Wei Li – Global Chief Investment Strategist of BlackRock Investment Institute together with Simon Blundell – Head of European Fundamental Fixed Income, Michel Dilmanian – Portfolio Strategist, and Devan Nathwani – Portfolio Strategist all forming part of the BlackRock Investment Institute share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
Key Points
Fixed income focus: Surging U.S. short-term Treasury yields and narrowing credit spreads support our preference for short- over long-dated credit and Europe over the U.S.
Market backdrop: U.S. stocks hovered near record highs last week. U.S. two-year Treasury yields hit two-month highs as markets priced out more Fed rate cuts in line with our view.
Week ahead: U.S. PCE and jobs data are in focus this week. We eye whether inflation will tick up like the CPI did as services inflation starts to reflect still-high wage growth.
Recent swings in fixed income markets reinforce our preference for quality and income. U.S. high yield spreads narrowed to near their tightest in 17 years as short-dated U.S. Treasury yields surged on markets pricing out Federal Reserve rate cuts. We prefer taking risk in equities from a whole portfolio perspective, yet we see investment opportunities in fixed income – like UK gilts over U.S. Treasuries. In credit, we favor short over long maturities and Europe over the U.S.
We leaned against two big swings in recent weeks: markets pricing in sharp Fed rate cuts and a jump in UK yields. Those moves have since started unwinding, especially in short-term yields. We see room for UK gilt yields to fall further relative to other major government bond yields: A tougher UK growth outlook paves the way for the Bank of England to cut further than the Fed, in our view. After an initial dip, gilt yields rose anew along with global yields last week – reflecting jitters ahead of this week’s UK budget announcement that we think are overblown. See the chart. At the same time, U.S. markets walked back recession fears that we saw as overdone as solid economic data quelled growth concerns. Markets have slashed some rate cuts they had priced in during the August stock selloff, driving short-dated bond yields up sharply. Markets are now closer to our view but have more room to run.
Inflation will keep the Fed from cutting as much as markets expect, in our view. Services inflation has proved sticky, with wage growth running hot enough that core inflation is unlikely to cool to the Fed’s 2% target. U.S. budget deficits look set to stay large regardless of who wins the U.S. presidential election, with neither candidate prioritizing a reduction. Longer term, we see mega forces – structural shifts impacting returns now and in the future – keeping inflation persistent. Higher inflation is why we’ve been expecting investors to demand significantly more term premium, or additional compensation for the risk of holding longer-dated bonds. We’re seeing early signs of this: Term premium on U.S. 10-year Treasury yields now sits near 20 basis points, having jumped around 45 basis points in the past month alone, LSEG Datastream data show.
Our European preference
Over the long term, we think term premium can rise further. Near term, shifting narratives can cause bouts of volatility and sharp yield swings in either direction, as seen recently. We favor international long-dated government bonds over U.S. long Treasuries, where we stay neutral. In the U.S., we prefer intermediate maturities that offer attractive income with less interest rate risk. We stay underweight short-dated U.S. Treasuries on a near-term tactical horizon. We prefer UK gilts and recently went overweight. UK bond markets await this week’s UK budget announcement, the first since Labour’s victory in the July election. Markets are pricing in some chance of a repeat of the 2022 mini-budget disaster – an outcome we see as unlikely.
Our preference for European over U.S. fixed income extends to credit. U.S. high yield spreads are rich relative to the euro area, especially given a weaker ratings profile in the U.S. Adjusting for ratings quality, European high yield is about 60 basis points cheaper than U.S. high yield, GFI data show. We think euro area high yield and investment grade credit better compensate investors for risk than their U.S. counterparts. Tight U.S. credit spreads are largely due to strong investor demand for new issues outstripping supply, resilient corporate balance sheets and strong macro data snuffing out lingering recession fears.
Our bottom line
Macro uncertainty is driving sharp interest rate swings, making long-dated government bonds less reliable portfolio diversifiers. Yet such swings and the return of total income in bonds creates investment opportunities we seize on.
Market backdrop
U.S. stocks hovered near record highs last week. Tesla’s share surge after its Q3 corporate earnings sets the stage for mega-cap tech earnings this week. Tech shares rebounded while small caps slid nearly 2% heading into the U.S. election. U.S. two-year Treasury yields hit two-month highs as markets priced out some Fed cuts in line with our view. U.S. 10-year Treasury yields touched three-month highs to near 4.19%, up nearly 60 basis points from September’s 16-month lows.
The focus is on the U.S. core PCE and jobs data this week. The core PCE – the Fed’s preferred inflation gauge – had been cooling as immigration has expanded the labor supply, and services inflation recently fell well below wage growth. CPI data for September suggested that services inflation measured by PCE could start to tick up given recent robust wage growth. The October jobs data should show still healthy payroll gains and still-solid wages.
Week Ahead
Oct. 30: U.S. GDP; euro area GDP
Oct. 31: U.S. PCE; Bank of Japan policy decision; flash euro area inflation data
Nov. 1: U.S. payrolls report
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