Portfolio perspectives

The new nominal: Just getting started

25-May-2021
  • BlackRock

Our strategic asset positioning still tilts towards equities over credit and government bonds, even after the strong rebound we have seen since the equity market’s lows of March 2020. We like developed markets (DM) and China within equities, helped in part by the impact of incorporating climate change in our return expectations. We prefer inflation-linked bonds to developed market (DM) nominal government bonds as portfolio ballast. The lower-for-longer environment also boosts the appeal of private markets for eligible investors.

A key reason for staying the course on our strategic asset views is that we see our new nominal investment theme – that calls for a more muted response interest rates to higher inflation than in the past – playing out. The new nominal has been key to our pro-risk tactical investment views. Yet taken alongside the powerful, joint monetary-fiscal policy revolution that has dominated the Covid-19 response, it has significant implications for our strategic views as well. We see central banks, notably the Federal Reserve, leaning against sharp long-term yield rises. The upshot: we see a lower path of short-term interest rates compared with our previous expectation and current market pricing. This affects all our long-term return expectations.

A disconnect
Expectations for U.S. policy interest rates, 2021-2026

The chart shows different expectations, including our assumption, for the path of U.S. interest rates in coming years.

Forward looking estimates may not come to pass. Source: BlackRock Investment Institute, Federal Reserve and Federal Reserve Bank of New York, with data from Refinitiv Datastream, May 2021. Notes: The chart shows expectations for the federal funds rate, the Fed’s policy target. Market pricing is based on futures on the U.S. dollar Secured Overnight Financing Rate. We use the median forecast in the March 2021 Survey of Market Participants by the New York Fed. The BII assumption is part of our economic projections in our capital market assumptions. The Fed median dot plot comes from the January 2021 Summary of Economic Projections.

We update our capital market assumptions – the building blocks of our portfolio construction framework – to the end of the first quarter of 2021 to incorporate the implications of the new nominal more fully and reflect the changes in market prices and fundamentals. We see the equity risk premium – our preferred gauge of equity valuations that accounts for changes in interest rates – as in-line with historical averages, suggesting the asset class is not overvalued. By contrast, credit spreads are close to their tightest levels relative to history, underscoring our preference for equities over credit.

We don’t agree with the narrative that higher long-term yields signal bad news for equities. We believe rising yields should not matter for equity valuations if they are due to the return of term premia – the compensation investors demand for holding riskier longer-term bonds – rather than expectations of a higher policy rate path. We believe higher term premia in a backdrop of a strong economic restart do not challenge equity valuations.

Markets appear skeptical about the Fed’s ability to hold its ground and keep interest rates pinned near zero. Accelerating growth and higher inflation have caused a large gap to open up between current market pricing and consensus expectations for the path of interest rates. Such a gap suggests the federal funds rate, the Fed’s policy rate, would start rising much sooner than Fed officials’ own projections. Markets have pulled forward their rate hike expectations to late 2022 – a time frame we believe is inconsistent with the high bar the Fed has set. We believe the Fed is likely to start raising rates later than markets expect and more gradually than markets expect. The chart below contrasts our expectations with previous rate hiking cycles.

More gradual rate hikes
Past and expected U.S. rate hike cycles

 

The chart shows our expectation of the path of U.S. interest rates compared with historical rate hike cycles.

Forward looking estimates may not come to pass. Source: BlackRock Investment Institute, Federal Reserve and Federal Reserve Bank of New York, with data from Refinitiv Datastream, May 2021. Notes: The chart shows the path of Fed rate hike cycles since the 1990s  (dotted lines) measured in quarters since the first hike and normalized to 0% at the point the Fed started raising rates for comparison purposes. The actual Fed policy rate at the start of each cycle were as follows:2.96% in 1993, 4.68% in 1998, 1% in 2004, 0.12% in 2016.  The orange line shows our assumed path over the next 3 years based on our views on Fed’s policy framework and macro assumptions.

Why the disconnect between the market and our expectations? We see two reasons. First, investors may be over-extrapolating from near-term growth and inflation data amid the powerful economic restart. We view the Covid shock as more akin to a natural disaster followed by a rapid “restart” – instead of a traditional business cycle recession followed by a “recovery.” That implies the huge near-term growth spurt will be transitory. And second, we believe many are still wedded to the central bank’s old policy framework and may underestimate the central bank’s commitment to meeting its inflation goals.

The new nominal has implications beyond policy rates and the path of short-term interest rates. We believe the rise in nominal government bond yields – the U.S. 10-year Treasury yield jumped 80 basis points over the first quarter – is justified. Rising yields reflect both financial markets and the Federal Reserve waking up to the reality of the strong, vaccine-driven activity restart – more powerful than a typical recovery – and large-scale fiscal spending becoming more concrete. Yet so far the rise in long-term U.S. Treasury yields – while quick – is more muted than typically seen in response to rising inflation and growth expectations in the past. Such market behaviour is typical of the new nominal dynamic that we expect to prevail in coming years.

