Quick read:
- In a world of high inflation and tightening monetary policy, expansionary fiscal policies have catalyzed sizable bond selloffs and weighed on global risk assets. The GTAA team believes this is because markets now expect expansionary fiscal policy to exacerbate the need for further monetary tightening.
- In our tactical multi-asset portfolios like the BlackRock Tactical Opportunities Fund, this outlook motivates an overall short position in global duration with shorts concentrated in European government bonds.
The September turmoil in UK bond markets has shifted the market’s focus back to fiscal policy. In contrast to positive market reactions to expansionary US fiscal announcements of 2020 and 2021, announcements of expansionary fiscal packages in the UK and Germany in 2022 have catalyzed sizable bond selloffs and weighed on global risk assets. The GTAA team believes this is because markets now expect expansionary fiscal policy to exacerbate the need for further monetary tightening. We have positioned portfolios, particularly within fixed income, with a view that fiscal sustainability and borrowing constraints are likely to remain a concern for global bond investors. Across portfolios we are outright short European government bond markets.
Europe opens the purse strings
Russia’s invasion of Ukraine continues to be pivotal to policy developments across Europe. The supply constraints related to Russian sanctions earlier in the year accelerated inflation pressures and monetary tightening across the region. More recently, shortages in the wholesale electricity markets and shutdowns of piped natural gas deliveries have forced governments to enact large fiscal packages to tame electricity prices. The recently announced, open-ended fiscal commitments by the UK and Germany stand out in an otherwise austere Europe and have proven to be quite disruptive to markets.
In the UK, the larger-than-expected fiscal announcements by the new Truss administration led to a sharp sell-off in the currency and temporarily broke the long-end of the government bond market as leveraged players found themselves unable to meet margin requirements. Despite intervention by the Bank of England and some less expansionary modifications by the government, UK Gilts continued to sell-off into early October as can be seen in the visual below.
Though the UK disruptions have dominated the new headlines, bond markets have also taken note of a succession of ever-larger German fiscal announcements. To insulate German households from potentially catastrophic energy price rises this winter, the German government announced at the end of September a very large (€200bn, or over 5% of GDP) and unfunded fiscal expansion. This policy should remove the tail risk of skyrocketing inflation, but it comes at the cost of greater government debt issuance. The market reaction has been a sharp sell-off in German Bunds as debt markets reprice for greater bond supply and a more aggressive European Central Bank policy response.
European government bonds have led the global sell-off
Source: BlackRock, Bloomberg as of 10 October 2022. Chart shows total returns of government bonds from 31 July 2022 – 10 October 2022. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
US fiscal policy set to shift expansionary again into 2023
In early 2022, a prevailing narrative was that a reduction in fiscal support in the United States would weigh on GDP growth following record expansions in 2020 and 2021. However, more recent developments suggest that fiscal policy will likely contribute positively to overall GDP growth again in 2023. At a federal level, the Biden Administration unexpectedly passed a large infrastructure package (the Inflation Reduction Act, or IRA) and introduced a student loan debt forgiveness plan this summer. Though the exact timing and budgetary impact of these packages are uncertain, the Congressional Budget Office has estimated that the IRA will add $100 billion in fiscal expenditures through 2023 and the student loan executive order will add ~$400 billion to the federal deficit.1 US state-level fiscal policy should also be expansionary heading into 2023.2
What does this mean for investors?
Higher inflation and the associated monetary response have shifted yields higher throughout 2022. More recent moves higher in European bond yields have had a different catalyst - market concerns about excessive fiscal policy and debt sustainability. To us, the signs point to expansionary fiscal policy continuing into 2023 and potentially leaving monetary policy behind the curve. In that environment we view the go-forward risks to bond markets to be the resilience of high nominal growth and the associated necessity for further monetary tightening.3
In our tactical multi-asset portfolios like the BlackRock Tactical Opportunities Fund, we continue to look for cross-country, relative value opportunities in both bonds and stocks. Within bonds, we remain short global duration with shorts concentrated in European government bond markets. The hawkish Fed also has us short US equities in the cross-section of countries as tighter monetary policy acts as a headwind to US equity multiples and the earnings outlook.
