Portfolio Perspectives

Confusion yields opportunity

  • BlackRock Investment Institute

Our strategic asset preferences for equities over nominal government bonds and credit have been positioned for the new market regime we flagged in our 2022 Global Outlook. We see this regime being driven by investors demanding greater compensation, or term premium, for the risk of holding government bonds and our expectation for higher inflation in the medium term. It reinforces a significant reallocation to equities and away from government bonds that has only just begun, in our view.

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Our latest strategic views

We are now in a fundamentally different market regime from the one we’ve seen over the past decade – one driven by higher supply-driven inflation and a more muted cumulative central bank response to such inflation. This macro backdrop – already baked into our capital market assumptions (CMAs) - reinforces a significant asset reallocation in favor of equities and away from fixed income that our strategic asset preferences have already been positioned for. The dislocations in markets so far in 2022 - driven by an adjustment to this regime shift and by near-term confusion stemming from the unusual economic restart, a surge in inflation and new central bank frameworks – presents long-term investors with a strategic opportunity to bump up equity allocations. We add to our developed market equity overweight following their year-to-date selloff and keep our strong underweight to nominal government bonds. See the chart on the left below.

The chart on the left shows that we add to our developed market equity overweight and keep our strong underweight to nominal government bonds. The right chart shows markets pricing in faster Fed rate hikes.

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Source: BlackRock Investment Institute, February 2022. The chart on the left shows our asset views on a 10-year view from an unconstrained U.S. dollar perspective against a long-term equilibrium allocation. Global government bonds and EM equity allocations include respective China assets. Income private markets comprise infrastructure debt, direct lending, real estate mezzanine debt and US core real estate. Growth private markets comprise global private equity buyouts and infrastructure equity. The allocation shown is hypothetical and does not represent a real portfolio. It is intended for information purposes only and does not constitute investment advice

The speed of the market’s repricing upwards of the path of interest rate hikes over the next two years – most notably at the Fed but also to varying degrees across other major DM central banks such as the European Central Bank (ECB) – has been striking. The swiftness of the move has sparked confusion – exacerbated by mixed messages from central banks themselves – about what is guiding their policy. The Fed appears to have effectively abandoned its prior guidance that it would wait until it reaches its “broad and inclusive” full employment objective before starting to raise rates. In doing so, it has lost an anchor for policy expectations and contributed, in our view, to the speed of the market’s repricing of the rate path over the next two years. The pace of the repricing has weighed on equity markets, adding to some investors’ concerns around slowing growth and potential erosion of profit margins as inflationary pressure build.

The confusion gripping markets can persist over the near-term – indeed, the repricing of the ECB's rate path occurred after 24 January cut-off date for this CMA update. On a strategic horizon of five years and beyond, we believe fundamentals will matter more, spurring us to take advantage of the recent selloff add to our DM equity overweight. It is not strange that the central banks should want to get back policy to neutral and away from emergency measures – and do so quickly – as the restart does not require stimulus. Yet we believe what we are seeing for the Fed in particular is a re-timing of rate rises and not a re-assessment of how far rate rises are going to go this cycle. The chart on the top right contrasts market pricing of short-term (orange line) and long-run rate expectations (yellow line). Market expectations and the Fed’s own projections of cumulative rate hikes – key for asset valuations - have remained stable at historically low levels through the repricing at the front-end. We believe central banks will ultimately choose to live with inflation. Why? The unusual supply-driven nature of inflation means fighting such inflation aggressively with monetary policy will dent growth while doing little to address the underlying cause. This suggests a muted policy response that keeps real rates relatively low and supportive of risk assets. We expect supply triggered inflation to last far beyond the restart. Why? We see the transition to reach net zero carbon emissions by 2050 completely rewiring the global economy and altering supply-demand patterns across sectors.

We believe bond markets are not fully pricing in higher medium-term inflation. We expect higher term premium to become a driver of higher nominal yields. This is also why we prefer and remain strongly overweight inflation-linked bonds. Our central case is for nominal yields to continue to rise. Yet they remain close enough to lower bounds to limit the effectiveness of DM government bonds as portfolio ballast. Meanwhile, China continues to stand out. In contrast to DM economies, the policy stance in China has become markedly dovish as policymakers look to counter the economic hit from new virus strains amid the Winter Olympics. We remain modestly overweight Chinese assets in strategic allocations, and like Chinese government bonds in particular for both returns and diversification.

