BLACKROCK INVESTMENT INSTITUTE

Downgrading government bonds

22.feb.2021
  • BlackRock

We broaden our tactical pro-risk stance in light of major developments since the publication of our 2021 outlook in December: the vaccine rollout and up to $2.8 trillion of additional US fiscal spending this year. Inflation expectations have risen sharply while real rates are steady in negative territory. We prefer equity over credit and turn underweight government bonds – in line with our strategic views.

Key points

Refreshed views
Recent developments lead us to refresh our asset views, including a broadening of our cyclical tilt and a tactical downgrade to government debt and credit.
Market backdrop
Rising inflation expectations have driven up US 10-year Treasury yields but to a lesser degree than in the past. Real yields were steady in negative territory.
Data watch
US consumer confidence data this week could bolster the expectation for a vaccine-led restart after retail sales rebounded strongly in January.
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Chart of the week
US retail sales during past recessions and the Covid shock

US retail sales during past recessions and the Covid shock

Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, February 2021. Notes: The chart compares the path of total US retail sales during business cycle contractions with that during the Covid shock. Retail sales are rebased to 100 at the peak of each business cycle as defined by the National Bureau of Economic Research (NBER). The grey area shows the range based on cycles starting with 1969. The Covid shock line is rebased to 100 at February 2020.

Our new nominal theme – which flags a more muted response in nominal bond yields to rising inflation than in the past – has played out since last year. A 1% increase in 10-year US breakeven inflation rates – a measure of market inflation expectations – has typically led to 0.9% rise in 10-year Treasury yields since 1998, we estimate. Yet since last March breakeven inflation has climbed 1.2%, and nominal yields are up just 0.5%. Inflation-adjusted yields, or real yields, have fallen further into negative territory as a result. The different nature of the Covid shock means activity has restarted much faster than seen in past business cycle recessions – and implies unusually high growth rates as a vaccine-led re-opening unfolds. The surprising jump in January US retails sales may offer a glimpse of things to come. See the chart above. Fresh US fiscal spending is turbocharging the restart, with recent pandemic relief payments explaining some of the retail sales boost. Further spending will ensure another wave of support, in our view.

We expect a strengthening economy, a huge fiscal impulse and rising inflation to further drive up nominal yields this year, albeit by less than in similar periods in the past. We expect central banks to lean against any market concerns around rising debt levels and to keep interest rates low for now. Yet if the narrative on high debt levels, combined with rising inflation, were to change, it could eventually undermine the markets’ faith in the low-rate regime – with implications across asset classes.

We have downgraded government bonds to underweight on a tactical basis, with an increased underweight in US Treasuries. We also downgrade euro area peripheral bonds to neutral, as peripheral yields have fallen to near record lows and spreads have narrowed. We downgrade credit to neutral on a tactical horizon, as spreads have narrowed to historical lows, but still like high yield for its income potential. 

Tactically, we now prefer equities over credit, as equity valuations appear more attractive. We also broaden our cyclical tilt: We are upgrading European equities to neutral, as we see room for the market to close its valuation gap versus the rest of the world with the restart becoming more entrenched. Yet the slow vaccine rollout and more muted fiscal support weigh. We debut an overweight call on UK equities in the wake of Brexit. We stay overweight US and emerging market (EM) equities, and underweight Japan, where we expect lower risk-adjusted returns.

Over a strategic horizon, we also prefer equities over credit. We turn underweight credit due to rich valuations and are now modestly overweight equities. This preference stems from incorporating the effects of climate change in our long-term expected returns. We see developed market equities best positioned to capture the opportunities from the climate transition – particularly on a sector level where we see material effects on expected returns. Equities valuations are also closer to long-term averages after factoring in historically low interest rates and an improving earnings outlook.

The bottom line: We expect our new nominal theme of stronger growth and a muted response in nominal bond yields to higher inflation to further play out, even after significant market moves. This supports our tactically pro-risk stance. A key risk is a further increase in long-term yields as markets grapple with an economic restart that could beat expectations. This could spark bouts of volatility, even though we believe the Fed would lean against any sharp moves for the time being.

Travel controls
What do Covid-19 strains mean for the economic restart? Read more in our Macro insights.
Eyes on inflation

Assets in review
Selected asset performance in the past 12 months

Selected asset performance in the past 12 months

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged It is not possible to  invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, February 2021. Notes: The two ends of the bars show the lowest and highest returns at any point this 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 US dollars, and the rest in local currencies. Indexes or prices used are: spot gold, Datastream 10-year benchmark government bond (US , German and Italy), MSCI USA Index, Bank of America Merrill Lynch Global Broad Corporate Index, MSCI Emerging Markets Index, J.P. Morgan EMBI index, Bank of America Merrill Lynch Global High Yield Index, the ICE US Dollar Index (DXY), MSCI Europe Index and spot Brent crude.

