Bonds are making a comeback. Why? U.S. bonds now offer an attractive source of income as well as key portfolio diversification benefits, as we write in our new Fixed income strategy: Bonds are back.
The key drivers: higher U.S. interest rates, a slowing but growing U.S. economy and a pause in the Federal Reserve’s tightening cycle.
We expect the Fed to avoid raising rates until the second half of this year, after it pledged a more patient and data-dependent stance on policy. However, whether this will really be a pause in, or instead the peak of, the Fed’s tightening cycle depends on economic data released in coming months, in particular inflation readings. For now, a Fed on hold should give comfort to investors looking to move out of cash and money market funds in search of greater income–via longer-duration bonds and credit.
We also like U.S. government bonds as portfolio shock-absorbers, against a backdrop where the risk of late-cycle volatility in the equity market is growing. We see U.S. growth slowing in 2019, as the economic cycle moves into the late stage. We see low odds of a U.S. recession this year but potential for investor angst around slowing growth leading to risk-off episodes. Bonds should serve as a buffer in such scenarios, with correlation to equities deeper in negative territory. See the chart below.
We believe such negative bond/equity correlations are likely here to stay, elevating bonds’ role as a powerful diversification tool in balancing risk and reward in portfolios. This supports our recent shift to a more constructive view on U.S. government bonds.
Beyond the U.S., we expect the European Central Bank to stay put on rates this year, and see its forward guidance as a focus for markets. Ongoing monetary policy support is vital to Europe’s economy, we believe, while fiscal stimulus provides some cushion. We see inflation below target in Europe and Japan, and expect China’s economy to regain its footing in the first half on policy easing, putting a floor under the synchronized slowdown in emerging market growth.
How does this all translate into our views on specific fixed income asset classes?
The table on our fixed income strategy site highlights our granular views from a U.S. dollar perspective over a three-month horizon. Views and comments are from a fixed income-only perspective, and may differ from whole-portfolio tactical views on fixed income in our Global weekly commentary. For example, we overweight U.S. credit and emerging market debt from a fixed income perspective because of their income potential. Yet we are neutral on these asset classes in a multi-asset context, where we prefer to take economic risk in equities.
What are the risks to our views?
The odds of a U.S. recession rise materially after 2019, as detailed in our 2019 Global investment outlook. Other risks include european fragmentation and an intensification of U.S. – China trade disputes. Read more on our views and key themes for fixed income in our latest fixed income strategy.
Scott Thiel is BlackRock’s chief fixed income strategist, and a member of the BlackRock Investment Institute. He is a regular contributor to The Blog.