, as shown in the chart. Equity performance generally deteriorated as recession drew nearer, with U.S. Treasuries taking the lead as investors turned to perceived “safe havens.” History may not repeat. The averages mask a wide range of market outcomes around recessions given differences in starting valuations and the character of each downturn. Yet history often can be informative.

Renewed focus on portfolio ballast

Still-easy monetary policy, few signs of economic overheating and a lack of elevated financial vulnerabilities point to ongoing economic expansion. Yet the U.S. economy is entering a late-cycle phase, and the likelihood of temporary risk-off events is higher with elevated uncertainty. Trade frictions and a U.S.-China battle for supremacy in the tech sector hang over markets. We see trade risks more fully reflected in asset prices than a year ago, but expect the twists and turns of trade talks to cause bouts of anxiety. And we worry about European political risks in the medium term against a weak growth backdrop. See our 2019 Global Investment Outlook for more.

As a result, we see U.S. government bonds playing a greater role in portfolios. For one, they can cushion against any late-cycle selloffs of risk assets. In addition, the Federal Reserve’s policy path may create a relatively benign environment for Treasuries. We see the Fed pausing its rate-hiking cycle at some point in 2019 to assess the effects of slowing economic growth and tightening financial conditions.

We prefer short- to medium-term bonds. Higher yields and a flatter curve as a result of the Fed’s rate increases over the past three years have made shorter maturities an attractive source of income for U.S. dollar-based investors. Short- to medium-dated Treasuries now offer nearly the same yield as the benchmark 10-year Treasury, we find. Core European government bonds (such as German bunds) appear less attractive, as the European Central Bank’s still-easy monetary policy pins down their yields at low levels.

Bottom line: Rising risks call for carefully balancing risk and reward: exposures to government debt as a portfolio buffer, twinned with high-conviction allocations to assets that offer attractive risk/return prospects such as EM equities. We prefer stocks over bonds, but our conviction is tempered. In equities, we prefer quality — free cash flow, sustainable growth and clean balance sheets. We favor
up-in-quality credit. We steer away from areas with limited upside but hefty downside risk, such as European stocks.


Dec. 11 Scheduled vote on Brexit deal in the UK parliament
Dec. 12 U.S. Consumer Price Index
Dec. 13 European Central Bank monetary policy meeting; start of European Union’s two-day summit
Dec. 14 China retail sales, industrial production, fixed asset investment; U.S. retail sales

Reports suggested that Prime Minister Theresa May is delaying a vote on the UK’s divorce deal with the EU. We had seen low odds of the UK parliament approving the deal in its current form. The probability of other possible twists, such as a general election or a second referendum, has risen in recent weeks. Markets are likely to stay jittery on Brexit-related headlines over coming weeks as the March 2019 deadline looms. The eventual passing of a withdrawal agreement would support the pound and lift UK government bond yields, as markets price back in the potential for gradual rate rises by the Bank of England due to reduced uncertainty over the UK economy’s future. We still view a “no-deal” Brexit as unlikely.

  • Financials led the decline in developed market equities. EM stocks outperformed along with the minimum-volatility style factor. Credit spreads widened in the U.S. and Europe. The U.S. yield curve flattened significantly, with the spread between two- and 10-year yields reaching post-crisis lows and the curve inverting between two and five years.
  • The Organization of the Petroleum Exporting Countries (OPEC) and allies agreed on an output cut larger than OPEC’s initial guidance, helping boost crude oil prices this week. The U.S.-requested arrest of a top executive of a prominent Chinese technology company in Canada added to worries about the fragility of the U.S.-China trade truce agreed last week.
  • U.S. November job growth undershot expectations but still showed a solid labor market. The cold weather was a drag, but the solid start of the holiday shopping season offered some offset. Wages growth slowed moderately.

Global snapshot

Weekly and 12-month performance of selected assets


EquitiesWeekYTD12 MonthsDiv. Yield
U.S. Large Caps -4.6% 0.3% 1.8% 2.1%
U.S. Small Caps -5.5% -4.6% -3.5% 1.4%
Non-U.S.World -2.1% -12.0% -8.9% 3.5%
Non-U.S.Developed -2.3% -11.4% -9.0% 3.7%
Japan -1.9% -8.4% -6.7% 2.4%
Emerging -1.3% -13.4% -8.7% 3.1%
Asia ex-Japan  -1.5% -13.3% -9.4% 2.9%
BondsWeekYTD12 MonthsYield
U.S. Treasuries 1.0% -0.3% -0.2% 2.8%
U.S. TIPS 0.6% -1.2% -0.6% 3.0%
U.S. Investment Grade 0.8% -3.2% -2.7% 4.3%
U.S. High Yield -0.1% -0.1% 0.2% 7.3%
U.S. Municipals 0.7% 0.8% 0.5% 2.8%
Non-U.S. Developed 0.9% -3.4% -2.5% 1.0%
Emerging Market $ Bonds 0.8% -4.7% -4.3% 6.9%
CommoditiesWeekYTD12 MonthsLevel
Brent Crude Oil 5.0% -7.8% -0.9% $61.67
Gold 2.4% -4.1% 0.2% $1,249
Copper -0.9% -15.2% -6.4% $6,145
CurrenciesWeekYTD12 MonthsLevel
Euro/USD 0.5% -5.2% -3.3% 1.14
USD/Yen -0.8% 0.0% -0.4% 112.69
Pound/USD -0.2% -5.8% -5.6% 1.27

