BlackRock’s Weekly Market Commentary: Policy revolution’s long reach

By BlackRock Investment Institute

The powerful policy revolution implies a lower future path of interest rates than markets are pricing in, even amid rising inflation over the medium term, as captured in our new nominal investment theme. Lower rates – even compared to our previous expectations – lift our expected returns across asset classes over the strategic horizon, and reinforce our preference for equities over bonds.

Chart of the week

Equity risk premium and credit spread current vs. historical

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. You cannot invest directly in an index. Sources: BlackRock Investment Institute and Refinitiv Datastream, data as of March 2021. Notes: The chart shows the equity risk premium and historical ranges since 1995 for major equity regions based on MSCI indexes and the credit spreads for the U.S. investment grade and high yield markets based on Bloomberg Barclays indexes. We calculate the equity risk premium based on our expectations for nominal interest rates and the implied cost of capital for respective equity markets. Credit spreads are calculated by taking the difference between the credit market yields and the corresponding government bond yields.

Both equities and credit have rallied strongly since March 2020, yet we still see equities as reasonably valued, while credit spreads are close to their tightest levels relative to history. We see the equity risk premium (ERP) – our preferred gauge of equity valuations that accounts for changes in interest rates – as in-line with historical averages, suggesting the asset class is not overvalued. See the chart above. The improving corporate earnings outlook has offset some of the impact of rising equity prices on valuations. The result? The ERP still remains above its historical median for the U.S. and euro area, bolstering their relative appeal. Our new nominal theme sees a lower path of short-term interest rates compared with our previous expectations and current market pricing, further supporting our estimates of the ERP today. The policy revolution also indicates a steeper yield curve than we have previously forecasted – and important implicit limits on how high government bond yields may go over the next five years, in our view.

We have updated our long-term return assumptions to fully incorporate the new nominal theme and broader implications of the policy revolution, and to reflect changes in market prices and fundamentals. Our non-consensus inflation outlook is key. We see higher medium-term inflation, due to rising production costs, the Federal Reserve’s new policy framework to allow inflation overshoots, and rising debt levels that will make it harder for central banks to lean against inflation. As a result, we believe markets are still underestimating inflation risk in the medium term.

Long-term U.S. government bond yields have risen this year, but the rise has been more muted than typically seen in response to rising inflation and growth expectations in the past. We believe the spike in bond yields earlier in the year was driven by a higher term premium – or the premium investors typically demand to hold riskier long-term government bonds – rather than expectations for higher policy rates. We don’t see it as threatening the broad equity market – particularly against the backdrop of economic restart – but could lead to leadership changes within equities. We believe a “term premium tantrum” – or an unexpected increase in term premium from here – would ultimately reduce the attractiveness of fixed income but reinforce that of equities.

Keeping yields low enough to ensure the viability of surging debt burdens in the developed world and stability in emerging markets is an important interaction between fiscal and monetary policy that informs our views. We ultimately expect yields to rise over the strategic horizon, but see important limits on the level of yields that the economy can withstand. We estimate if the 10-year Treasury yield rose to 2.5% or higher, debt servicing costs would exceed the 50-year average share-to-GDP of 2% as estimated by the Congressional Budget Office. Over the longer term, fiscal sustainability concerns could lead investors to demand greater compensation for holding government bonds relative to holding cash – and our updated assumptions feature steeper yield curves in the future to reflect this. Both factors reinforce our strategic underweight on developed market (DM) nominal bonds.

The bottom line: We prefer equities over credit and government bonds on a strategic horizon. Within equities we like DM and China, helped in part by the impact of incorporating climate change in our return expectations. We prefer inflation-linked bonds to nominal bonds as portfolio ballast.