Seizing on fixed income swings
Market take
Weekly video_20241028
Michel Dilmanian
Opening frame: What’s driving markets? Market take
Camera frame
Rising yields for U.S. short-term Treasuries and tightening credit spreads are two recent market swings that reinforce our fixed income views.
Title slide: Seizing on fixed income swings
1: Staying underweight short-term Treasuries
We had leaned against markets pricing in sharp interest rate cuts by the Federal Reserve.
Markets have since priced out some rate cuts as solid economic data has quelled recession fears. That has driven short-dated bond yields sharply higher.
Markets are now closer to our U.S. policy expectations. Yet we think even more cuts could be priced out. This supports our underweight to short-dated U.S. Treasuries.
2: Long-term Treasury yields staying higher
Higher inflation is why we’ve been expecting investors to demand more compensation for the risk of holding longer-dated bonds. We see that starting to play out.
Yet we stay neutral long-dated U.S. Treasuries in the near term as yields can swing in either direction.
3: Preferring European fixed income
After an initial dip, UK yields rose alongside global yields last week.
Yet we think gilt yields can fall further relative to other major government bond yields. A tough growth outlook means the Bank of England could cut rates more than the Fed.
We also think euro area investment-grade and high-yield credit better compensate investors for risk than their U.S. counterparts.
Outro: Here’s our Market take
We favor European credit over U.S. credit.
In the U.S., we prefer medium-term bonds for attractive income with less sensitivity to interest rate swings.
We recently went overweight UK gilts.
Closing frame: Read details: blackrock.com/weekly-commentary
Surging U.S. short-term Treasury yields and narrowing credit spreads support our preference for short- over long-dated credit and Europe over the U.S.
U.S. stocks hovered near record highs last week. U.S. two-year Treasury yields hit two-month highs as markets priced out more Fed rate cuts in line with our view.
U.S. PCE and jobs data are in focus this week. We eye whether inflation will tick up like the CPI did as services inflation starts to reflect still-high wage growth.
Recent swings in fixed income markets reinforce our preference for quality and income. U.S. high yield spreads narrowed to near their tightest in 17 years as short-dated U.S. Treasury yields surged on markets pricing out Federal Reserve rate cuts. We prefer taking risk in equities from a whole portfolio perspective, yet we see investment opportunities in fixed income – like UK gilts over U.S. Treasuries. In credit, we favor short over long maturities and Europe over the U.S.
UK yields: room to fall
Developed market 10-year government bond yields, 2019-2024
Source: BlackRock Investment Institute, with data from LSEG Datastream, October 2024. Notes: The chart shows weekly yields for benchmark 10-year government bonds in the U.S., UK and Germany.
We leaned against two big swings in recent weeks: markets pricing in sharp Fed rate cuts and a jump in UK yields. Those moves have since started unwinding, especially in short-term yields. We see room for UK gilt yields to fall further relative to other major government bond yields: A tougher UK growth outlook paves the way for the Bank of England to cut further than the Fed, in our view. After an initial dip, gilt yields rose anew along with global yields last week – reflecting jitters ahead of this week’s UK budget announcement that we think are overblown. See the chart. At the same time, U.S. markets walked back recession fears that we saw as overdone as solid economic data quelled growth concerns. Markets have slashed some rate cuts they had priced in during the August stock selloff, driving short-dated bond yields up sharply. Markets are now closer to our view but have more room to run.
Inflation will keep the Fed from cutting as much as markets expect, in our view. Services inflation has proved sticky, with wage growth running hot enough that core inflation is unlikely to cool to the Fed’s 2% target. U.S. budget deficits look set to stay large regardless of who wins the U.S. presidential election, with neither candidate prioritizing a reduction. Longer term, we see mega forces – structural shifts impacting returns now and in the future – keeping inflation persistent. Higher inflation is why we’ve been expecting investors to demand significantly more term premium, or additional compensation for the risk of holding longer-dated bonds. We’re seeing early signs of this: Term premium on U.S. 10-year Treasury yields now sits near 20 basis points, having jumped around 45 basis points in the past month alone, LSEG Datastream data show.