Source: Bloomberg. As of December 7, 2018.
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon


Asset Class View Comments
Equities U.S. icon-up Solid corporate earnings and strong economic growth underpin our positive view. We have a growing preference for quality companies with strong balance sheets as the 2019 macro and earnings outlooks become more uncertain. Health care is among our favored sectors.
Europe icon-down Relatively muted earnings growth, weak economic momentum and political risks are challenges. A value bias makes Europe less attractive without a clear catalyst for value outperformance. We prefer higher-quality, globally-oriented names.
Japan icon-neutral We see a weaker yen, solid corporate fundamentals and cheap valuations as supportive, but await a clear catalyst to propel sustained outperformance. Other positives include shareholder-friendly corporate behavior, central bank stock buying and political stability.
EM icon-up Attractive valuations and a backdrop of economic reforms and robust earnings growth support the case for EM stocks. We view financial contagion risks as low. Uncertainty around trade is likely to persist, though much has been priced in. We see the greatest opportunities in EM Asia.
Asia ex Japan icon-up The economic backdrop is encouraging, with near-term resilience in China and solid corporate earnings. We like selected Southeast Asian markets but recognize a worse-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.
Fixed Income U.S. government bonds icon-neutral Higher yields and a flatter curve after a series of Fed rate increases make short-to-medium term bonds a more attractive source of income. Longer maturities are also gaining appeal as an offset to equity risk, particularly as the Fed gets closer to neutral and upward rate pressure is more limited. We see reasonable value in mortgages. Inflation-linked debt has cheapened, but we see no obvious catalyst for outperformance.
U.S. municipals icon-neutral Solid demand for munis as a tax shelter and expectations for muted issuance should support the asset class. We prefer a long duration stance, expressed via a barbell strategy focused on two- and 20-year maturities.
U.S. credit icon-neutral Solid fundamentals support credit markets, but late-cycle economic concerns pose a risk to valuations. We favor an up-in-quality stance with a preference for investment grade credit. We hold a balanced view between high yield bonds and loans.
European sovereigns icon-down Yields are relatively unattractive and vulnerable to any growth uptick. Rising rate differentials have made European sovereigns more appealing for global investors with currency hedges. Italian spreads reflect quite a bit of risk.
European credit icon-neutral Valuations are attractive, particularly on a hedged basis for U.S. dollar investors. We see opportunities in industrials but are cautious on other cyclical sectors. We favor senior financial debt that would stand to benefit from any new ECB support, over subordinated financials. We prefer European over UK credit on Brexit risks. Political uncertainty is a concern.
EM debt icon-neutral We prefer hard-currency over local-currency debt and developed market corporate bonds. Slowing supply and broadly strong EM fundamentals add to the relative appeal of hard-currency EM debt. Trade conflicts and a tightening of global financial conditions call for a selective approach.
Asia fixed income icon-neutral Stable fundamentals, cheapening valuations and slowing issuance are supportive. China’s representation in the region’s bond universe is rising. Higher-quality growth and a focus on financial sector reform are long-term positives, but a sharp China growth slowdown would be a challenge.
Other Commodities and currencies * A reversal of recent oversupply is likely to underpin oil prices. Any relaxation in trade tensions could signal upside to industrial metal prices. We are neutral on the U.S. dollar. It maintains “safe-haven” appeal but gains could be limited by a high valuation and a narrowing growth gap with the rest of the world.

icon-up Overweight     icon-neutral Neutral     icon-down Underweight

* Given the breadth of this category, we do not offer a consolidated view.

Download now

Richard Turnill
Global Chief Investment Strategist
Richard Turnill, Managing Director, is Global Chief Investment Strategist for BlackRock, leading the Investment Strategy Function within the BlackRock ...
Isabelle Mateos y Lago
Managing Director, Chief Multi-Asset Strategist
Isabelle Mateos y Lago, Managing Director, is BlackRock's Chief Multi-Asset Strategist. As part of the BlackRock Investment Institute (BII), she is responsible ...
Kate Moore
Chief Equity Strategist, Americas
Kate Moore, Managing Director, is Chief Equity Strategist – Americas for BlackRock and is a member of the BlackRock Investment Institute. She is responsible for ...