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.

Overview

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.

Bonds as ballast
Performance of government bonds since first reported coronavirus case outside China, March 2020

Bonds as ballast

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 Refinitiv Datastream, March 2020. Notes: The chart shows the rebased performance in total return terms of government bond indices between Jan 13, 2020 – the date of the first reported coronavirus case outside China – and March 24, 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.

Assessing the fallout

The key question now is – should strategic asset preferences change? Long-term investors should know that what worked before won’t necessarily work now, either due to the sheer size of market moves or due to changes in medium-term macroeconomic assumptions. We illustrate the strategic asset allocation implications of two scenarios: a pure price shock and another where alongside the near-term price shock, long-term fundamental assumptions vary from our current base case as detailed here. In revising fundamentals, we assume a changed monetary and fiscal policy outlook, a realignment of global supply chains that upend assumptions about corporate profitability, and explicit lower bounds being priced into developed government bond markets.

Expected returns
Estimated change in our five-year CMAs for select assets in US dollar terms, March 2020

Expected returns

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 charts show how our CMAs for select asset classes might change relative to our current CMAs as of Dec 31, 2019 assuming year-to-date (as of March 10, 2020) asset price performance only (orange bars) and assuming performance and revised fundamentals under an alternative economic scenario (yellow bars). The right panel shows the change in each asset’s expected returns relative to its risk, defined as our forward-looking view on the asset’s long-term expected volatility as laid out in the Assumptions at a glance section of our capital market assumptions website. A set of alternative macro assumptions under a hypothetical scenario and index proxies are shown on the Appendix on pg. 7.

We start by estimating how much year-to date price action alone might change our current expected five-year asset class returns. See the orange bars in the chart above. These CMAs assume economic fundamentals over five years and beyond stay consistent with our current base case outlined on our website. The impact of the outbreak is severe and containment measures will bring economic activity to a standstill, yet we believe activity should eventually rebound rapidly with little permanent damage, provided both fiscal and monetary policy actions are taken to support businesses and households through the shock. Our current models find materially higher expected returns for equity and lower government bond returns. Expected equity returns get the biggest boost (see the chart on the left), yet in risk adjusted terms the relative appeal of equities falls (the chart on the right). It is important to note that these are based on a defined snapshot during a time of extremely high market volatility. Equity markets have bounced sharply off the lows as policy measures helped to calm investor nerves yet prices are still significantly off their peaks.

Next we consider an alternative scenario where recent events set the economy on a different course. Uncertainty around how the world evolves is very high and the scenario we outline here is just one possible economic outcome to illustrate the potential impact on expected returns. We re-estimate our CMAs assuming a different set of underlying fundamentals (discussed below and shown in the appendix) as well as accounting for price moves (yellow bars in charts below). Policymakers have a limited toolkit to address a future downturn, we argued in Dealing with the next downturn. The little ammunition available to policy makers is being drawn upon heavily now to pre-emptively protect the economy. An expansion of ultra-loose monetary policy globally could pull down the path of cash rates over the coming years. We believe this leaves policymakers less prepared (and more vulnerable) to future shocks. For this scenario, we consider a lower path of policy rates and higher inflation over the medium-term as the policy baton passes to fiscal policy.

The second key element of our alternative scenario is the acceleration of a realignment of global supply chains. Coming close on the heels of a rise in trade protectionism, the coronavirus outbreak has highlighted the vulnerabilities of integrated global supply chains and just-in-time manufacturing. We note the recent resilience of Chinese supply chains through the crisis, but this doesn’t alter a broader trend towards deglobalisation in the alternative scenario. Corporates are re-assessing global supply chains and considering localizing, driven by a focus on sustainability and less attractive tax and labor cost savings than the past. This could spur supply shocks and hinder productivity as companies operate sub-optimally during transition.

In either scenario, we would cut government bond allocations due to lower expected returns, diminished ballast properties at lower yield levels, and the emergence of a potentially preferable risk-off asset – inflation-linked bonds. We see a strategic opportunity emerging to allocate more to equities given the repricing that has occurred, underpinned by our belief that the coronavirus impact is different to the financial crisis. Many portfolios will have drifted from their target asset allocation. We prefer rebalancing equity exposure back up to target. The case for credit is also stronger yet more nuanced. Valuations are clearly cheaper now, creating opportunities for investors, but late-cycle risks such as higher defaults, particularly in the high yield market, cannot be ignored.

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.

A few important conclusions emerge for a multi-asset, liability-agnostic portfolio. First, the case for nominal developed market government bonds is materially diminished. Why? We see three reasons: lower expected returns, reduced ballast properties and the emergence of a potentially more preferable risk-off asset – inflation-linked bonds. Prospective returns are likely to be materially lower if one assumes recent yield falls are temporary and that expected yields are unchanged in the medium term. If we assume that bond yields are nearing effective lower bounds the allocation goes down further still – the correlation offset they provide to equities is reduced because in many future states of the world, yields can fall no further even though equities could fall. In other words, they cease to provide ballast. Finally, inflation-linked bonds may become the preferable risk-off asset, rather than nominal bonds if de-globalization and supply chain changes pick up pace, governments are loosening the budget reins, and inflation begins to emerge. Investors should be mindful of the implementation challenges in making shifts. The market for inflation-linked bonds is less deep and liquid than that of nominal bonds, and not all nominal bonds have inflation-linked counterparts.

Secondly, equities remain a sizeable allocation, and we would be neutral to overweight relative to a portfolio designed at end December 2019. Many portfolios have below-benchmark exposure to equities after the sell off. We do not envisage a repeat of the global financial crisis. We favor rebalancing back up to starting levels rather than dialing down risk. This conclusion holds even in our alternative scenario of supply chain reform leading to falling margins and weaker earnings growth. Equities remain a key source of return, though their case is less strong in this alternative scenario.

The case for corporate credit is more nuanced. For the last few years, we have been underweight credit assets in strategic portfolios, as a barbell of equities and treasuries was preferable in a late-cycle environment and given prevailing spread levels. The sizeable spread widening is clouding this view. Absolute returns look more attractive now, and the potential benefit this offers could offset some of the increased risk of a spike in defaults and downgrades. Yet we could see spreads remain particularly volatile in the near term, particularly in high yield. The sharp dislocation in oil prices also muddies the outlook for high yield given the energy sectors’ heavy weight in benchmark indices.

Philipp Hildebrand
Vice Chairman, BlackRock
Jean Boivin
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