Our European preference
Over the long term, we think term premium can rise further. Near term, shifting narratives can cause bouts of volatility and sharp yield swings in either direction, as seen recently. We favor international long-dated government bonds over U.S. long Treasuries, where we stay neutral. In the U.S., we prefer intermediate maturities that offer attractive income with less interest rate risk. We stay underweight short-dated U.S. Treasuries on a near-term tactical horizon. We prefer UK gilts and recently went overweight. UK bond markets await this week’s UK budget announcement, the first since Labour’s victory in the July election. Markets are pricing in some chance of a repeat of the 2022 mini-budget disaster – an outcome we see as unlikely.
Our preference for European over U.S. fixed income extends to credit. U.S. high yield spreads are rich relative to the euro area, especially given a weaker ratings profile in the U.S. Adjusting for ratings quality, European high yield is about 60 basis points cheaper than U.S. high yield, GFI data show. We think euro area high yield and investment grade credit better compensate investors for risk than their U.S. counterparts. Tight U.S. credit spreads are largely due to strong investor demand for new issues outstripping supply, resilient corporate balance sheets and strong macro data snuffing out lingering recession fears.
Our bottom line
Macro uncertainty is driving sharp interest rate swings, making long-dated government bonds less reliable portfolio diversifiers. Yet such swings and the return of total income in bonds creates investment opportunities we seize on.
Market backdrop
U.S. stocks hovered near record highs last week. Tesla’s share surge after its Q3 corporate earnings sets the stage for mega-cap tech earnings this week. Tech shares rebounded while small caps slid nearly 2% heading into the U.S. election. U.S. two-year Treasury yields hit two-month highs as markets priced out some Fed cuts in line with our view. U.S. 10-year Treasury yields touched three-month highs to near 4.19%, up nearly 60 basis points from September’s 16-month lows.
The focus is on the U.S. core PCE and jobs data this week. The core PCE – the Fed’s preferred inflation gauge – had been cooling as immigration has expanded the labor supply, and services inflation recently fell well below wage growth. CPI data for September suggested that services inflation measured by PCE could start to tick up given recent robust wage growth. The October jobs data should show still healthy payroll gains and still-solid wages.
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 LSEG Datastream as of Oct. 24, 2024. Notes: The two ends of the bars show the lowest and highest returns at any point year to date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, LSEG Datastream 10-year benchmark government bond index (U.S., 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.
U.S. GDP; euro area GDP
U.S. PCE; Bank of Japan policy decision; flash euro area inflation data
U.S. payrolls report
Read our past weekly market commentaries here.
Big calls
Our highest conviction views on tactical (6-12 month) and strategic (long-term) horizons, October 2024
Reasons | ||
---|---|---|
Tactical | ||
AI and U.S. equities | We see the AI buildout and adoption creating opportunities across sectors. We get selective, moving toward beneficiaries outside the tech sector. Broad-based earnings growth and a quality tilt make us overweight U.S. stocks overall. | |
Japanese equities | A brighter outlook for Japan’s economy and corporate reforms are driving improved earnings and shareholder returns. Yet the drag on earnings from a stronger yen and some mixed policy signals from the Bank of Japan are risks. | |
Income in fixed income | The income cushion bonds provide has increased across the board in a higher rate environment. We like quality income in short-term credit. We’re neutral long-term U.S. Treasuries. | |
Strategic | ||
Private credit | We think private credit is going to earn lending share as banks retreat – and at attractive returns relative to public credit risk. | |
Fixed income granularity | We prefer intermediate credit, which offers similar yields with less interest rate risk than long-dated credit. We also like short-term government bonds, and UK long-term bonds. | |
Equity granularity | We favor emerging over developed markets yet get selective in both. EMs at the cross current of mega forces – like India and Saudi Arabia – offer opportunities. In DM, we like Japan as the return of inflation and corporate reforms brighten our outlook. |
Note: Views are from a U.S. dollar perspective, October 2024. 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.
