Higher rates reinforce income’s appeal
Market take
Weekly video_20230130
Nicholas Fawcett
Opening frame: What’s driving markets? Market take
Camera frame
The Federal Reserve and European Central Bank are set to raise rates again this week to fight inflation.
Title slide: Rate hikes reinforce why yield is back
But markets are pricing rate cuts in 2023 even as both central banks insist that they will stay the course.
1: Policy rates higher for longer
We see the disconnect resolving in favor of central banks.
Inflation is set to fall a lot – but not all the way to 2% in our view.
Like central banks – we are looking for wage pressures to sustainably subside. They’ll want to see this before declaring victory on inflation – so rate cuts are a long way off.
2: Risks underpinning higher long-term yields
That’s one reason we prefer short-term bonds. Another is that we see investors demanding more to hold long-term bonds.
That might happen if the Bank of Japan changes its yield curve control policy and that causes market dislocations.
That may also happen amid the tussle to lift the U.S. debt ceiling, though we do expect negotiations to be resolved.
3: Opportunity in short-term fixed income
Short-term government bonds and investment grade credit now offer some of the highest yields in the last two decades.
We prefer them for income. We also like agency mortgage-backed-securities to diversify income.
Global investment grade credit offers even more yield than short-term bonds, and should weather a downturn.
Outro frame: Here’s our Market take
We like short-term government bonds and high-grade credit for their income potential.
Closing frame: Read details:
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Favoring fixed income
We don’t see major central bank rate cuts this year, so we prefer to earn income in short-term bonds, high-grade credit and agency mortgage-backed securities.
Market backdrop
US stocks rose and Treasury yields were mostly steady. US Q4 GDP was resilient but declining consumer spending suggests growth is slowing quickly.
Week ahead
The Fed and the European Central Bank anchor policy decisions this week. We see them hiking and holding rates higher for longer than markets expect.
Major central banks are set to hike policy rates again this week and keep them higher, counter to market views for cuts this year. We see this disconnect resolving and favoring higher rates. That’s because we think inflation will fall fast but stay above target. Rates staying high plus the political tussle over raising the US borrowing limit are market risks. We prefer to earn income and like short-term government bonds, high-grade credit and mortgage-backed securities.
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Chart of the week
Yield is back
Investment grade and short-term government debt yields, 2002-2022
Source: BlackRock Investment Institute, with data from Refinitiv, January 2023. Notes: The chart shows yields for the Bloomberg Global Aggregate Corporate Index and benchmark two-year US Treasuries.
Income is finally back in fixed income thanks to higher yields and coupons. Short-term government bonds and investment grade (IG) credit now offer some of the highest yields in the last two decades. See the chart. We prefer to earn income right now from these high-quality fixed income assets as rates rise and stay high. Fixed income’s appeal remains intact the longer central banks keep rates near their peak. The lack of duration – or the sensitivity of bond prices to interest rates – in short-term paper also helps preserve income even if yields rise anew. Global IG credit offers high-grade, liquid income – and we think the strong balance sheets of high-quality companies that refinanced debt at lower rates can weather the mild recession we see ahead. We also like agency mortgage-backed securities (MBS) to diversify income.
We see major central banks on a path to overtighten policy because they’re worried about the persistence of underlying core inflation, excluding food and energy prices. PCE data in the US confirmed the outlook for core inflation hasn’t improved, and it’s tracking to be well above policy targets into 2024. Core services inflation is proving sticky even as goods prices fall. That stickiness is tied to wage pressures in the labor market that we see remaining tight. We think central banks will want more evidence that core inflation and wage pressures are sustainably subsiding before they declare victory on inflation and think about easing policy. This will take a long time – and is unlikely to happen this year, in our view.
This week, the Fed and ECB are set to push rates further up again. We see the Fed hiking 0.25% and the ECB raising 0.5%, with more hikes likely to follow. Then we see them keeping rates high. But markets are pricing rate cuts in 2023 even as both central banks insist they will stay the course. That disconnect needs to be resolved, and we think it will be in favor of higher rates as inflation persists above central banks’ 2% target. Rates staying high is one reason we prefer earning income with shorter duration paper.
