For qualified investors

Upgrading US government bonds

By Richard Turnill

Key points

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

Upgrading US government bonds

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 US 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 US recessions, 1978-2018

Chart of the week

Past performance is not a reliable indicator of current or future results.
Sources: BlackRock Investment Institute, with data from Bloomberg and NBER, December 2018. Notes: The bars show average returns in selected assets in periods before US 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. US stocks are represented by the S&P 500 Index, DM stocks by the MSCI World Index, US Treasuries by the Bloomberg Barclays US Treasury Total Return Index. 60/40 refers to a hypothetical portfolio of 60% S&P 500 and 40% Bloomberg Barclays US Treasury Total Return Index, weighted monthly. Equities reflect price returns and bonds total returns, all in US dollar terms.

A US recession is not imminent, in our view, yet trade-related uncertainty and fears of a slowdown are 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 US 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 US economy is entering a late-cycle phase, and the likelihood of temporary risk-off events is higher with elevated uncertainty. Trade frictions and a US-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 US 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 US 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 favour up-in-quality credit. We steer away from areas with limited upside but hefty downside risk, such as European stocks.

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  • Financials led the decline in developed market equities. EM stocks outperformed along with the minimum-volatility style factor. Credit spreads widened in the US and Europe. The US 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 US-requested arrest of a top executive of a prominent Chinese technology company in Canada added to worries about the fragility of the US-China trade truce agreed last week.
  • US 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.



  Date: Event
Dec. 11 Scheduled vote on Brexit deal in the UK parliament
Dec. 12 US 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; US retail sales

We see low odds of the UK parliament approving Prime Minister Theresa May’s divorce deal with the EU on Tuesday, but still view a “no-deal” Brexit as unlikely. The probability of other possible twists, such as a general election or a second referendum, has risen in recent weeks. 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. But markets are likely to stay jittery, with more Brexit-related headlines to come over the next few weeks.

Richard Turnill
Managing Director, ist Global Chief Investment Strategist von BlackRock
Richard Turnill ist Global Chief Investment Strategist von BlackRock. Davor war er Chief Investment Strategist von BlackRocks Fixed Income und active Equities ...

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Sources: Bloomberg unless otherwise specified.

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