Don’t bank on bonds to keep protecting portfolios: BlackRock
Investors should be wary of using government bonds to protect their portfolios because rising inflation and the Russia/Ukraine conflict could erode their diversification benefits, according to BlackRock.
Government bonds had traditionally been used to protect portfolios in times of market stress as they tended to rise when stocks were falling. Although this relationship had been tested in the past, government bonds had shown some of their traditional diversification properties since Russia started an invasion of Ukraine at the end of February.
However, as the chart below shows, the protection offered by bonds waned in the recent sell-off.
Average 10-year US Treasury returns on days when equities fall
Source: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2022
Strategists at BlackRock said: “In the short period since the conflict started to escalate, government bonds briefly helped guard portfolios against some equity losses. Yet we see this diversification role as increasingly challenged due to supply-driven inflation and central banks’ higher tolerance of such inflation”.
Research by the investment house found government bonds tended to have a negative correlation with equities – so offer the desired portfolio protection – when demand shocks dominate the market. But the correlation turns positive when falls in the stock market are driven by supply shocks.
“In other words, bonds are less likely to act as portfolio ballast during equity sell-offs in a world shaped by supply constraints – what’s happening now and we see persisting in coming years,” the strategists added.
“The Russia-Ukraine war will have long-term humanitarian and geopolitical consequences. We see high energy prices as the main macro transmission channel – exacerbating supply-driven inflation in the near term.”
Inflation had ticked up since the world opened up from the COVID-19 lockdowns as the supply of key goods ran into bottlenecks at the same time demand was rising. In the US, inflation was running at 7% – its highest in 40 years – while the UK’s consumer prices index stood at 4.9%.
The sanctions placed on Russia were expected to contribute even more to soaring inflation given the fact that the country is a major exporter of several key commodities, including oil, gas, aluminium, nickel, lead, cobalt, copper, wheat and corn.
In light of this, BlackRock was maintaining its underweight on conventional developed market government bonds (as well as credit) while preferring developed market stocks against the backdrop of historically low and negative real yields.
However, the firm still wants to build some protection into portfolios against stock market sell-offs and said there is “more appeal” in Treasury inflation-protected securities (TIPSs) and Chinese government bonds (CGBs) in the current inflationary environment.
“Our work finds TIPS and CGBs offer better risk-adjusted returns and lower correlation to equities than other assets of broadly comparable risk,” BlackRock’s analysts finished.
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