By Nick Hedley
The relative appeal of developed market equities over government bonds has narrowed, says BlackRock.
With yields on the rise, the world’s largest asset manager has reduced its “underweight” tilt to government bonds, and trimmed its “overweight” position in developed market equities.
“Near-term risks appear skewed to the downside for growth and risk assets: Central banks talking tough on inflation, an ongoing commodity price shock and China’s restrictive COVID lockdowns adding to a weaker macro outlook,” BlackRock said in a weekly update. These risks will likely weigh on growth assets over the next 12 months, and the firm has responded by reducing portfolio risk.
Although stocks have clawed back some of their losses on hopes that the U.S. Federal Reserve would soon pause interest rate hikes to assist the economy, the firm said a sustained rebound was unlikely, at least until the Fed took a clear dovish turn.
With the market still pricing in aggressive rate hikes – more than is warranted in BlackRock’s view – the firm has downgraded its 12-month outlook for developed market equities to neutral.
However, given expectations that central banks will ultimately allow inflation to settle above pre-pandemic levels, developed market stocks and inflation-linked bonds remain its largest long-term overweights.
“We still prefer equities over fixed income on a strategic horizon, but we moderate our stance after this year’s big market moves,” BlackRock said.
On long-term bonds, BlackRock says the outlook “remains challenged.” Long-term yields could rise as investors demand a term premium for holding these assets due to high debt burdens and inflation risks.
“The jump in short-term yields and our expectation that the policy rate path will reprice lower mean we like shorter maturities over longer ones.”
The asset manager prefers private credit over public debt on a long-term basis, and still favors inflation-linked bonds.
Joe Zidle, chief investment strategist for Private Wealth Solutions at alternative investment manager Blackstone, said in a note that the new macro environment “will require a different approach than the traditional 60/40 portfolio of stocks and bonds.”
“More broadly, it will require creativity, high-conviction investing and a renewed look for uncorrelated assets,” he said. “If ultra-low interest rates and balance sheet expansion benefited beta strategies, monetary tightening will require more active, selective investing – alpha – to deliver outperformance.”
For instance, in the face of increasing credit risk, senior secured debt and investments that are higher in the capital structure “could be well positioned to weather a potential storm,” Zidle said.
Return assumptions across all asset classes should be tempered, Zidle said.
“As the liquidity recedes, we will see which investors were simply riding the wave of beta without any value-add of their own.”
James Knightley, chief international economist at Dutch financial services group ING, said in a research note that the U.S. economy and jobs market remain strong, and this strengthens the case for steeper rate hikes.
After an unexpected contraction in the first quarter, it appears the economy will rebound in the second quarter with growth of 4% or more being possible. At the same time, there are still nearly two job vacancies for every unemployed American.
“A tighter jobs market means more upward pressure on wages, which is likely to keep inflation stickier in the U.S. than in other developed markets,” Knightley said. “In turn, this supports our view that the Federal Reserve will continue to be more aggressive in raising interest rates than the European central banks, which will help keep the dollar supported over the next few months.”