Global Weekly Commentary: Favoring short-term bonds long term
Leaning in
We up short-term sovereign bonds on attractive yields and downgrade credit in the long-run. We stay cautious on long-term bonds even with the surge in yields.
Market backdrop
U.S. stocks recovered last week as 10-year yields slid from 16-year highs. Jobs data showed a normalizing labor market. We see demographics starting to bite.
Week ahead
China data this week will help gauge fading economic momentum. We see weak consumer and export demand leading to growth below the pre-Covid trend.
Sovereign bond yields have surged this year, with U.S. long-term yields hitting 16-year highs last month. We prefer short-term government bonds over credit. We go underweight high quality credit on a strategic view of five years and longer and trim our overall underweight to sovereign bonds. We still see investors demanding more compensation for holding long-term bonds given higher inflation, greater macro volatility and rising debt levels. We also like inflation-linked bonds.
Closing the gap
Yields on U.S. investment grade (IG) credit and short-term Treasuries, 1992-2023
Source: BlackRock Investment Institute, with data from LSEG Datastream, September 2023. Notes: The chart shows the yields for U.S. investment grade credit (using the Bloomberg U.S. Credit USD index) and short-term U.S. Treasuries (Bloomberg U.S. Treasury 1-3 Year USD index).
We believe the new regime of greater macro volatility calls for more nimble and dynamic strategic views. Short-term government bond yields have risen alongside long-term yields due to rapid central bank rate hikes. That move has pushed short-term U.S. Treasury yields (yellow line in the chart) near high quality credit yields (orange line), making short-term bond income comparable. We trim our overall underweight to developed market (DM) nominal government bonds to lean into short-term paper and reduce investment grade (IG) credit to underweight from neutral. We think high quality credit offers limited compensation for any potential hit to returns from wider spreads and sensitivity to interest rate swings. We prefer higher yields in private credit and see alternative lenders filling a corporate financing gap as banks curb lending.
Mega forces – structural shifts that can drive returns now and in the future – reinforce why we’re in a new regime of greater macro and market volatility, in our view. Aging DM populations could add to inflation as workforces shrink, keeping labor markets tight and wage growth high. And the rate of growth the economy will be able to sustain without stoking inflation will likely be lower than in the past. Aging also tends to come with elevated levels of government debt. We see the low carbon transition, another mega force we track, driving up energy costs over the next decade. A related capital spending surge and additional government spending will likely boost economic activity and bolster inflationary pressures. These and other mega forces underpin why we see central banks having a tightening bias to try to keep inflation near their policy targets.
Our view on long-term bonds
We went very underweight nominal government bonds in 2020 – but have trimmed that underweight at times when markets moved in line with our view. We trim it again but are not ready to turn positive on long-term bonds, even with the yield rise. That’s because term premium, or the compensation investors demand for the risk of holding long-term bonds, has risen from its lows but remains negative – especially for U.S. Treasuries, according to LSEG data. That is historically unusual.
We see three reasons long-term bond yields and term premium can climb higher: First, we believe markets will price in inflation settling above DM central bank 2% policy targets longer term. Second, we also see investors demanding more term premium to reflect greater risk in nominal bonds due to higher inflation volatility and rising debt levels. The U.S. credit rating downgrade last month underscored the fiscal challenges ahead. Third, foreign demand for long-term Treasuries may wane: For example, Japanese investors may switch to domestic bonds as yields climb from the Bank of Japan further lifting its cap on long-term yields. To turn positive on long-term bonds, we would need to see term premium rise much more or think market expectations of future policy rates are too high. We are not there yet.
Bottom line
We evolve our views with the August update of capital market assumptions and strategic portfolios. We up our allocation to short-term sovereign bonds, trim our overall underweight to nominal government bonds and cut IG credit to underweight. We stay underweight nominal government bonds overall due to the risks we see in long-term bonds. We favor inflation-linked bonds. And we like equities in the long term. Their returns should surpass fixed income returns when growth rebounds from the near-term stagnation we expect – even if it muddles along due to the demographic hit ahead.
Market backdrop
U.S. stocks bounced back last week from a 2% drop in August as 10-year Treasury yields eased off a 16-year near 4.30%. The stock gains show just how sensitive market sentiment remains to yield moves and expectations for policy rates. The drop in July job openings and the August payrolls report indicated the U.S. labor market is now normalizing from pandemic mismatches. We see inflation on a rollercoaster ride ahead as normalization unfolds and an aging population starts to bite.
A slew of China data this week will help gauge fading economic momentum after a rapid post-Covid restart. China is facing two key challenges: weak consumer and export demand. We cut our growth expectation for this year to around 5% as a result. Two-year average growth over 2022-23 is set to be about 4%, much lower than the pre-Covid rate of roughly 5%.
Week ahead
Sept. 5
China Caixin services PMI
Sept. 6
U.S. ISM services PMI
Sept. 7
China trade data
Sept. 8-15
China total social financing; China CPI and PPI (Sept. 9)
Source
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of Aug. 31, 2023. Notes: The two ends of the bars show the lowest and highest returns at any point in the last 12-months, and the dots represent current 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, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
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