Another reason is term premium – the compensation investors demand for holding long-term government bonds. We see investors seeking more term premium with higher inflation and other near-term risks on the horizon. Political pressure on the Bank of Japan to change its yield curve control policy is likely to ramp up with inflation running at a four-decade high. The risk: a global spillover from higher Japanese government bond yields to global yields. We think moving away from yield curve control would be like a move away from a currency peg – even tweaks could lead to abrupt market dislocations.
Risks over raising the US borrowing cap are also in focus now after the US hit its debt ceiling this month – this reinforces our view that investors will once again demand term premium. Negotiations are likely to go down to the wire this summer and could be as fraught as 2011, when S&P Global downgraded the US triple-A credit rating. We ultimately expect a resolution. If a US default were to occur, it would likely be technical in nature, meaning the US would prioritize debt payments over other obligations. We would expect only a temporary rise in selected Treasury bill yields as the default date nears. Another debt ceiling impasse could also pressure risk assets as in past episodes – this keeps us cautious on US equities.
Our bottom line:
Rates staying high and the political tussle over the US debt ceiling are market risks. We take a granular view on fixed income at this juncture. We tactically like short-term government bonds, high-grade credit and agency mortgage-backed securities for attractive income.
Market backdrop
US stocks climbed and bond yields were mostly steady, with European and emerging market shares outperforming the US on investor inflows. US GDP was resilient in the last quarter of 2022. Consumer spending helped prop up growth, but we see signs of weakness beneath the surface. The US PCE data showed consumer spending was losing momentum at the end of the year and suggests that growth is slowing more quickly than we expected.
The Fed and the European Central Bank anchor this week’s central bank decisions. We see them both pushing up rates further and pushing back against market expectations for rate cuts. The US services PMI and payrolls data will give the latest view on recession risks. We think further resilience in activity and the labor market could embolden the Fed.
Week ahead
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of Jan. 26, 2023. Notes: The two ends of the bars show the lowest and highest returns at any point in the last 12-months, and the dots represent current 12-month returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in US dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE US Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (US, Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
Jan. 31
Euro area flash Q4 GDP; US consumer confidence
Feb. 1
Fed policy decision; US job openings; euro area inflation
Feb. 2
European Central Bank, Bank of England policy decisions
Feb. 3
US payrolls, US ISM services PMI; China services PMI
Read our past weekly commentaries here.
Investment themes
01
Pricing in the damage
Central banks are deliberately causing recession by overtightening policy to tame inflation, in our view. That makes recession foretold. What matters: our view on the pricing of economic damage and our assessment of market risk sentiment. Investment implication: We stay underweight DM equities but expect to turn more positive at some point in 2023.
02
Rethinking bonds
We see higher yields as a gift to investors long starved of income in bonds. And investors don’t have to go far up the fixed income risk spectrum to receive it. Investment implication: We like short-term government bonds, investment grade credit and agency mortgage-backed securities for income. We stay underweight long-term government bonds.
03
Living with inflation
Long-term trends of the new regime, such as aging workforces and geopolitical fragmentation, will keep inflation persistently above pre-pandemic levels, in our view. Investment implications: We stay overweight inflation-linked bonds on both tactical and strategic horizons. We are strategically overweight DM equities.
Directional views
Strategic (long-term) and tactical (6-12 month) views on broad asset classes, January 2023.
