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.
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. Sources: BlackRock Investment Institute, August 2020. Notes: The bars show our hypothetical, unconstrained, U.S. dollar-denominated portfolio built using our portfolio construction approach and capital market assumptions. Global nominal government bonds and emerging market (EM) equity allocations include respective China assets. Income private markets include infrastructure debt, direct lending, real estate mezzanine debt and U.S. core real estate. Growth private markets include global private equity buyouts and infrastructure equity. The hypothetical portfolio is intended for information purposes only and does not constitute investment advice. The indexes representing equities are the MSCI Emerging Markets and MSCI World indexes. The fixed income indexes include Bloomberg Barclays Global High Yield Total Return, U.S. MBS, Global Aggregate – Corporate and Global Treasury indexes, JP Morgan GBI-EM and EMBI Global Diversified indexes, and ICE BofA Merrill Lynch Global Inflation-Linked Government Index. Indexes are unmanaged. It is not possible to invest directly in an index. We use BlackRock proxies for selected private markets because of lack of sufficient data. These proxies represent the mix of risk factor exposures that we believe represents the economic sensitivity of the given asset class.
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.
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, August 2020. Notes: The two ends of the bars show the lowest and highest returns versus the end of 2019, and the dots represent 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 Brent crude, MSCI USA Index, the ICE U.S. Dollar Index (DXY), MSCI Europe Index, Bank of America Merrill Lynch Global Broad Corporate Index, Bank of America Merrill Lynch Global High Yield Index, Datastream 10-year benchmark government bond (U.S. , German and Italy), MSCI Emerging Markets Index, spot gold and J.P. Morgan EMBI index.
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.
- August 25th: German ifo Business Climate Index; U.S. consumer confidence
- August 27th to 28th: Annual Jackson Hole Kansas Fed Economic Policy Symposium
- August 28th: Euro area business and consumer survey results; German gfk consumer sentiment; ISM-Chicago Business
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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