High rates persist

11-30-2023
High rates persist

Investment agility, selectivity more important than ever

 

We had been underweight DM government bonds since March 2020 as we expected yields to rise. We gradually trimmed the underweight as our view played out, increasingly preferring shorter-dated bonds. Now with yields even higher, we explicitly carve out an overweight on DM short- and medium-term government bonds. We stay underweight long-term bonds as we see room for long-term yields to climb again.

Why? Investors will demand more term premium, or compensation for the risk of holding these bonds across DMs, in our view. See the accompanying chart. This is due to more uncertain and volatile inflation spurring heightened bond market volatility. We also see weaker demand for bonds amid rising debt levels. Central banks are no longer reinvesting the proceeds of maturing bonds as part of quantitative tightening, and investors are struggling to digest a flood of new bonds.

The path to higher long-term yields is unlikely to be straight in the next five years. Indeed, we recently went neutral long-term Treasuries from a tactical, six-to-12-month view because we see more even odds of yields swinging in either direction. Inflation-linked bonds remain our highest-conviction overweight on the strategic horizon.

Sure, inflation is falling in the near term as pandemic-era mismatches unwind, with consumer spending shifting back to services from goods. But in the long run, we see inflation well above 2% central bank policy targets. The reasons are big structural shifts constraining supply: slowing labor force growth, geopolitical fragmentation, and the low-carbon transition. That’s why we see central banks keeping interest rates high for longer. Our updated strategic views bake in the impact of this.

We also turn neutral developed market (DM) equities, with U.S. stocks remaining our largest portfolio allocation. We had been overweight since the end of Western pandemic lockdowns due to attractive valuations. Bond and stock markets have been moving toward our view of high-for-longer rates in fits and starts, and long-term valuations for stocks now look about fair to us. This is why we have turned neutral on the broad asset class – and look for opportunities within.

Investment implications

The new regime has created uncertainty, resulting in greater dispersion of sector and individual security returns. How to capture these potential opportunities to generate above-benchmark returns? Nimble portfolios, getting granular, and investment skill are part of the answer, we think.

These changes demonstrate why we think it’s important to be agile with strategic views. This new, more volatile regime means the relative attraction of different assets is shifting faster than we have been used to for a generation.

Credit is a case in point. Just a year ago, we were overweight investment-grade credit because spreads looked attractive versus our long-run expectations. Then spreads tightened materially, and we turned underweight as we expect them to widen in the long run. High-for-longer rates will likely eat into corporate margins and earnings, in our view, especially as companies refinance debt. We see private credit lenders benefitting from refinancing activity as banks curb lending due to high rates reshaping the financial industry. That said, private markets are complex and not suitable for all investors. And private credit is not immune to the tough economic backdrop, but we think current yields compensate investors for the risks.

Our bottom line: High rates are a core tenet of the new regime. We carve out a strategic overweight on shorter-term DM bonds and stick to our preference for inflation-linked bonds. We go neutral DM stocks but see granular opportunities.

Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.

Wei Li, Global Chief Investment Strategist – BlackRock Investment Institute, Vivek Paul, Global Head of Portfolio Research – BlackRock Investment Institute, and Devan Nathwani, Portfolio Strategist – BlackRock Investment Institute, contributed to this article.

Disclaimer

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