| Asset | Strategic view | Tactical view | Commentary |
|---|---|---|---|
| Equities |  |
 |
We are overweight equities in our strategic views as we see central banks ultimately choosing to live with some inflation. Valuations on a long horizon do not appear stretched to us. Tactically, we’re underweight DM stocks as central banks look set to overtighten policy – we see recessions looming. Corporate earnings expectations have yet to fully reflect even a modest recession. |
| Credit |  |
 |
Strategically, we are significantly overweight global investment grade on attractive valuations and income potential given higher yields. We turn neutral high yield as we see the asset class as more vulnerable to recession risks. Tactically, we’re also overweight investment grade and neutral high yield. We prefer to be up in quality. We are neutral EM debt after its strong run. We see better opportunities for income in DMs. |
| Government bonds | |
|
The underweight in our strategic view on government bonds reflects a big spread: max underweight nominal, max overweight inflation-linked and an underweight on Chinese bonds. We think markets are underappreciating the persistence of high inflation and the implications for investors demanding a higher term premium. Tactically, we are underweight long-dated DM government bonds as we see term premium driving yields higher, yet we are neutral short-dated government bonds as we see a likely peak in pricing of policy rates. The high yields offer relatively attractive income opportunities. |
| Private markets | |
- | We’re underweight private growth assets and neutral on private credit, from a starting allocation that is much larger than what most qualified investors hold. Private assets are not immune to higher macro and market volatility or higher rates, and public market selloffs have reduced their relative appeal. Private allocations are long-term commitments, however, and we see opportunities as assets reprice over time. Private markets are a complex asset class not suitable for all investors. |
Note: Views are from a US dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.
Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.
Tactical granular views
Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, January 2023.
| Asset | Tactical view | Commentary | ||
|---|---|---|---|---|
| Equities | ||||
| Developed markets | |
We are underweight. Earnings expectations and valuations don’t fully reflect recession risk. We prefer a sectoral approach: energy, financials and healthcare. | ||
| United States | |
We are underweight. The Fed is set to raise rates into restrictive territory. Earnings downgrades are starting but don’t yet reflect the coming recession. | ||
| Europe | |
We are underweight. The energy price shock and policy tightening raise stagflation risks. | ||
| U.K. | |
We are underweight UK equities following their strong performance versus other DM markets thanks to energy sector exposure. | ||
| Japan |  |
We are neutral Japan stocks. We like still-easy monetary policy and increasing dividend payouts. Slowing global growth is a risk. | ||
| China | |
We are neutral. Activity is restarting, but we see China on a path to lower growth. Tighter state control of the economy makes Chinese assets riskier, in our view. | ||
| Emerging markets | |
We are neutral EM equities on the back of slowing global growth. Within the asset classes, we lean toward commodity exporters over importers. | ||
| Asia ex-Japan | |
We are neutral Asia ex-Japan equities. China’s near-term cyclical rebound is a positive yet we don’t see valuations compelling enough to turn overweight. | ||
| Fixed income | ||||
|
Long US Treasuries |
|
We are underweight. We see long-term yields moving up further as investors demand a greater term premium. | ||
|
Short US Treasuries |
|
We are neutral. We remain invested in the front end due to attractive income potential. | ||
| Global inflation-linked bonds | |
We are overweight. We see breakeven inflation rates underpricing the persistent inflation we expect. | ||
| European government bonds | |
We turn underweight the long end. We expect term premium to raise long-term yields and high inflation to persist. Rate hikes are a risk to peripheral spreads. . |
||
| UK Gilts | |
We are underweight. Perceptions of fiscal credibility have not fully recovered. We prefer short-dated gilts for income. | ||
| China government bonds | |
We are neutral. Policymakers have been slow to loosen policy to offset the slowdown, and they are less attractive than DM bonds. | ||
| Global IG credit | |
We add to our overweight. High quality corporates’ strong balance sheets imply IG credit could weather a recession better than stocks. | ||
|
US agency MBS |
|
We are overweight. We see the asset class as a high-quality exposure within a diversified bond allocation. Soaring US mortgage rates boost potential income. | ||
| Global high yield | |
We are neutral. We prefer up-in-quality credit exposures amid a worsening macro backdrop. | ||
| Emerging market - hard currency | |
We are neutral. We see support from higher commodities prices yet it is vulnerable to rising US yields. | ||
| Emerging market - local currency | |
We cut EM debt to neutral after it’s strong run. We see better opportunities for income in DMs. | ||
| Asia fixed income | |
We are neutral Asia fixed income amid a worsening macro outlook. We don’t find valuations compelling enough yet to turn more positive on the asset class. | ||
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: views are from a US dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.
