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BlackRock Commentary: Why we stay underweight bonds

Jean Boivin, Head of the BlackRock Institute together with Wei Li , Global Chief Investment Strategist, Scott Thiel, Chief Fixed Income Strategist and Vivek Paul, Senior Portfolio Strategist all forming 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.

Key Points:

Ineffective portfolio diversifiers – We see developed market (DM) government bonds as ineffective portfolio diversifiers and favor inflation-linked bonds in this inflationary environment.

Market backdrop – Energy prices surged on further supply concerns. Equities slid, with Europe harder hit than the U.S. Bond yields fell on reduced rate hike expectations.

Week ahead – The European Central Bank will likely emphasize the need to assess how higher energy prices will hurt activity, suggesting less for it to do to normalize policy.

Government bonds have shown some traditional diversification properties since Russia’s invasion of Ukraine last month. Yet our work shows that government bonds historically offer less diversification during periods of supply-driven inflation such as we’re seeing now and exacerbated by the conflict. We stay strategically and tactically underweight DM nominal government bonds and look for diversification in inflation-linked and Chinese government bonds (CGBs).

Why we stay underweight bonds Article Image 1

Russia’s invasion of Ukraine came just as investors had become excessively hawkish about central bank policy expectations, in our view. The broad rise in yields across the curve had created some yield cushion just before a global risk-off move sparked by a major geopolitical event. In the short period since the conflict started to escalate, government bonds briefly helped guard portfolios against some equity losses. Yet we see this diversification role as increasingly challenged due to supply-driven inflation and central banks’ higher tolerance of such inflation. Market performance suggests so as well. The chart shows average daily returns in U.S. 10-year Treasuries on days when the MSCI World index of DM equities fell. The contrast in performance of Treasuries between 2000-2020 (red and yellow bars) and the past 14 months (green bars) has been stark, particularly on days when stocks fell over 1.5%. We prefer Treasury inflation-protected securities (TIPS) relative to nominal Treasuries to provide duration exposure and as a relative play on market pricing of higher inflation.

The correlation of stock and bond returns is key in assessing bonds’ ability to play the role of portfolio diversifiers. Our analysis of the stock-bond correlation and macro factors such as growth and inflation in the U.S. since the mid-1960s reveals a key link between the two. We find that the correlation is typically negative when demand shocks dominate and positive when supply shocks are the driving force. In other words, bonds are less likely to act as portfolio ballast during equity selloffs in a world shaped by supply constraints – what’s happening now and we see persisting in coming years.

The Russia-Ukraine war will have long-term humanitarian and geopolitical consequences. We see high energy prices as the main macro transmission channel – exacerbating supply-driven inflation in the near-term. This is particularly evident in Europe where coal, electricity and natural gas prices have surged from already elevated levels. Higher energy costs will take a toll on growth – more starkly in the euro area than the U.S. given geographical proximity, deeper economic linkages and energy dependency on Russia. The relative impact may push up U.S. long-term yields more than euro area yields.

All this complicates the dilemma central banks were already facing. With a commodity price shock adding to a persistent inflation narrative, we think central banks will need to carry on with policy normalization. We used to see the possibility of central banks slamming the policy brakes as the biggest risk. But that risk is now reduced due to the higher cost of slowing growth, especially in Europe. This for now supports our overweight to DM equities, which we twinned with an underweight to credit. To balance this exposure in a whole-portfolio context, we seek alternatives to nominal government bonds, particularly given our view that the risk of inflation expectations becoming unanchored is going up over time. We see more appeal in assets such as TIPS – for duration as well as relative exposure to inflation – and CGBs. Our work finds TIPS and CGBs offer better risk-adjusted returns and lower correlation to equities than other assets of broadly comparable risk.

Bottom line: Our preference for equities over both government bonds and credit keeps us positioned for a new market regime – one of investors demanding greater compensation, or term premium, for the risk of holding government bonds and one where we expect higher inflation in the medium term than markets are pricing. We retain our underweight on DM nominal government bonds on both a tactical and strategic horizon. Last month we downgraded credit – where valuations remain rich given how well spreads have held up and because of the duration risk from a renewed rise in long-term yields. Historically low and negative real yields reinforce our overweight to DM equities. We remain overweight TIPS and stay modestly overweight Chinese assets, and we like CGBs in particular for both returns and diversification.

Why we stay underweight bonds Article Image 2

Market backdrop

Crude oil prices shot up to around $120 a barrel and European natural gas prices doubled to hit record highs on concerns about supply. Both Russia and the West have avoided weaponizing energy, but we see the risk is rising as the conflict deepens. Equity markets fell, with Europe underperforming the U.S.  Euro area inflation hit a new record high in February. The ECB this week will likely emphasize the need to assess how higher energy prices will hurt activity.

Week ahead

March 7 – China trade data
March 10 – ECB policy decision, U.S. Consumer Price Index
March 11 – U.S. University of Michigan consumer sentiment data

The ECB meets this week against the backdrop of Russia’s war with Ukraine and soaring energy prices. While updated ECB forecasts are likely to show materially higher inflation and lower growth, we believe the conflict lowers the risk that the ECB starts to raise policy rates soon – and it may even keep up bond purchases for longer. The U.S. CPI is likely to show few signs of peaking yet, with the headline index seen pushing to a new 40-year high near 8%.

BlackRock’s Key risks & Disclaimers:

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 28th, 2022 and may change. The information and opinions are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain ’forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets. 

Issued by BlackRock Investment Management (UK) Limited, authorized and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL.

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BlackRock anticipates that the new macroeconomic environment, characterized by increased volatility, will lead to more frequent valuation changes across asset classes. While short-term outcomes may not always be influenced by valuations, they remain significant in the long run.

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