BlackRock Investment Institute: ‘Pockets of value’ restored in bond markets

In a note published yesterday evening (9 May), BII said the commodities price shock and growth slowdown in China also led to a downgrade of Chinese assets and Asia fixed income.

“We see little chance of a perfect economic scenario of low inflation and growth humming along,” the team warned. “Last week’s market rout shows investors are adjusting to this reality.”

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While BII pointed out bonds are “generally not attractive in inflationary times” and it therefore remains “well underweight” the asset class, it believes the broad-based sell-off experienced year to date has “restored some value in pockets of the market”.

“First, we have warmed up to European government bonds because we believe market expectations of rate hikes by the European Central Bank (ECB) are too hawkish,” the team explained. “We see the energy shock hitting Europe hard – and causing the ECB to move very slowly in normalising policy.

“We also see the asset class as a buffer against the growth shock, after downgrading European equities in March.”

Elsewhere, BII’s research team is finding “some value” in investment-grade credit which, according to its in-house research, has hit its highest average coupon in more than a decade at 4% as spreads have widened and US Treasury yields have risen.

“Crucially, we remain underweight US Treasuries,” it continued. “We see the yield curve steepening on further rises in long-term yields as investors want more compensation for holding long-term bonds amid inflation.”

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While BII still favours equities over fixed income, given it believes the US Federal Reserve will not raise rates above neutral and that it will “have to live with inflation… settling at a higher level than pre-Covid”, it recognises that “risks have risen”.

“The commodities price shock is set to hit growth, especially in Europe and emerging markets that are commodities importers,” the team said. “The Fed rightly is fast normalising policy but could slam the brakes on the economy if it chooses to fight inflation. It is tough to see a perfect outcome.”

While bringing inflation down to pre-Covid levels would likely mean a recession, according to BII, it said China’s outlook is rapidly deteriorating amid widespread lockdowns to halt the resurgence of coronavirus. This, combined with geopolitical concerns regarding China’s ties to Russia, means the team has downgraded Chinese stocks and bonds to neutral.

“We are nudging down risk amid the commodities price shock, deteriorating growth in China and tough trade-offs for central banks,” it concluded. “We upgrade European government bonds and IG credit to neutral as we see tactical opportunities there.

“We downgrade Chinese assets to neutral due to geopolitical concerns and a worsening macro outlook.

“Overall, we remain overweight equities, with a preference for US and Japanese stocks, and are underweight US Treasuries.”