Global Weekly Commentary: Downgrading government bonds
Recent developments lead us to refresh our asset views, including a broadening of our cyclical tilt and a tactical downgrade to government debt and credit.
Rising inflation expectations have driven up U.S. 10-year Treasury yields but to a lesser degree than in the past. Real yields were steady in negative territory.
U.S. consumer confidence data this week could bolster the expectation for a vaccine-led restart after retail sales rebounded strongly in January.
We broaden our tactical pro-risk stance in light of major developments since the publication of our 2021 outlook in December: the vaccine rollout and up to $2.8 trillion of additional U.S. fiscal spending this year. Inflation expectations have risen sharply while real rates are steady in negative territory. We prefer equity over credit and turn underweight government bonds – in line with our strategic views.
Chart of the week
U.S. retail sales during past recessions and the Covid shock
Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, February 2021. Notes: The chart compares the path of total U.S. retail sales during business cycle contractions with that during the Covid shock. Retail sales are rebased to 100 at the peak of each business cycle as defined by the National Bureau of Economic Research (NBER). The grey area shows the range based on cycles starting with 1969. The Covid shock line is rebased to 100 at February 2020.
Our new nominal theme – which flags a more muted response in nominal bond yields to rising inflation than in the past – has played out since last year. A 1% increase in 10-year U.S. breakeven inflation rates – a measure of market inflation expectations – has typically led to 0.9% rise in 10-year Treasury yields since 1998, we estimate. Yet since last March breakeven inflation has climbed 1.2%, and nominal yields are up just 0.5%. Inflation-adjusted yields, or real yields, have fallen further into negative territory as a result. The different nature of the Covid shock means activity has restarted much faster than seen in past business cycle recessions – and implies unusually high growth rates as a vaccine-led re-opening unfolds. The surprising jump in January U.S. retails sales may offer a glimpse of things to come. See the chart above. Fresh U.S. fiscal spending is turbocharging the restart, with recent pandemic relief payments explaining some of the retail sales boost. Further spending will ensure another wave of support, in our view.
We expect a strengthening economy, a huge fiscal impulse and rising inflation to further drive up nominal yields this year, albeit by less than in similar periods in the past. We expect central banks to lean against any market concerns around rising debt levels and to keep interest rates low for now. Yet if the narrative on high debt levels, combined with rising inflation, were to change, it could eventually undermine the markets’ faith in the low-rate regime – with implications across asset classes.
We have downgraded government bonds to underweight on a tactical basis, with an increased underweight in U.S. Treasuries. We also downgrade euro area peripheral bonds to neutral, as peripheral yields have fallen to near record lows and spreads have narrowed. We downgrade credit to neutral on a tactical horizon, as spreads have narrowed to historical lows, but still like high yield for its income potential.
Tactically, we now prefer equities over credit, as equity valuations appear more attractive. We also broaden our cyclical tilt: We are upgrading European equities to neutral, as we see room for the market to close its valuation gap versus the rest of the world with the restart becoming more entrenched. Yet the slow vaccine rollout and more muted fiscal support weigh. We debut an overweight call on UK equities in the wake of Brexit. We stay overweight U.S. and emerging market (EM) equities, and underweight Japan, where we expect lower risk-adjusted returns.
Over a strategic horizon, we also prefer equities over credit. We turn underweight credit due to rich valuations and are now modestly overweight equities. This preference stems from incorporating the effects of climate change in our long-term expected returns. We see developed market equities best positioned to capture the opportunities from the climate transition – particularly on a sector level where we see material effects on expected returns. Equities valuations are also closer to long-term averages after factoring in historically low interest rates and an improving earnings outlook.
The bottom line: We expect our new nominal theme of stronger growth and a muted response in nominal bond yields to higher inflation to further play out, even after significant market moves. This supports our tactically pro-risk stance. A key risk is a further increase in long-term yields as markets grapple with an economic restart that could beat expectations. This could spark bouts of volatility, even though we believe the Fed would lean against any sharp moves for the time being.
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