By: BlackRock Investment Institute (BII).
Markets have rallied sharply from their virus lows, driven by the policy revolution and economic restart. Tighter valuations increase the risk of volatility, particularly ahead of divisive U.S. elections. Last week’s equity selloff illustrates this. Against this background, we cut our tactical view on investment grade (IG) credit to neutral, but increase our overweight on high yield for its income potential.
Chart of the week
Investment grade and high yield credit yield spread, 2010-2020
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv, September 2020. Notes: The lines show yield spread of investment grade and high yield credit over the past 10 years, represented by the option-adjusted spread of Bloomberg Barclays Global Aggregate Total Return Index and Bloomberg Barclays Global High Yield Total Return Index.
Yield spreads of both IG and high yield credit spiked in March as the coronavirus spread further globally. They peaked later that month – and started to decline – when central banks including the Federal Reserve launched extraordinary monetary policy support. IG spreads have shrunk more than half from the March 23 peak to under 1.3%, about where they were before the Covid spike, as the orange line in the chart shows. The risk/reward balance now looks much less appealing: The extraordinary monetary policy support has already priced in, and IG is offering little buffer against risks such as rising rates due to its interest ratesensitive nature, in our view. High yield spreads have also narrowed sharply from late March (see the yellow line), yet there may still be room for further tightening, in our view, particularly as the economic restart gains steam.
The policy response to the virus shock has been a major driver of markets, but its composition over coming months will likely be different from what we’ve seen. We see limited room or appetite for central banks to further cut interest rates or ramp up asset purchases – a driver behind the recent compression in credit spreads. Fiscal policy is becoming key in the ongoing policy revolution, and the quantitative easing programs of major central banks help offset some downside risks. As a result, for now we stay overweight credit on a tactical basis and neutral on equities over both a tactical and strategic horizon. We see a growing risk that fiscal policy support dries up in the U.S. – barring a Democratic sweep in November that would pave the way for a boost to spending. Our base case, however, still calls for a new fiscal package of up to $2 trillion.
Our stronger preference for high yield is also supported by fundamentals that appear disconnected from market pricing. The current pricing implies around 25% of the bonds on the Bloomberg Barclays U.S. Corporate High Yield Index could default over the next five years, our calculations showed. This has fallen from the 40% implied rate in April, but is still higher than a median actual default rate of 19% since 1990. Many high yield issuers have been able to access the capital market for their liquidity needs over the past few months, likely helping them weather any further economic turmoil caused by the virus shock. We expect mid- to high- single digit high yield default rates over the coming year. Yet many of the victims will likely be companies with the weakest balance sheets that were already prime candidates for default in coming years, in our view. We value high yield as a source of income in low-yield world, and expect it to outperform IG once growth reaccelerate.
The bottom line: We stay moderately overweight on credit overall on a tactical basis for now. We strongly favor high yield, and are neutral on IG. We are still overweight U.S. Treasuries over the next six to 12 months as ballast against uncertainties around the pandemic and U.S. election. Yet over the strategic horizon we advocate reducing allocation to nominal developed market (DM) government bonds as interest rates are near their lower bounds and medium-term inflation risks grow. On a tactical basis we have also downgraded EM local-currency debt and are underweight hard-currency EM debt too, as we generally prefer to take risk in developed markets. Many EM countries have insufficient public health systems to control the virus spread and less policy space to cushion the economic blow. Yet we are neutral on Asia fixed income given China’s ongoing recovery from the virus shock.
Assets in review
Selected asset performance, 2020 year-to-date and range
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, September 2020. Notes: The two ends of the bars show the lowest and highest returns versus the end of 2019, and the dots represent 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, MSCI USA Index, the ICE U.S. Dollar Index (DXY), MSCI Europe Index, Bank of America Merrill Lynch Global Broad Corporate Index, Bank of America Merrill Lynch Global High Yield Index, Datastream 10-year benchmark government bond (U.S. , German and Italy), MSCI Emerging Markets Index, spot gold and J.P. Morgan EMBI index.
Activity has started to normalize around the globe, albeit with renewed localized lockdowns to contain virus clusters. Market volatility is returning after months of steady advances in risk assets. Valuations have risen, and we could see greater volatility in coming months as a result, especially as the U.S. election closes in. A contributing factor: Negotiations over the size and makeup of a new U.S. fiscal stimulus package have stalled. In addition, the pandemic is still spreading in many countries, and U.S.-China tensions have escalated.
2020 Investment Themes
- Economies are slowly restarting, but at different paces. We are tracking the evolution of the virus and mobility. The longer it takes for activity to restart, the more cracks might appear in the financial system and productive capacity.
- Activity is restarting around the globe, albeit with localized lockdowns to contain virus clusters. The surge of new infections in U.S. Sun Belt states looks to have peaked, but has resulted in a reversal of some reopening measures and is affecting activity. Europe has seen a pickup in cases but nowhere on the same scale as the U.S.
- The nature of the activity rebound will depend on the path of the outbreak, delivery of policy response and potential changes to consumer and corporate behaviors. Success will not just be about restarting the economy and containing the virus – but balancing both objectives.
- Market implication: We are moderately pro-risk, and express it in an overweight to credit in strategic, long-term portfolios. We prefer Europe among cyclical equity exposures on a tactical horizon.
- The policy revolution was needed to cushion the devastating and deflationary impact of the virus shock. In the medium term, however, the blurring of monetary and fiscal policy could bring about upside inflation risks. It’s crucial to have proper guard rails around policy coordination, as we discuss in Policy Revolution.
- The Federal Reserve built on its “whatever it takes” approach to helping the economy through the shock and ensuring markets function properly, but has so far steered clear of committing to explicit yield curve control.
- After a slow start, Europe has followed suit. The European Central Bank started fresh and more flexible quantitative easing. European leaders agreed on a historic €750 billion European recovery plan that introduces mutualized debt and creates jointly issued European bonds that can compete with other perceived safe-haven assets.
- EU leaders appear committed to the recovery plan, but it may take time to implement.
- The combined sum of fiscal and monetary actions is covering the virus hit to the economy in both the U.S. and euro area, our analysis shows.
- We see a risk of policy exhaustion, especially in the U.S. Enhanced jobless benefits expired on July 31, and negotiations on new fiscal relief measures have dragged on. We could see a $1-1.5 trillion fiscal package that extends some federal stimulus measures through late-2020. Aid to states and local governments is a key item, with many facing budget holes.
- Market implication: We are underweight nominal government bonds and like inflation-linked bonds on a strategic horizon. Tactically, we overweight credit and European equities, and see U.S. stocks at risk of fading fiscal stimulus.
- Supercharged structural trends are changing the nature of portfolio diversification. Countries and sectors will make a comeback as diversifiers in a more fragmented world, in our view, offering resilience to real economy trends.
- Portfolio resilience has to go beyond broad asset class diversification alone. Investors should consider alternative return sources that can provide diversification, such as private markets.
- A focus on sustainability can help make portfolios more resilient. We believe the adoption of sustainable investing is a tectonic shift that will carry a return advantage for years to come – and the coronavirus shock seems to be accelerating this shift.
- Market implication: We prefer sustainable assets, private markets and deliberate country diversification for strategic portfolios. We have increased our overweight in the quality factor on a tactical horizon, and favor assets with policy backstops.