US Treasuries should play a bigger role in portfolios in the year ahead as investors seek to balance risk and reward against a backdrop of renewed uncertainty in markets, according to BlackRock’s Richard Turnill.
After a relatively benign market backdrop in 2017, this year has been more volatile than many investors may have expected.
Following a sell-off in markets earlier in the year over weaker-than-anticipated economic data, markets have corrected again in recent months over concerns of an escalation in the US-China trade war and a faster rate-hiking regime by the Federal Reserve.
Indeed, the S&P 500 index has fallen by 8.31 per cent over the past three months in US dollar terms, while the FTSE All Share – facing the additional challenge of the ongoing Brexit saga – has dropped by 7.74 per cent in sterling terms, as the below chart shows.
Performance of indices over 3mths
Source: FE Analytics
Turnill – BlackRock’s global chief investment strategist – said markets have become more sensitive to any hints of an economic slowdown as the late-cycle phase of markets approaches.
As such, US Treasuries can play a bigger role as “portfolio ballast”, said Turnill, and the firm had recently upgraded its view on the asset class to ‘neutral’.
This view is backed by the performance of US government bonds in the run-up to a recession, said the strategist, which many are now beginning to anticipate as the era of loose monetary policy nears its end.
While BlackRock is not forecasting an imminent recession, the probability of one rises to just above 50 per cent by the end of 2021.
“We find equities have historically done well in late-cycle slowdowns,” explained Turnill. “This includes even the calendar year preceding an economic downturn.”
However, against a backdrop of trade-related uncertainty and fears of a slow-down, risk assets could face challenges, the BlackRock strategist warned.
Turnill said that equity performance has deteriorated as a recession has drawn closer and have been overhauled by US Treasuries as investors turn to ‘safe havens’.
“History may not repeat,” noted the BlackRock strategist. “The averages mask a wide range of market outcomes around recessions given differences in starting valuations and the character of each downturn.
“Yet history often can be informative.”
Average 12-month returns in periods preceding US recessions 1978-2018
Source: BlackRock
While all signs point to ongoing economic expansion – still-easy monetary policy, few signs of economic overheating and a lack of financial vulnerabilities – the US economy is entering the late-cycle stage and becoming more vulnerable to external shocks, said Turnill.
“Trade frictions and a US-China battle for supremacy in the tech sector hang over markets,” he explained.
“We see trade risks more fully reflected in asset prices than a year ago, but expect the twists and turns of trade talks to cause bouts of anxiety.”
Given the more challenging longer-term outlook for risk assets, Turnill said that US Treasuries can provide investors with a buffer in the event of a market turndown.
“For one, they can cushion against any late-cycle sell-offs of risk assets,” he explained. “In addition, the Federal Reserve’s policy path may create a relatively benign environment for Treasuries.
“We see the Fed pausing its rate-hiking cycle at some point in 2019 to assess the effects of slowing economic growth and tightening financial conditions.”
Indeed, BlackRock thinks that US rates are already on their way to neutral levels which it believes is around 3.5 per cent.
Within the US government debt, the strategist said it has a preference for shorter-term debt, offering yields that are comparable with longer-term Treasuries.
“Higher yields and a flatter curve as a result of the Fed’s rate increases over the past three years have made shorter maturities an attractive source of income for US dollar-based investors,” said Turnill.
Indeed, the US Treasury yield curve has flattened significantly in recent weeks, with the spread between two- and 10-year yields reaching post-crisis lows, Turnill noted, with the curve inverting between two and five years.
Historical Treasury rates 2yr v 5yr (nominal) over 12mths
Source: US Department of Treasury
Alternatives such as core European government bonds appear less attractive, said the strategist, as the European Central Bank’s loose monetary policy pins down yields at low levels.
The asset manager said in its outlook for the year ahead that it does not foresee a hike in rates by the European Central Bank before president Mario Draghi leaves his role at the end of October 2019.
Additionally, there are further concerns about the wider European economy, which remains sluggish and exposed to ongoing trade frictions, as well as potential threats to the political structure.
“Europe has us worried,” BlackRock noted. “We expect no immediate flare-up in the region’s political risk but believe investors are underappreciating medium-term threats to European unity.
“We see Italy’s budget deficit stoking a protracted fight with Brussels and could see further pressure on Italian bonds and other assets sensitive to European political risks against a backdrop of slowing growth across the eurozone.”
As a result, Turnill said it has been advocating a carefully balanced approach towards risk and reward in constructing portfolios.
“Exposures to government debt as a portfolio buffer, twinned with high-conviction allocations to assets that offer attractive risk/return prospects such as emerging market equities,” he said.
“We prefer stocks over bonds, but our conviction is tempered. In equities, we prefer quality — free cash flow, sustainable growth and clean balance sheets.”
Turnill concluded. “We favour up-in-quality credit. We steer away from areas with limited upside but hefty downside risk, such as European stocks.”