Tactical granular views
Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, October 2024
Our approach is to first determine asset allocations based on our macro outlook – and what’s in the price. The table below reflects this. It leaves aside the opportunity for alpha, or the potential to generate above-benchmark returns. The new regime is not conducive to static exposures to broad asset classes, in our view, but it is creating more space for alpha. For example, the alpha opportunity in highly efficient DM equities markets historically has been low. That’s no longer the case, we think, thanks to greater volatility, macro uncertainty and dispersion of returns. The new regime puts a premium on insights and skill, in our view.
Asset | Tactical view | Commentary | ||||
---|---|---|---|---|---|---|
Equities | ||||||
United States | We are overweight given our positive view on the AI theme. Valuations for AI beneficiaries are supported as tech companies keep beating high earnings expectations. We think upbeat sentiment can broaden out. Falling inflation is easing pressure on corporate profit margins. | |||||
Europe | We are underweight relative to the U.S., Japan and the UK – our preferred markets. Valuations are fair. A growth pickup and European Central Bank rate cuts support a modest earnings recovery. Yet political uncertainty could keep investors cautious. | |||||
U.K. | We are overweight. Political stability and a growth pickup could improve investor sentiment, lifting the UK's low valuation relative to other DM stock markets. | |||||
Japan | We are overweight. A brighter outlook for Japan’s economy and corporate reforms are driving improved earnings and shareholder returns. Yet the drag on earnings from a stronger yen and some mixed policy signals from the Bank of Japan are risks. | |||||
Emerging markets | We are neutral. The growth and earnings outlook is mixed. We see valuations for India and Taiwan looking high. | |||||
China | We are modestly overweight. Major fiscal stimulus may be coming and prompt investors to step in given Chinese stocks are at a deep discount to DM shares. Yet we stay ready to pivot. We are cautious long term given China’s structural challenges. | |||||
Fixed income | ||||||
Short U.S. Treasuries | We are underweight. We don’t think the Fed will cut rates as sharply as markets expect. An aging workforce, persistent budget deficits and the impact of structural shifts like geopolitical fragmentation should keep inflation and policy rates higher over the medium term. | |||||
Long U.S. Treasuries | We are neutral. Markets are pricing in sharp Fed rate cuts and term premium is close to zero. We think yields will keep swinging in both directions on incoming data. We prefer intermediate maturities less vulnerable to investors demanding greater term premium. | |||||
Global inflation-linked bonds | We are neutral. We see higher medium-term inflation, but cooling inflation and growth may matter more near term. | |||||
Euro area government bonds | We are neutral. Market pricing reflects policy rates in line with our expectations and 10-year yields are off their highs. Political uncertainty remains a risk to fiscal sustainability. | |||||
UK Gilts | We are overweight. Gilt yields offer attractive income, and we think the Bank of England will cut rates more than the market is pricing given a soft economy. | |||||
Japan government bonds | We are underweight. Stock returns look more attractive to us. We see some of the least attractive returns in JGBs. | |||||
China government bonds | We are neutral. Bonds are supported by looser policy. Yet we find yields more attractive in short-term DM paper. | |||||
U.S. agency MBS | We are neutral. We see agency MBS as a high-quality exposure in a diversified bond allocation and prefer it to IG. | |||||
Short-term IG credit | We are overweight. Short-term bonds better compensate for interest rate risk. We prefer Europe over the U.S. | |||||
Long-term IG credit | We are underweight. Spreads are tight, so we prefer taking risk in equities from a whole portfolio perspective. We prefer Europe over the U.S. | |||||
Global high yield | We are neutral. Spreads are tight, but the total income makes it more attractive than IG. We prefer Europe. | |||||
Asia credit | We are neutral. We don’t find valuations compelling enough to turn more positive. | |||||
Emerging market - hard currency | We are neutral. The asset class has performed well due to its quality, attractive yields and EM central bank rate cuts. We think those rate cuts may soon be paused. | |||||
