Jean Boivin, Head of BlackRock Investment Institute, together with Mike Pyle, Global Chief Investment Strategist, Vivek Paul, Senior Portfolio Strategist, and Natalie Gill, Portfolio 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.
The pandemic has sped up key structural trends and triggered substantial market swings, precipitating an urgent need to rethink strategic asset allocations. Among the big changes: We favor reduced exposure to nominal developed market (DM) government bonds and greater allocations to inflation-linked bonds, as interest rates approach their lower bounds and inflation risks grow in the medium term.
Market prices, asset valuations and economic projections have seen big swings in the space of two quarters. This, in turn, has had a sizeable impact on our expected returns and asset views. Anchoring investment views to the past is becoming less relevant, in our view, as structural trends such as rising inequality, deglobalization, the policy revolution and sustainability race toward us. We started the year with a strategic overweight in nominal DM government bonds. Today, this asset class is our biggest strategic underweight. Allocations to nominal government bonds in a hypothetical, U.S. dollar-based strategic portfolio based on our capital market assumptions have been reduced since February. See the darkest purple bars in the chart. We had flagged as early as March growing risks around inflation. Inflation-linked bonds have gone from a neutral to our biggest overweight, with greatly expanded strategic allocations.
Views on nominal government bonds and inflation are key to constructing strategic portfolios for the post-Covid world. The policy revolution to cushion the Covid shock challenges the role of nominal government bonds in strategic portfolios by lowering their returns and reducing their ballast properties. We expect negative returns across DM government bonds on a five-year horizon. Furthermore, the inverse correlation between bonds and stocks weakens as yields are near perceived lower bounds. This reduces bonds’ ballast role, or ability to cushion portfolios against risk asset sell-offs.
We see risks of higher inflation over the medium term. Central banks are already explicitly signalling a greater tolerance to let inflation overshoot their targets to make up for past misses. That could join force with other factors that we see as driving inflation in the medium term: negative supply shocks, deglobalization and reduced competition among large firms. Higher inflation could become more politically tempting as elevated debt levels make it hard to sustain materially higher rates, at a time of explicit monetary and fiscal coordination. Breakeven rates, a measure of market-based inflation expectations, are already on the rise. We see inflation-linked bonds as an increasingly attractive alternative to nominal bonds, even though its limited market size creates liquidity challenges in some markets.
Sharp market swings this year are requiring strategic views to evolve with an unusually high frequency. From late 2018 until the start of this year, we favored a barbell approach in our strategic allocation, preferring equities and government bonds to credit. In March, we made a case for leaning into equity exposures and significantly upgraded credit after a sharp risk selloff that we saw as excessive, as we expected the unprecedented policy response would make the cumulative impact of the virus shock likely a fraction of that seen after the 2008 global financial crisis. This strategic opportunity has now largely dissipated after the sharp rebound in valuations – and today we are mildly underweight global investment grade credit and DM equities. We still see an important role for private markets and Chinese assets playing in strategic portfolios.
The pandemic dynamics and policy revolution have had different implications on some of our tactical asset views. We still like credit over the next six to 12 months, especially high yield, due to broad policy support and still-attractive valuations. In equities our strongest preference is for high quality exposures, though we have closed our underweight to value-oriented markets broadly and still think Europe has upside among cyclical exposures.
Activity has started to normalize around the globe, albeit with renewed localized lockdowns to contain virus clusters. The unprecedented policy response has boosted risk assets. Europe has agreed on a historic recovery fund, but U.S. stimulus is now at risk of fading. Talks over the size and makeup of a new U.S. fiscal package have stalled as some key benefits expired and states face budget shortfalls. Our base case calls for a $2 trillion fiscal package that extends some federal stimulus measures through late-2020, but there is a risk no deal will materialize. Another risk: escalating U.S.-China tensions.
The annual gathering of central bankers and other policymakers will be a focus - and it will be conducted virtually and open to the public for the first time. Markets will look for clues for what potential policy framework changes might imply for the medium-term inflation outlook.
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