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Bonds as ballast

Building portfolio resilience is crucial at a time of elevated macro uncertainty. Relatively muted cross-asset volatility suggests markets are not fully pricing in heightened geopolitical risks that threaten to weaken economic activity. We believe central banks’ dovish pivot is buying investors time to add resilience to portfolios – with government bonds playing an important role in providing ballast.


Raising resilience
Stock-bond correlations in the U.S. and euro area, 2000-2019

Stock-bond correlations in the U.S., 2000-2019
Stock-bond correlations in Europe, 2000-2019

Past performance is not a reliable indicator of current or future results.
Source: BlackRock Investment Institute, with data from Refinitiv Datastream, September 2019. Notes: The charts show the correlations between daily percentage moves for stocks and bonds over a rolling one-year period. The dot shows the correlation over the most recent 90 day period. For the United States, we use the MSCI USA index for stocks and the 10-year Treasury for bonds. For the euro area, we use MSCI Europe ex-UK index and the German 10-year bund. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index.

Themes: Government bonds play an important role in building portfolio resilience – even at low yield levels. We see them as crucial diversifiers that can help offset the impact of equity selloffs in an environment of rising macro uncertainty. We prefer U.S. Treasuries for this role due to their negative correlation with equity returns. See the chart above. European bonds may be less effective shock absorbers as euro area rates approach a lower bound.

Yet we also note that the cost of this diversification is higher, and the risk/reward tradeoff is different on a near-term horizon. On a tactical basis we prefer euro area bonds over U.S. Treasuries. A relatively steep yield curve brightens euro area sovereign bonds’ appeal even at low or negative yields. We still see markets pricing in too much U.S. easing, while the European Central Bank (ECB) exceeded market expectations. And U.S. dollar-based investors can potentially pick up an immediate yield boost after hedging euro-denominated exposures back into their home currency. Another key theme: We see central bank easing helping stretch the length of this economic cycle. This underpins our positive view on credit and other income generating assets in the near term.

Central banks: Policy rates at major central banks are falling again, backing away from neutral rates. We see the Federal Reserve cutting rates further, but not by as much as what markets are pricing in. And it’s far from certain that the Fed will try to respond to the trade war fallout with meaningfully looser monetary policy. Supply chain disruptions could deliver a hit to productive capacity that fosters mildly higher inflation even as growth slows. This complicates the case for further policy easing.

Elsewhere, the ECB materially exceeded market expectations on stimulus, launching open-ended asset purchases, cutting rates and strengthening its forward guidance. We see this broad package having a combined impact that should be greater than the sum of its parts.

Growth and inflation: Persistent uncertainty from protectionist policies is denting corporate confidence and slowing business spending. We see little near-term risk of recession, thanks to dovish central banks and a still-robust U.S. consumer. We see policy easing helping sustain the economic expansion, but the road to recovery could be a bumpy one in the near term. Easier financial conditions are being offset by the negative impact of a protectionist push – and have not yet filtered through to the broader economy. Yet we see growth troughing over the next six to 12 months as easier financial conditions filter through to the broader economy.

Our Inflation GPS points to a diverging inflation outlook. The U.S. signal suggests core inflation should remain close to the Fed’s target. In contrast, the euro area inflation outlook looks more subdued, with core inflation likely to rise from current exceptionally low levels but still fall short of the ECB’s target. In Japan, the actual pace of core inflation has caught up with the GPS, suggesting little further near-term upside from current subdued levels.

Risks: We see the protectionist push as a key driver of global markets and economy. Recent geopolitical volatility – including attacks on Saudi oil infrastructure – underscores this message from our midyear outlook. We see some possibility of a U.S.-China truce, but a comprehensive trade deal appears unlikely and geopolitical uncertainty from protectionist policies is likely to persist. We believe building portfolio resilience is critical against this backdrop, as detailed in the Q4 update to our Global investment outlook. Read more about key geopolitical risks on our BlackRock geopolitical risk dashboard. Other risks to fixed income markets: Any introduction of easier fiscal policy could quickly send rates higher, while a supply price shock could spark inflation. Neither are our base case over the near term.

Fixed income views

Our views are from a U.S. dollar perspective over a three-month horizon. Views and comments are from a fixed income-only perspective, and may differ from whole-portfolio tactical views on fixed income in our Global weekly commentary and Global investment outlook. For example, we overweight Asia fixed income from a bond portfolio perspective because of their income potential. Yet we are neutral on this asset class in a multi-asset context, where we prefer to take economic risk in equities. Views are as of Sept. 30.


