This year’s moves prompt a tweak to our tactical views. We favour short-term government bonds for income. We trim our overweight to credit after spreads tightened. We go overweight emerging market (EM) stocks, adding to our relative preference over developed markets.
Yield is back
U.S. investment grade spreads and two-year Treasury yields, 2020-2023
Source: BlackRock Investment Institute, with data from Refinitiv Datastream, February 2023. Notes: The chart shows the spread of U.S. investment-grade corporate bonds over U.S. Treasury yields (dark orange line) and the two-year U.S. Treasury yield (yellow line).
Risk assets have jumped to start 2023 thanks to falling inflation, Europe’s easing energy shock, China’s rapid restart from Covid restrictions and technical factors that drove the quick move up. Yet we think the rally also reflects hopes that the sharpest central bank policy tightening in decades can avoid economic damage: growth will be sustained even if rates stay higher, and inflation will drop to 2% targets. Central banks then wouldn’t need to further tighten policy and create recessions to lower inflation. Now bond markets are waking up to the risk the Fed hikes rates higher and holds them there for longer. We boost our allocation to short-term government bonds on our six-to-12-month tactical horizon to take advantage of higher yields. See the chart. We balance that by reducing our overweight to investment-grade credit. We go overweight EM equities and prefer them over DM equities, partly to get exposure to China’s rapid restart.
This is not a typical economic cycle – and that’s why we have argued a new investment playbook is needed. Recent data has shown that U.S. economic activity is holding up. Core inflation is proving stickier than many expected as confirmed by recent U.S. CPI data and revisions. The U.S. labour market remains tight with unemployment at its lowest in five decades. We don’t think inflation is on track to return to policy targets – and a recession would be needed to get it down. That means solid activity data should be viewed through its implications for inflation. In other words: Good news on growth now implies that more policy tightening and weaker growth later is needed to cool inflation. That’s bad news for risk assets, in our view.
Shifting views
We increase short-term Treasuries to an overweight. The jump in yields – the two-year U.S. Treasury yield is now near 4.6% compared with 1.5% a year ago – that now means short-term bonds provide income. We also like their ability to preserve capital at higher yields in this more volatile macro and market regime. We reduce our overweight to investment grade credit. Credit spreads have tightened sharply along with stocks pushing higher, reducing their relative attraction. We remain moderately overweight and still think highly rated companies will weather a mild recession well given stronger balance sheets compared with before the pandemic. We also cut agency mortgage-backed securities to neutral due to the spread tightening.
We have had a relative preference for EM equities over developed markets (DM) for some time. We add to this relative preference by going overweight EM. We prefer EM as their risks are better priced: EM central banks are near the peak of their rate hikes, the U.S. dollar is broadly weaker in recent months and China’s restart is playing out. That is in contrast to major economies that have yet to feel the full impact of central bank rate hikes – and yet still have a too-rosy earnings outlook, in our view. Plus, the risk is growing that DM central banks press ahead with more rate hikes. We see risks in EMs, too, but think they are better priced for now. EM equities would not be immune to any resulting risk asset selloff and U.S. dollar surge if the Fed keeps hiking rates. And China’s restart – like those seen in DM economies – doesn’t change the long-term drags on growth it faces. Investors are still requiring more compensation for the geopolitical risk of holding Chinese assets – which has risen, in our view – and also considering risks from regulatory and government intervention.
Our bottom line
We put into practice our new playbook of making more frequent changes to our tactical asset allocation. We lean further into short-term government bonds and our preference for EM equities over DM. We trim our overweight to investment-grade credit and turn neutral on agency mortgage-backed securities.
Market backdrop
Two-year U.S. Treasury yields surged back near 15-year highs as markets priced out Fed rate cuts this year. The yield curve between two- and 10-year Treasuries inverted further to its most extreme levels since the early 1980s. The yield jump sparked a broad retreat in equities, with the S&P 500 falling for a second straight week. We think investors are realizing that sticky core inflation may mean the Fed hikes rates further – and holds them there for longer – than markets had expected.
We’re looking at flash PMIs in the U.S. and Europe for more signs of resilience. Stronger activity could reinforce expectations that further central bank tightening could be needed to bring inflation down to policy targets. We’re also watching the U.S. PCE report for confirmation of stickier core inflation as seen in the U.S. CPI.