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An opportunity to add to equities

Confusion over the restart, new virus strains, supply-driven inflation and new central bank frameworks has been evident in markets through January. Alongside the pace of rates pricing, this confusion has weighed on equity markets. The swift repricing in the path of short rates has sparked a surge in bond yields and triggered a rotation away from long-duration sectors such as tech that have dominated equity markets over the past decade. For long-term investors, we see this selloff as a mispricing to exploit by adding to equity positions. We believe equity markets are not making the distinction between the repricing in the near-term path of policy rates – which has been sharp yet has a limited impact on long-term expected returns – and the muted change in long-run rate expectations – far more important for equity valuations and returns.

The value of an equity is based on the future value of cash flows – the vast majority of that value lies beyond 2022 or 2023, in our view. This means a higher discount rate in those years but not further out should, all else equal, have only a limited impact on long-term equity valuations. In our CMAs, certain key sectors – such as tech and communications - have become more attractive now than they were prior to the equity market sell-off, and our higher allocation to equities overall reflects a larger share of these sectors in our portfolios.

In a whole-portfolio context, the valuation argument has implications beyond public equities. In our paper the core role of private markets in modern portfolios, we emphasized that prevailing market conditions should dictate the split between public and private assets rather than a pre-determined split. We determine the attractiveness of private versus public markets independently every quarter. The relative attractiveness of public equity, and, as we’ll discuss in the next page the relative unattractiveness of public fixed income influences our private market allocations. Today, we prefer to access credit exposures via private markets, and on a relative basis, prefer to access equity exposures publicly. Importantly, however, our relative underweight to private equity should not be seen as a recommendation to sell private equity allocations or abandon long-standing funding programmes. We believe private growth assets should play a sizeable role in any institutional asset allocation eligible to hold such assets. Yet in a hypothetical scenario of designing a portfolio from scratch today, we believe such assets would play a lesser role than they did due to the increased attractiveness of public equity.

The bottom-line: The bigger picture is little changed amid the volatility of the past month. The sum total of expected rate hikes - key for asset valuations - has not moved much. That means publicly traded equities have become even more attractively valued than they were after their recent drop, leading to our upgrade. We find the public equities particularly appealing relative to growth private markets where the repricing we describe above has not occurred, in our view.

The left chart shows that price-to-earnings ratios in the U.S. and Europe may appear expensive but the right chart shows that the equity risk premium suggests that equities are valued fairly.

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index . Past performance is not a reliable indicator of future results. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, February 2022. Notes: The chart on the left shows forward 12-month price-to-earnings (PE) ratios and the equity risk premium with historical ranges since 1995 for the MSCI U.S.A and MSCI Europe indices. We calculate the equity risk premium using an implied cost of capital approach (Li et al, 2013. We use a discounted cashflow model and take today’s market price and expectations of future dividends and growth and interest rates to arrive at an implied equity risk premium. A price-to-earnings ratio above the mean suggests the index is more richly valued than history while an equity risk premium above the mean suggests the opposite as it shows the extra compensation investors are demanding to hold the index.

Lower bounds still matter for bonds

Nominal government bonds have become less expensive since our last update, as yields have backed up. Yet we remain convinced in our underweight to nominal DM government bonds even after the backup in yields we have witnessed in recent months. Why? Two key reasons: first, we see yields as being close enough to effective lower bounds that bonds’ role as portfolio ballast remains challenged and second, we believe we are seeing a re-assessment of fixed income risk in markets as term premium – or the extra compensation investors demand to hold long-term bonds – is restored. We believe there is further to go on the term premium, keeping our central estimate for expected returns low.