Rates View Comments
U.S. government bonds icon-down We remain underweight U.S. Treasuries. We do expect the Fed to cut rates by a further quarter percentage point this year. Yet market expectations of Fed easing in 2020 look excessive to us. This, coupled with the flatness of the yield curve, leaves us cautious on Treasury valuations. We still see long-term government bonds as an effective ballast against risk asset selloffs.
U.S. inflation protected icon-neutral TIPS have caught the market’s attention, following the recent spike in oil prices on increased tensions in the Gulf. Valuations now look more attractive, with 10-year U.S. breakeven rates around 1.6%, well below core inflation at 2.4%. TIPS have also lagged the broader rally in other fixed income risk assets. We do expect the U.S. Consumer Price Index to be more volatile into year end, so we would look to increase inflation-protection exposure on opportunity.
U.S. agency mortgages icon-down The sharp fall in rates has prompted mortgage prepayments and shortened asset class durations. Higher-coupon mortgages have been particularly hit, while lower- and current-coupon mortgages have seen increased demand as hedging vehicles. Following this price volatility, we see short term opportunities in actively trading current coupons. However, we continue to favor high-coupon mortgages or specified pools for long-term asset allocation purposes.
U.S. municipal bonds icon-neutral Favorable supply-demand dynamics and improved fundamentals are supportive. The tax overhaul has made munis’ tax-exempt status more attractive. Yet muni valuations are on the high side, rate volatility is a risk and the asset class may be due for a breather after a 10-month stretch of positive performance.
European Sovereigns icon-up We remain overweight on European sovereign bonds. The resumption of asset purchases by the ECB supports our overweight stance, particularly in non-core markets. A relatively steep yield curve – especially in peripheral markets - is a plus for euro area investors. Yields look attractive for hedged U.S. dollar-based investors thanks to the hefty U.S.-euro interest rate differential.


Credit and other View Comments
U.S. investment grade icon-up We remain overweight investment grade bonds even after their strong performance in the first half of 2019. Easier monetary policy that may extend the economic expansion, constrained new issuance and conservative corporate behavior support investment grade. Investment-grade credit remains a key part of our income thesis.
U.S. high yield icon-up We see a favorable backdrop for high yield performance, amid easier monetary policy that may prolong this cycle. Generally healthy corporate fundamentals are also a positive. We like the asset class for its income potential and favor BB-rated bonds even after their recent outperformance. They offer attractive income along with lower exposure to risks associated with decelerating economic growth.
U.S. bank loans icon-neutral We view bank loans as an attractive source of high-quality income. With the recent sell off, we see selected opportunities versus high yield, as heightened expectations for Fed rate cuts have challenged investor sentiment for bank loans and improved their relative value. Loans’ floating-rate nature can potentially provide a cushion against rising rates, and they offer attractive risk-reward potential in a scenario where the Fed raises rates less than expected.
U.S. securitized assets icon-up We like securitized assets for their relatively attractive yields and income potential. We favor a diversified approach that balances allocation to residential and commercial mortgage backed securities (RMBS and CMBS), collateralized loan obligations (CLOs) and whole loans, as well as asset-backed securities (ABS).
Euro investment grade icon-neutral The ECB’s “lower for even longer” rate shift against a backdrop of near-term economic weakness should help limit market volatility and support the asset class. The resumption of asset purchases by the ECB is another positive. European banks are much better capitalized after years of balance sheet repair. Even with tighter spreads, credit should offer attractive income to both European investors and global investors on a currency-hedged basis.
Euro high yield icon-up We remain overweight, even after impressive performance in the second quarter in response to major central banks’ dovish shift. High yield is becoming the only liquid European market with positive yields in the front end of the yield curve. The asset class would benefit from resumption of asset purchases by the ECB– even if not directly eligible. We see further outperformance of high yield on attractive income, potential spread compression and low default rates. We see the most value in BB-/B+ rated bonds, AT1-tiered securities and corporate hybrids.
Emerging market debt icon-up We remain overweight to EM bonds on their income potential. The Fed’s dovish shift has spurred local central banks to cut rates, local rates to rally and helped local currencies recover versus the U.S. dollar. We believe local-currency markets have further to run and prefer them over hard-currency markets. We see opportunities in Latin America (with little contagion from Argentina’s woes) and in countries not directly exposed to U.S.-China tensions.
Asia fixed income icon-up The dovish pivot by the Fed and ECB gives Asian central banks room to ease. Currency stability and stabilizing growth in China are also positives. Valuations have become richer after a strong rally, however, and we see geopolitical risks increasing. As a result, we have reduced overall risk and moved up in quality across credit, while maintaining long credit risk positioning.

icon-up Overweight     icon-neutral Neutral     icon-down Underweight

Scott Thiel
Chief Fixed Income Strategist, BlackRock Investment Institute
Scott Thiel, Managing Director, is Chief Fixed Income Strategist for BlackRock and a member of the BlackRock Investment Institute (BII). He is responsible for developing ...