Lower for longer
U.S. spot yield curve vs market and BlackRock estimates

The chart shows our expectation of the shape of the U.S. yield curve five years from now compared with market expectations.

Forward-looking estimates may not come to pass. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, May 2021. Notes: The chart shows the spot U.S. yield curve (green line) as of March 31, 2021 and estimates of what the curve might look like five years from now. The market-implied projection (yellow line) is derived from the spot rate using the forward rate formula. The dotted orange line shows our assumption of the shape of the yield curve in five years time.

The interaction of monetary and fiscal policy is critical. We believe there is greater willingness from the central banks to quell rising government bond yields. Why? We see a strong incentive for policymakers to keep interest costs low to ensure the viability of surging debt burdens that were necessary to cushion the impact of the Covid shock. Even as long-term yields have risen this year, we see them topping out in five years’ time at lower levels than previously assumed. Their proximity to the effective lower bound, or the natural limits to how far long-term yields can drop, curtails the ability of DM nominal government bonds to act as portfolio ballast. Also, the blurring of monetary and fiscal policy – without proper guardrails – raises the risk of diminished central bank independence and uncontrolled fiscal spending.

The relatively relaxed attitude to rising debt stems in large part due to low prevailing interest rates. In the US, debt is poised to reach a record level of 135% of GDP based on IMF forecasts, twice as high as in the 1990s, but financing costs are only half what they were then as a share of GDP.

Eyes on the debt burden
U.S. interest cost estimates, 1990-2025

The chart shows historical and expected U.S. interest costs

Forward-looking estimates may not come to pass. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, May 2021. Notes: The chart shows : Interest payments are calculated as the difference between U.S. general government net borrowing and U.S. general government primary deficit and expressed as a share of nominal GDP. The first scenario in red shows hypothetical interest costs assuming that the effective interest rate on the existing debt stock rises quickly to 2.5% and holds there over the next four years. The second scenario shows the hypothetical impact of a more gradual rise to 2.5% by 2025. Hypothetical data results are based on assumptions applied retroactively with the benefit of hindsight, were not made under actual market conditions and, therefore, cannot completely account for the impact of economic risk. Actual results may differ.

The spike higher in bond yields this year has spurred comparisons with the 2013 “taper tantrum” when a suggestion that the Fed would slow its asset purchases stoked fears of a stalling economic recovery, leading to a sharp selloff in equities. The chart below shows how the drivers of this year’s yield rise are very different. In 2013, it was a sharp repricing of the Fed’s projected rate path via higher real rates. Now it is a higher term premium – or the premium investors typically demand to hold riskier long-term government bonds – driven partly by greater uncertainty around inflation. This dynamic of low short rates alongside a powerful restart underpins our preference for equities over debt.

Not stretched
BlackRock estimate equity risk premium vs. history

the chart shows our estimates of the equity risk premium for major regions compared to their 25-year history.

Past performance is no guarantee of future results. Source: BlackRock Investment Institute, with data from Refinitiv Datastream, April 2021. Notes: The chart shows the equity risk premium and historical ranges since 1995 for major equity regions based on respective MSCI indices. We calculate the equity risk premium based on our expectations for nominal interest rates and the implied cost of capital for each equity markets.

Our belief that the move in bond yields is driven by rising term premia rather than expectations of higher policy rates is one reason why we don’t see the current rise in yields as detrimental to equities. Changes in term premia reflect duration risk and do not have direct implications for equity prices, in our view. Structural shifts such as persistently lower interest rates make it difficult to judge the signals from traditional metrics such as price-to-earnings ratios. Such metrics may suggest equities are overvalued yet fail to take into account the prevailing interest rate environment. We use the equity premium (ERP) – or the expected return of equities over the risk-free rate – as our preferred gauge. This approach helps us assess valuations across different interest rate environments and also accounts for the growth outlook.

The chart above shows our estimates of the ERP for major equity markets relative to their history since 1995. All, expect Japan, are still above the historical median, underscoring our view that equities do not appear overvalued. See our global outlook for more. We believe a term premium tantrum in the current environment would imply a further shift away from allocations to DM government bonds– and could reinforce the strong performance of cyclical equity sectors rather than destabilizing broader risk assets.

Philipp Hildebrand
Vice Chairman, BlackRock
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Jean Boivin
Head of BlackRock Investment Institute
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Simona Paravani-Mellinghoff
Global Head of Investments, BlackRock Client Portfolio Solutions
Ed Fishwick
Global Co-head of Risk and Quantitative Analysis, BlackRock
Elga Bartsch
Head of Macro Research, BlackRock Investment Institute
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Vivek Paul FIA
Senior Portfolio Strategist, BlackRock Investment Institute
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Natalie Gill
Portfolio Research, BlackRock Investment Institute
Christian Olinger
Chief Fixed Income Strategist, BlackRock Investment Institute