Mike Pyle, Global Chief Investment Strategist, Scott Thiel, Chief Fixed Income Strategist, Beata Harasim, Senior Investment 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.
We recently moved to a strategic overweight on credit after being underweight for the past year. Cheaper valuations compensated for the risk of corporate defaults and downgrades in the wake of the Covid-19 pandemic, in our view. We also prefer credit over equities on a tactical basis. Extraordinary central bank easing, including renewed purchases of corporate debt, underpin the asset class.
The pandemic has accelerated key structural trends, and calls for a wholesale review of strategic asset allocation. Valuations in investment grade credit had cheapened significantly as of mid-April, and looked set to be less of a drag on future returns than they were in late 2019. See the shrinking yellow bars in the chart above. This effect more than outweighed the negative drag from an expected rise in losses resulting from corporate downgrades and defaults (the orange bars). In high yield, valuations swung to a modest tailwind for expected returns. Valuations have since risen, but still look fair to us.
We maintain a modest pro-risk stance overall on a tactical basis, given our macro assessment of the virus shock and the strong policy response. This is balanced by a preference for assets that are high up the corporate capital structure and have policy backstops in the U.S. and Europe. These backstops go beyond investment grade credit and European peripherals, with the Federal Reserve for the first time purchasing “fallen angels” that have lost investment grade status. We prefer credit over equities as a result and are overweight in investment grade credit, high yield and euro area peripheral debt. These sectors offer attractive income in a world where decently yielding assets are hard to find. Credit (particularly high yield corporate debt) has lagged equities in the comeback rally, making it more attractive on a relative basis, in our view. Credit and equities also offer different sector exposures. Financials have a greater weight in credit, while tech has an outsized weight in equities. We prefer to take financials exposure in credit due to the strong policy backstop. Financial equities face challenges such as low rates and curbs on dividend payouts that could limit upside. And our overweight in the quality factor – even as we stay neutral overall in equities – gives us exposure to large-cap tech stocks riding secular trends.
The Federal Reserve is buying more assets relative to U.S. GDP than in the three rounds of quantitative easing that followed the global financial crisis combined. The Fed and European Central Bank look set to purchase roughly the equivalent of all the net supply across European and U.S. sovereign and corporate debt this year, by our calculations. To date, these purchases have been mostly of government debt, but the credibility of central banks’ corporate debt backstop has helped underpin credit markets. As such, investors have easily digested the highest run rate of new bond issuance since 1980 in global investment grade credit. We see issuance easing over the summer, providing a strong technical backdrop for credit.
Have credit markets already run too far? For now, we do not think so. Investment grade and peripheral bond spreads remain wider than pre-Covid levels. To be sure, the resurgence of Covid-19 cases in the U.S. poses near-term risks. But overall, we see the policy revolution and a strong investor appetite for income underpinning credit markets. Equity markets look more vulnerable to sagging corporate earnings, as well as any deterioration in the key signposts we are watching: how successful economies are at the activity restart while controlling the virus spread; whether stimulus is still reaching households and businesses in sufficient scale; and whether any signs of lasting economic scarring are emerging.
Measures to contain the virus are being gradually eased in many developed economies, and lifted activity and employment in June. A surge of COVID-19 cases in many U.S. states threatens to undermine a recovery in mobility, which we see as closely tied to economic activity. The unprecedented policy response has boosted risk assets, leaving the U.S. resurgence of infections and policy implementation as key market risks. U.S. Congress is headed for a fiscal cliff as jobless benefits, state support and payroll protection measures are expiring soon.
Leaders of the 27 EU member states are scheduled to hold their first physical summit since the coronavirus lockdown began. The two-day meeting will see leaders discuss an economic recovery package and the EU’s next seven-year budget. Europe has ramped up its stimulus efforts in line with a much needed global policy revolution to cushion the coronavirus shock.
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