Given the move in yields, a valid question is whether they are sufficiently far away from effective lower bounds for them not to matter. Perhaps yes, for investors focused on short time horizons. But for investors building strategic horizon portfolios, history and our estimates uncertainty around the path of returns going forward suggest not. Take the outlook for the U.S. Treasuries all-maturities index. When building a 10-year portfolio, the question 'do lower bounds matter?' effectively means asking what is the probability of falling around 150 basis points - the current average yield to maturity of the Bloomberg U.S. Treasuries index, as of 24 January 2022 - over the next 10 years. Data from Federal Reserve of St. Louis shows that since 1969 yields were 150 basis points below their starting levels five years later on 36% of the days over the whole period even after accounting for any structural decline in rates over time. See table below. Even when we adjust this data to allow for the structural decline in yields in recent decades, the number is 26%. See the table below. That means based on history alone, we would expect more than a quarter of our return pathways to be impacted by the lower bound over a 10-year horizon.

Lower bounds still in range

No. of days yields fell 150 basis point from starting level

Period Percentage of days over 5-year horizon Percentage of days over 10-year horizon
1969-2022 (adjusted for structural decline in interest rates) 16% 26%
1985-2022 (adjusted for structural decline in interest rate) 8% 8%
1969-2022 (unadjusted) 20% 36%
1985-2022 (unadjusted) 21% 42%

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index . Past performance is not a reliable indicator of future results. Source: BlackRock Investment Institute, Federal Reserve of St. Louis, with data from Refinitiv Datastream. February 2022.Notes: The table shows the percentage of days yields fell below their starting level by 150 basis points or more from their starting levels over 5- and 10-year rolling periods

But historical performance can be thought of as just one of multiple unknown pathways that asset prices might take going forward. The market environment of past few months has underscored the importance of incorporating uncertainty in return estimates – and sharply brought into focus the idea that historical performance may not be much of a guide for future returns. Our approach to portfolio construction is based on achieving resilience in worst-case outcomes. We simulate thousands of potential return pathways around our central estimate and provide a “term structure” of returns over different time horizons – from five years out to the long-term. In our simulations, these worst-case outcomes are ones where risk assets such as equities do poorly. This could be, hypothetically, a recession - a plausible scenario over a 10-year year period. This is precisely when portfolio ballast will be needed. Yet it is in these same simulations where lower bounds on bond yields may be breached as yields fall again in response to accommodative monetary policy that has been employed to counter downturns and market shocks. See our April 2019 paper Understanding uncertainty for more on our approach to incorporating uncertainty.

The bottom line: we keep our strong strategic underweight to government bonds even after the recent back-up in yields. Our central case assumes yields keep rising – driven in part by the return of term premium. See the chart below on the right for our estimates of where U.S. Treasury yields will be in five years’ time relative to market estimates. That means our expected returns remain low relative to other asset classes, and the ability of government bonds to act as risk-off diversifiers due to proximity of yields to effective lower bounds over a strategic horizon.

Steeper curves ahead

U.S. yield curve vs. estimates, Feb 2022

The chart shows that a steeper U.S. yield curve is expected.

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index . Past performance is not a reliable indicator of future results. Source: BlackRock Investment Institute, Federal Reserve of St. Louis, with data from Refinitiv Datastream. February 2022. Notes: We use the daily market yield data for 7-year Constant Maturity U.S. Treasury Securities from the FRED database maintained by the Federal Reserve Bank of St. Louis. We use the 7-year constant maturity to reflect the average duration of the Bloomberg all-maturity U.S. Government index but choose the FRED data to get a significantly longer history than we would get with index data. The analysis is conducted on both an adjusted - accounting for a structural decline in rates over the sample period - and unadjusted basis. We make the adjustment to isolate instances of "pure" yield volatility, or those drops of 150 basis points or more that were not due to structural changes such as changes in policy rates over the sample period. The chart on the right shows compares our estimate of the shape of the U.S. yield curves in five years’ time with market-pricing implied projection and the spot yield curve as of 24 January 2022.

Jean Boivin
Head, BlackRock Investment Institute
Ed Fishwick
Global Co-head of Risk and Quantitative Analysis, BlackRock
Vivek Paul
Senior Portfolio Strategist, BlackRock Investment Institute
Natalie Gill
Portfolio Research, BlackRock Investment Institute
Christian Olinger
Portfolio Research, BlackRock Investment Institute