Mike Pyle, Global Chief Investment Strategist, together with Elga Bartsch, Head of Macro Research, Scott Thiel, Chief Fixed Income Strategist, and Beata Harasim, Senior Investment Strategist, all part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
Markets have rallied sharply from their virus lows, driven by the policy revolution and economic restart. Tighter valuations increase the risk of volatility, particularly ahead of divisive U.S. elections. Last week’s equity selloff illustrates this. Against this background, we cut our tactical view on investment grade (IG) credit to neutral, but increase our overweight on high yield for its income potential.
Yield spreads of both IG and high yield credit spiked in March as the coronavirus spread further globally. They peaked later that month – and started to decline – when central banks including the Federal Reserve launched extraordinary monetary policy support. IG spreads have shrunk more than half from the March 23 peak to under 1.3%, about where they were before the Covid spike, as the orange line in the chart shows. The risk/reward balance now looks much less appealing: The extraordinary monetary policy support has already priced in, and IG is offering little buffer against risks such as rising rates due to its interest rate-sensitive nature, in our view. High yield spreads have also narrowed sharply from late March (see the yellow line), yet there may still be room for further tightening, in our view, particularly as the economic restart gains steam.
The policy response to the virus shock has been a major driver of markets, but its composition over coming months will likely be different from what we’ve seen. We see limited room or appetite for central banks to further cut interest rates or ramp up asset purchases – a driver behind the recent compression in credit spreads. Fiscal policy is becoming key in the ongoing policy revolution, and the quantitative easing programs of major central banks help offset some downside risks. As a result, for now we stay overweight credit on a tactical basis and neutral on equities over both a tactical and strategic horizon. We see a growing risk that fiscal policy support dries up in the U.S. – barring a Democratic sweep in November that would pave the way for a boost to spending. Our base case, however, still calls for a new fiscal package of up to $2 trillion.
Our stronger preference for high yield is also supported by fundamentals that appear disconnected from market pricing. The current pricing implies around 25% of the bonds on the Bloomberg Barclays U.S. Corporate High Yield Index could default over the next five years, our calculations showed. This has fallen from the 40% implied rate in April, but is still higher than a median actual default rate of 19% since 1990. Many high yield issuers have been able to access the capital market for their liquidity needs over the past few months, likely helping them weather any further economic turmoil caused by the virus shock. We expect mid- to high- single digit high yield default rates over the coming year. Yet many of the victims will likely be companies with the weakest balance sheets that were already prime candidates for default in coming years, in our view. We value high yield as a source of income in low-yield world, and expect it to outperform IG once growth reaccelerate.
The bottom line: We stay moderately overweight on credit overall on a tactical basis for now. We strongly favor high yield, and are neutral on IG. We are still overweight U.S. Treasuries over the next six to 12 months as ballast against uncertainties around the pandemic and U.S. election. Yet over the strategic horizon we advocate reducing allocation to nominal developed market (DM) government bonds as interest rates are near their lower bounds and medium-term inflation risks grow. On a tactical basis we have also downgraded EM local-currency debt and are underweight hard-currency EM debt too, as we generally prefer to take risk in developed markets. Many EM countries have insufficient public health systems to control the virus spread and less policy space to cushion the economic blow. Yet we are neutral on Asia fixed income given China’s ongoing recovery from the virus shock.
Activity has started to normalize around the globe, albeit with renewed localized lockdowns to contain virus clusters. Market volatility is returning after months of steady advances in risk assets. Valuations have risen, and we could see greater volatility in coming months as a result, especially as the U.S. election closes in. A contributing factor: Negotiations over the size and makeup of a new U.S. fiscal stimulus package have stalled. In addition, the pandemic is still spreading in many countries, and U.S.-China tensions have escalated.
Markets will focus on the ECB this week, particularly their updated economic projections and the implications for policy. The central bank is expected to keep interest rates unchanged. The traditional election campaign season is kicking off in the U.S. with the poll date only eight weeks away. Former Vice President Joe Biden currently leads President Donald Trump by just over 7 percentage points, according to an average of national polls by FiveThirtyEight, an influential forecasting site.
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