US 10-year Treasury yields hit the highest levels in nearly a year. Nominal yields have been climbing since September, but the magnitude has lagged that of the rise in inflation expectations during the period. Inflation-adjusted yields have been stable in negative territory – in line with our new nominal theme. US stocks hit new high on fiscal stimulus hopes. Crude oil prices rose to the highest levels in over a year as a rare cold snap hit oil production in Texas, the biggest oil-producing state in the US

Week ahead

Feb. 22 - Germany’s ifo Business Climate Index
Feb. 23 - US consumer confidence

Sentiment data in the US and Europe could shed light on the status of the activity restart. US consumer confidence data could further bolster the expectation for a forceful restart, after January’s retail sales data rebounded sharply after households received additional pandemic relief payment.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, February 2021

Legend Granular

Asset Strategic view Tactical view
Equities Strategic equities - neutral Tactical view - neutral
We turn overweight equities on a strategic horizon. We see a better outlook for earnings amid moderate valuations. Incorporating climate change in our expected returns brightens the appeal of developed market equities given the large weights of sectors such as tech and healthcare in benchmark indexes. Tactically, we stay overweight equities as we expect the restart to re-accelerate and interest rates to stay low. We tilt toward cyclicality and maintain a bias for quality.
Credit Strategic equities - neutral Tactical view - neutral
We are underweight credit on a strategic basis as valuations are rich and we prefer to take risk in equities. On a tactical horizon, we downgrade credit to neutral following the tightening in spreads, particularly investment grade. We still like high yield for income.
Govt Bonds Strategic equities - neutral Tactical view - neutral
We are strategically underweight nominal government bonds as their ability to act as portfolio ballasts are diminished with yields near lower bounds and rising debt levels may eventually pose risks to the low-rate regime. This is part of why we underweight government debt strategically. We prefer inflation-linked bonds as we see risks of higher inflation in the medium term. We turn underweight duration on a tactical basis as we anticipate gradual increases in nominal yields supported by the economic restart.
Cash Tactical view - neutral Tactical view - neutral
We use cash to fund overweight in equities. Holding some cash makes sense, in our view, as a buffer against supply shocks driving both stocks and bonds lower.
Private markets Strategic equities - neutral Tactical view - neutral
Non-traditional return streams, including private credit, have the potential to add value and diversification. Our neutral view is based on a starting allocation that is much larger than what most qualified investors hold. Many institutional investors remain underinvested in private markets as they overestimate liquidity risks, in our view. Private markets are a complex asset class not suitable for all investors.

Note: Views are from a US dollar perspective, February 2021. 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, February 2021

Legend Granular
Equities

Asset Tactical view
United States United States
We are overweight US equities. We see the tech and healthcare sectors offering exposure to structural growth trends, and US small caps geared to an expected cyclical upswing in 2021.
Europe
Europe
We are underweight European equities. The market has relatively high exposure to financials pressured by low rates. It also faces structural growth challenges, even given potential for catch-up growth in a vaccine-led revival.
Japan
Japan
We are underweight Japanese equities. Other Asian economies may be greater beneficiaries of more predictable US trade policy under a Biden administration. A stronger yen amid potential US dollar weakness may weigh on Japanese exporters.
Emerging markets Emerging markets
We are overweight EM equities. We see them as principal beneficiaries of a vaccine-led global economic upswing in 2021. Other positives: our expectation of a flat to weaker US dollar and more stable trade policy under a Biden administration.
Asia ex-Japan Asia ex-Japan
We are overweight Asia ex-Japan equities. Many Asian countries have been more effective at containing the virus – and are further ahead in the economic restart. We see the region’s tech orientation allowing it to benefit from structural growth trends.
UK Emerging markets
We are overweight UK equities. The removal of uncertainty over a Brexit deal should see the risk premium on UK assets attached to that outcome erode. We also see UK large-caps as a relatively attractive play on the global cyclical recovery as it has lagged peers.
Momentum Momentum
We keep momentum at neutral. The factor has become more exposed to cyclicality, could face challenges in the near term as a resurgence in Covid-19 cases and a slow start to the vaccination efforts create potential for choppy markets.
Value
Value
We are neutral on value despite recent underperformance. The factor could benefit from an accelerated restart, but we believe that many of the cheapest companies – across a range of sectors – face structural challenges.
Minimum volatility Minimum volatility
We are underweight min vol. We expect a cyclical upswing over the next six to 12 months, and min vol has historically lagged in such an environment.
Quality
Quality
We are overweight quality. We like tech companies with structural tailwinds and see companies with strong balance sheets and cash flows as resilient against a range of outcomes in the pandemic and economy.
Size
Size
We are overweight the US size factor. We see small- and mid-cap US companies as a key place where exposure to cyclicality may be rewarded amid a vaccine-led recovery.