Euro-denominated tactical granular views
Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, January 2023.
| Asset | Tactical view | Commentary | ||
|---|---|---|---|---|
| Equities | ||||
| Europe ex UK | |
We are underweight European equities. We don’t think consensus earnings expectations are pricing in heightened risks of a deep recession. We see a sharp hit to euro area growth from the energy price shock alone. The European Central Bank looks intent on squeezing out inflation via higher rates – another drag on activity. | ||
| Germany | |
We are neutral German equities. While valuations are supportive relative to peers, near-term headwinds to earnings prospects remain significant amid tense gas supplies, rapid ECB tightening and slower growth of major trading partners. Looking further ahead, opportunities arise from political ambitions to bring the economy to net zero. | ||
| France | |
We are underweight French equities. France’s more favourable energy mix and the stock market’s tilt to energy could help insulate portfolios against elevated inflation. High electricity prices put pressure on corporate margins, though, despite policy relief. The pace of structural reforms looks set to slow following the parliamentary elections. | ||
| Italy | |
We are underweight Italian equities. The economy’s relatively weak credit fundamentals amid tightening financial conditions globally keep us cautious. | ||
| Spain | |
We are underweight Spanish equities. The market’s outperformance in 2022 – driven largely by its greater relative exposure to rate-sensitive financials – leave it vulnerable, in our view, to profit-taking amid a broader, regional downturn on slowing growth. | ||
| Netherlands | |
The earnings outlook has weakened more than in other European markets, resulting in a negative earnings outlook over the next 12 months. Dutch stocks are trading at a comparable valuation but offer a relatively low dividend yield. | ||
| Switzerland | |
We are neutral Swiss equities. The equity benchmark sports a defensive tilt with high sector weights to health care and consumer goods, providing a cushion amid heightened uncertainty over the global macro outlook. | ||
| UK | |
We are underweight UK equities. We see UK growth slowing sharply – as explicitly acknowledged by the Bank of England and yet not reflected in consensus earnings expectations. The market – that has outperformed other DMs in 2022 due to energy sector exposure – is not immune to a global downturn. | ||
| Fixed income | ||||
| Euro area government bonds | |
We are neutral nominal European government bonds. Market pricing of ECB policy is too hawkish, we think, given looming recession. The end of ECB net asset purchases, likely issuance to support fiscal policies and our view of elevated inflation keeps us from turning positive and underpins our preference for inflation-linked bonds. | ||
| German bunds | |
Weare neutral German bunds. Further upward pressure on yields appears limited to us given hawkish ECB policy expectations even with rising recessionary risks, elevated – yet possibly peaking – headline inflation, and lingering geopolitical uncertainty. | ||
| French OATs | |
Elevated French public debt and a slower pace of structural reforms remain negatives even as French spreads to German bonds are above historical averages. | ||
| Italian BTPs | |
We have a modest underweight on Italian BTPs. Spreads have already widened this year, yet we stay cautious given weaker credit fundamentals, global policy tightening and lingering political uncertainty. The ECB’s Transmission Protection Instrument – a bond purchase scheme – offers a backstop. | ||
| Swiss government bonds | |
We are neutral Swiss bonds. The Swiss National Bank has quickly moved its policy rate into positive territory despite the highly valued Franc. Further upward pressure on yields appears limited, though, in light of lingering uncertainties and still comparatively subdued underlying inflation pressure. | ||
| UK gilts | |
We are neutral UK gilts. Perceptions of fiscal credibility have improved, though not fully, after a reversal of planned fiscal stimulus. We think the BoE will have to hike rates less than we assumed immediately after the Sept. 23 “mini budget.” | ||
| European inflation-protected securities | |
We are overweight European inflation-protected government bonds because we see persistent inflation and the ECB ultimately living with higher levels of it. Weaning off Russian fossil fuels is likely to keep energy inflation high in the medium term. The short-term impact will be even more severe if Russia cuts off the gas supply. | ||
| European investment grade credit | |
We are overweight investment-grade credit. We find valuations attractive in terms of both overall yield and the spread vs. government bonds. Coupon income is the highest in about a decade. | ||
| European high yield | |
We are neutral high yield. We find the income potential attractive, yet prefer up-in-quality credit exposures amid a worsening macro backdrop. | ||
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a euro perspective, October 2023. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.
Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Kurt Reiman
Senior Strategist for North America – BlackRock Investment Institute
Nicholas Fawcett
Macro research – BlackRock Investment Institute
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