Emerging market - local currency | We are neutral. Yields have fallen closer to U.S. Treasury yields, and EM central banks look to be turning more cautious after cutting policy rates sharply. |
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. The statements on alpha do not consider fees. Note: Views are from a U.S. 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, October 2024
Asset | Tactical view | Commentary | ||
---|---|---|---|---|
Equities | ||||
Europe ex UK | We are underweight relative to the U.S., Japan and the UK – our preferred markets. Valuations are fair. A growth pickup and European Central Bank rate cuts support a modest earnings recovery. Yet political uncertainty could keep investors cautious. | |||
Germany | We are neutral. Valuations and earnings momentum are supportive relative to peers, especially as global manufacturing activity bottoms out and ECB rate cuts ease financing conditions. | |||
France | We are underweight given modestly supportive valuations. The result of France’s parliamentary election could impact business conditions for French companies. Yet only a small portion of the revenues and operations of major French companies are tied to domestic activity. | |||
Italy | We are underweight. Valuations dynamics are supportive relative to peers, but recent growth and earnings outperformance seems largely due to significant fiscal stimulus in 2022-2023 that cannot be sustained over the next few years. | |||
Spain | We are neutral. Valuations and earnings momentum are supportive relative to other euro area stocks. The utilities sector looks set to benefit from an improving economic backdrop and advances in AI. | |||
Netherlands | We are underweight. The Dutch stock markets' tilt to technology and semiconductors, a key beneficiary of higher demand for AI, is offset by relatively less favorable valuations and a weaker earnings outlook than their European peers. | |||
Switzerland | We are underweight, in line with our broad European view. The earnings outlook has brightened, but valuations remain high versus other European markets. The index’s defensive tilt will likely be less supported as long as global risk appetite holds up, we think. | |||
UK | We are overweight. Political stability and a growth pickup could improve investor sentiment, lifting the UK's low valuation relative to other DM stock markets. | |||
Fixed income | ||||
Euro area government bonds | We are neutral. Market pricing reflects policy rates in line with our expectations, and 10-year yields are off their highs. Political uncertainty remains a risk to fiscal sustainability. | |||
German bunds | We are neutral. Market pricing reflects policy rates broadly in line with our expectations, and 10-year yields are off their highs. | |||
French OATs | We are neutral. The EU has already warned France for breaching fiscal rules and had its sovereign credit rating downgraded earlier this year. Elevated political uncertainty, persistent budget deficits and a slower pace of structural reforms remain challenges. | |||
Italian BTPs | We are neutral. The spread over German bunds looks tight given its budget deficits and debt profile, also prompting a warning from the EU. Other domestic factors remain supportive, with growth holding up relative to the rest of the euro area and Italian households showing solid demand to hold BTPs at higher yields. | |||
UK gilts | We are overweight. Gilt yields offer attractive income, and we think the Bank of England will cut rates more than the market is pricing given a soft economy. | |||
Swiss government bonds | We are neutral. The Swiss National Bank has been cutting policy rates this year amid reduced inflationary pressure. But it is unlikely to cut rates much further from here. | |||
European inflation-linked bonds | We are neutral. We see higher medium-term inflation, but cooling inflation may matter more near term. Short-term breakeven inflation rates fell further after recent inflation data, making euro area inflation-linked bonds less attractive. | |||
European investment grade credit | We are neutral European investment grade credit, with a preference for short- to medium-term paper for quality income. We maintain our regional preference for European investment grade over the U.S. given spreads are not as tight. | |||
European high yield | We are overweight. We find the income potential attractive. We still prefer European high yield given its more appealing valuations, higher quality and lower duration than in the U.S. Spreads compensate for risks of a potential pick-up in defaults, in our view. |
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 2024. 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.