Market Updates
27/10/2020
BlackRock Commentary: Changing our government bond views

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 are increasingly reflecting a unified Democratic government outcome that may lead to a significant fiscal expansion. This electoral outcome would bring forward the market pricing of the higher inflation regime that we were already reflecting in our strategic asset views. This is why, tactically, we are downgrading nominal U.S. Treasuries and upgrading their inflation-linked peers.

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Sources: BlackRock Investment Institute and Refinitiv Datastream, data as of Oct.12, 2020. Notes: U.S. 10-year nominal yield refers to the 10-year Treasury yield. Real yield refers to the yield of 10-year Treasury Inflation-Protected Securities (TIPS). Breakeven inflation rate refers to the difference between the yields of a nominal bond and an inflation-linked bond of the same maturity – the 10-year maturity in this case.

 

Developed market (DM) government bond yields collapsed after the Covid shock and since appear to have found a bottom. The economic restart has been quicker than expected, even though the hardest part of the recovery lies ahead. Significant fiscal stimulus under a united Democratic government – an election scenario that markets are increasingly pricing in – could put upward pressure on Treasury yields. Yet the rise in yields would likely be limited as the Fed would act to prevent a sharp tightening in financial conditions, in our view. We already expected rising inflation over the next few years, as production costs rise and the Fed has pledged to allow inflation overshoots and let the labor market run hot. The monetary-fiscal policy revolution may also place greater political constraints on the Fed’s ability to lean against inflation. We see the prospects of a unified Democratic government accelerating the market pricing of these dynamics. Breakeven inflation rates, a market-based measure of expected inflation, have rallied since March. See the green line in the chart. We see inflation-adjusted, or real yields, falling further, supporting prices of Treasury Inflation-Protected Securities (TIPS).

We are upgrading German government bonds (bunds) to neutral, reflecting our greater caution on Europe’s economic prospects. As Covid infections have picked up , the focus on further policy response has shifted to more monetary easing including additional asset purchases. Our views on bunds or U.S. Treasuries shouldn’t be considered in isolation. We believe nominal DM government bond prices are headed lower, and expect bunds to have more modest price declines than U.S. Treasuries. Bunds are also likely to be less volatile, in our view, thanks to large-scale ECB asset purchases that have driven net issuance into negative territory, as well as the potential for further monetary policy support.

These latest changes in our tactical views align with our strategic views. We favor reduced exposure to nominal DM government bonds and greater allocations to inflation-linked bonds over a longer horizon, as interest rates remain near  their lower bounds and inflation risks grow. We don’t expect nominal bond yields to rise as much as the inflation backdrop might typically imply, as central banks keep rates low and allow temporary overshoots of their inflation targets. This environment could persist for some time, providing a favorable backdrop for risk assets.

The result of next week’s U.S. election will further inform our tactical views. Democratic nominee and former Vice President Joe Biden has expanded his lead in national polls over President Donald Trump, and the likelihood of a Democratic sweep – winning the White House and the Senate – has risen. This outcome would have the most market impact as it would bring significant policy changes. The net difference in fiscal spending between a Democratic sweep and a Democratic presidency under divided government could be several percentage points of GDP over each of the next few years, we estimate.

Bottom line: We are downgrading nominal U.S. Treasuries to underweight and upgrading TIPS to overweight due to the growing likelihood of a sizable fiscal expansion, with a Fed likely leaning against major yield increases. We have closed our underweight in German bunds, anticipating their outperformance over U.S. Treasuries. We keep the rest of our tactical asset views unchanged for now, such as an overweight in the quality style factor in equities. A Democratic sweep outcome in the election would tip us to a more pro-risk stance, with implications for many of our granular asset views. A risk to our view: An election outcome that diminishes the likelihood of significant fiscal stimulus.

 

Market Updates

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Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, October 2020. 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 U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot gold, Datastream 10-year benchmark government bond (U.S. , 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 U.S. Dollar Index (DXY), MSCI Europe Index and spot Brent crude.


Market backdrop

We do not see the resurgence of Covid-19 as a replay of the spring. We believe daily new infections are likely a fraction of the peaks then, and rising case counts are having a diminishing negative impact on mobility. The economic restart has been quicker than expected, but the part that remains will be hardest. We do not expect a similarly large hit to economic activity as seen in the spring. But the economic restart now looks to face significant challenges in the near term. The other market focus: How the U.S. election result could shift U.S. fiscal stimulus, public investment, taxation, regulation and foreign affairs.

Week Ahead

  • October 26th: Germany ifo Business Index; U.S. new home sales
  • October 27th: U.S. Consumer Confidence Index
  • October 29th: ECB policy meeting; U.S. advance third-quarter GDP; German preliminary consumer price index
  • October 30th: Preliminary third-quarter GDP for Germany, Spain, France and Italy

The ECB policy meeting will be in focus. We expect the central bank to announce further monetary easing before the end of the year in order to fend off a further undershoot of its inflation objective. A string of data from Europe this week could shed light on the pace of the recovery, as Covid infections rise again in the region and threaten to derail the economic restart.


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