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Global Weekly Commentary: Positioning for the new nominal
Key points
Strategic implication
We favor inflation-linked bonds and see equities supported in strategic portfolios, expecting firmer inflation and falling real rates in coming years.
Market backdrop
Global stocks hit record highs amid positive vaccine news and hopes for a U.S. fiscal package, even as near-term challenges weighed.
Fed watch
The Federal Reserve may provide some forward guidance on asset purchases at this week’s monetary policy meeting.
A key consequence of this year’s policy revolution is the potential for a more muted response of nominal yields to higher inflation, in our view. This means investors should start positioning their long-term portfolios for this new dynamic now, in our view. We favor holding more inflation linked bonds and see equities supported by falling real rates in strategic portfolios.
Chart of the week
U.S. sector return sensitivity to rising nominal rates, December 2020
This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance. Source: BlackRock Investment Institute, with data from Refinitiv Datastream, December 2020. Notes: The chart shows the implied equity risk premium and the sensitivity of 5-year expected returns to a 50 basis point rise in nominal rates for MSCI USA sectors. Past performance is no guarantee of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index.
The joint fiscal and monetary policy revolution this year implies central banks will likely keep nominal bond yields capped – even as inflation rises. We believe this has big implications for overall asset class returns – and sector performance. The sensitivity of different equity market sectors to rising interest rates varies. Traditional “value” sectors with higher equity risk premia, such as energy, typically have outperformed others in periods of rising nominal rates. The chart above shows our estimate of the expected return impact on each sector from a hypothetical 0.5% rise in U.S. nominal rates: financials and energy would suffer least and technology the most. Higher-valued growth sectors with lower equity risk premia – such as tech – have higher sensitivity to interest rates due to their long-duration cash flows. Yet rangebound nominal rates and lower real rates – as in our base case – mean we are unlikely to see a clear catalyst for a durable rotation to value from growth as past periods with rising inflation would suggest.
The changing relationship between inflation and interest rates is a key investment theme that we name The new nominal, as detailed in our 2021 global outlook. Our inflation outlook is structural in nature. It is due to the impact of the joint fiscal-monetary policy revolution and higher production costs from the expected realignment of global supply chains, rather than simply a large, external supply shock that has historically been a driver of inflationary pressures.
We do not see inflation expectations becoming unanchored as they did in the 1970s, and instead expect U.S. consumer price index (CPI) inflation to average just under 3% between 2025-2030. Yet investors may be under-appreciating the potential for higher inflation, in our view. Breakeven inflation rates – a market-based measure of inflation expectations – have risen since March, but are still materially below our expectations. Even the modest rise in price pressures we anticipate would be a significant departure from the experience of recent decades, during which inflation has persistently undershot central bank targets. This large gap between our expectation and market pricing may offer a strategic investment opportunity. Investors could start positioning their strategic portfolios to guard against risks – and take advantage of opportunities – presented by the new nominal.
In our new inflation playbook, nominal yields will be less responsive to rising inflation. Combined with the fact they are closer to effective lower bounds, we believe this likely means a narrower expected range for yields. As a result we see less negative correlations with risk assets and a challenge to the role of nominal government bonds as portfolio ballast. Falling real yields alongside higher inflation increases the expected returns of inflation-linked bonds relative to nominal government bonds, underscoring our preference to reduce nominal bond holdings and add inflation-linked exposures.
The bottom line: A new inflation regime has major implications for strategic asset allocation decisions, in our view, with a material cost to both getting the inflation call wrong and misinterpreting the impact of inflation on nominal and real yields. In our base case we prefer holding more inflation-linked bonds and less nominal government bonds. Limits on nominal bond yields mean our preferred equity allocation stays higher than it would typically in an inflationary environment. Professional investors can read more about the strategic implications of the new nominal in our Portfolio perspectives publication.
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