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Government bonds’ safe haven status is ‘obsolete’, warns BlackRock

18 October 2022

Investors who think government bonds will protect them in a recession should look at the situation playing out in the UK, strategists say.

By Gary Jackson,

Head of editorial, FE fundinfo

Investors should not bank on government bonds protecting portfolios as they traditionally have in a recession because their safe haven status is “obsolete”, BlackRock strategists have cautioned.

With central banks around the world tightening monetary policy to curb surging inflation, the global economy is at significant risk of contracting in 2023. Bodies such as the International Monetary Fund and the World Bank have been ramping up warnings in recent weeks that a recession could be on the cards, accompanied by a series of financial crises.

Amid these fears, strategists at the BlackRock Investment Institute have argued that “the old recession safe-haven playbook doesn’t apply” and explained why the investment house – which is the largest asset management firm in the world – is underweight government bonds.

During the so-called ‘Great Moderation’ – or the period of steady growth and inflation prior to the Covid-19 pandemic – any signs of slowing growth prompted central banks to ease monetary policy in order to kickstart the economy. This tended to benefit government bonds, allowing them to provide a cushion for investors during recessions.

This time around, however, it is the central banks themselves creating the heightened risk of recession by aggressively hiking interest rates in a bid to get on top of inflation. This is negative for government bonds, which have fallen over the course of 2022.

The latest note from the BlackRock Investment Institute said: “Recession fears are roiling markets. Investors traditionally take cover in sovereign bonds, but we see this recession playbook as obsolete.

“Why? First, central banks are hiking rates to try to tame inflation, causing recessions. Second, we don’t see them cutting rates like they typically do in recessions due to persistent inflation. Third, we expect investors to demand more compensation for the risk of holding government bonds amid high debt loads.”

It added that the situation playing out in the UK at the moment demonstrates that the above scenario is not just a theory. The gilt market tanked after unfunded tax cuts were announced and concern rose that the Bank of England would have to hike rates more than expected to offset this potentially inflationary fiscal stimulus, even though this would add to recessionary pressures.

“While the government has trimmed its tax cut plans, they have already dented UK fiscal credibility and would still add to the debt build-up during the Covid-19 shock. In this environment, bond vigilantes are back and heralding term premium’s return,” the institute added.

Against this backdrop, BlackRock is broadly underweight government bonds, particularly when it comes to the US, the UK and Italy. However, it has a neutral stance on eurozone government debt (apart from Italy) as it considers expectations for European Central Bank rate hikes to be too hawkish.

“Strategically, we’re underweight developed market government bonds and see yields higher in five years and beyond. We prefer inflation-linked bonds both tactically and strategically given they are not pricing in persistent inflation,” the BlackRock Investment institute finished.

“We like high quality credit: Strong corporate balance sheets should limit default risks even in a recession, in our view.”

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