Fixed income

Asset Tactical view
US Treasuries U.S. Treasuries
We are underweight US Treasuries. We see nominal US yields rising but largely due to a repricing higher of inflation expectations. This leads us to prefer inflation-linked over nominal government bonds.
Treasury Inflation-Protected Securities Treasury Inflation-Protected Securities
We are overweight TIPS. We see potential for higher inflation expectations to get increasingly priced in on the back of structurally accommodative monetary policy and increasing production costs.
German bunds
Europe
We are neutral on bunds. We see the balance of risks shifting back in favor of more monetary policy easing from the European Central Bank as the regional economic rebound shows signs of flagging.
Euro area peripherals Japan
We are closing our overweight to euro peripheral bond markets that we have held since April 2020. Yields have rallied to near record lows and spreads have narrowed. The ECB supports the market but it is not price-agnostic - its purchases have eased as spreads have narrowed.
Global investment grade Global investment grade
We are underweight investment grade credit. We see little room for further yield spread compression and favor more cyclical exposures such as high yield and Asia fixed income.
Global high yield
Global high yield
We are moderately overweight global high yield. Spreads have narrowed significantly, but we believe the asset class remains an attractive source of income in a yield-starved world.
Emerging market - hard currency Emerging market - hard currency
We are neutral hard-currency EM debt. We expect it to gain support from the vaccine-led global restart and more predictable US trade policies.
Emerging market - local currency Value
We are neutral local-currency EM debt. We see catch-up potential as the asset class has lagged the risk asset recovery. Easy global monetary policy and a stable-to-weaker US dollar should also underpin EM.
Asia fixed income
Asia fixed income
We are overweight Asia fixed income. We see the asset class as attractively valued. Asian countries have done better in containing the virus and are further ahead in the economic restart.

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.

 


Read details about our investment themes and more in our 2021 Global outlook.

Growth edges up

 

We see a more muted response of government bond yields to stronger growth and higher inflation than in the past, as central banks lean against any sharp yield rises. This should support risk assets, even as the restart takes shape.

    • Medium-term inflation risks look underappreciated. Production costs are set to rise amid the rewiring of global supply chains. Central banks appear more willing to let economies run hot with above-target inflation to make up for past undershoots. They may also face greater political constraints that make it harder to lean against inflation.
    • The policy revolution has led to a surge in public debt – and increased tolerance for it. We don’t see high debt levels as a concern in the near term. Yet there are risks bubbling below the surface – over time we could see a change in the premium for the perceived safety of government debt, with major market implications.
    • Market implication: We favor inflation-linked bonds amid inflationary pressures in the medium term. Tactically we prefer to take risk in equities over credit amid low rates and tight spreads.
Policy Pause

 

Covid-19 has accelerated geopolitical transformations such as a bipolar US-China world order and a rewiring of global supply chains, placing greater weight on resilience.

    • Strategic US-China rivalry looks here to stay, particularly in tech. The Biden administration is likely to shift away from a focus on bilateral trade deficits to a multi-lateral approach. It will also seek to balance cooperation on climate change and public health within a broader US-China agenda that includes areas of potential heightened tensions such as trade and human rights.
    • We see assets exposed to Chinese growth as core strategic holdings that are distinct from EM exposures. There is a clear case for greater exposure to China-exposed assets for returns and diversification, in our view.
    • We expect persistent inflows to Asian assets as many global investors remain underinvested and China’s weight in global indexes grows. Risks to China-exposed assets include China’s high debt levels, yuan depreciation and US-China conflicts. But we believe developments have been incrementally positive over the past 12 months, and investors are well compensated for these risks.
    • Market implication: Strategically we favor deliberate country diversification and above-benchmark China exposures. Tactically we like Asia ex-Japan equities, and see UK equities as an inexpensive, cyclical exposure.
Raising resilience

 

The pandemic has added fuel to pre-existing structural trends such as an increased focus on sustainability, rising inequality within and across nations, and the dominance of e-commerce at the expense of traditional retail.

    • The pandemic has focused attention on underappreciated sustainability-related factors and supply chain resilience.
    • It has also accelerated “winner takes all” dynamics that have led to the outperformance of a handful of tech giants in recent years. We see tech as having long-term structural tailwinds despite its increased valuations, yet it could face challenges from higher corporate taxes and tighter regulation under a united Democratic government.
    • The pandemic has heightened the focus on inequalities within and across countries due to the varying quality of public health infrastructure – particularly across EMs – and access to healthcare.
    • Market implication: Strategically we see returns being driven by climate change impacts, and view developed market equities as the asset class best positioned to capture the opportunities from the climate transition. Tactically we favor tech and healthcare as well as selected cyclical exposures.
 Jean Boivin
Head – BlackRock Investment Institute
Elga Bartsch
Head of Macro Research — BlackRock Investment Institute
Vivek Paul
Senior Portfolio Strategist – BlackRock Investment Institute
Scott Thiel
Chief Fixed Income Strategist -BlackRock Investment Institute

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