2022 midyear Global Outlook | BlackRock Investment Institute

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2022 MIDYEAR GLOBAL OUTLOOK

We are braving a new world of heightened macro volatility – and investors are demanding more compensation for the risk of holding both bonds and equities. We stay pro-equities on a strategic horizon but are underweight in the short run.

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Investment themes

Bracing for volatility

We have entered a regime of higher macro and market volatility. This implies that market views may have to change more quickly and get more granular.

Living with inflation

We see the Fed ultimately living with higher inflation as it sees the effect of its rate hikes on growth and jobs. For now, the Fed seems to be responding solely to the politics of inflation. This has caused us to reduce portfolio risk.

Positioning for net zero

Investing in high-carbon-emitting companies with credible transition plans or that are key to the transition can give investors exposure to the transition as well as mitigate the impact of its bumps.

Read details of our midyear outlook:

Global Outlook Asset class views An unprecedented reality

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The Great Moderation is over

The Great Moderation, from mid-1980s until 2019 before the Covid-19 pandemic struck, was a remarkable period of stability of both growth and inflation. We were in a demand-driven economy with steadily growing supply. Borrowing binges drove overheating, while collapsing spending drove recessions. Central banks could mitigate both by either raising or cutting rates.

That period has ended, in our view.

A regime shift

This chart shows that growth and inflation volatility has spiked since the onset of the pandemic, ending decades of stable growth and low inflation.

Sources: BlackRock Investment Institute, U.S. Bureau of Economic Analysis and Labor Department, with data from Haver Analytics, March 2022. Notes: The chart shows the standard deviation of the annualized quarterly change of U.S. real GDP and the core Consumer Price Index.

A regime shift

The pandemic upended an unusual period of mild volatility in output and inflation.

Production constraints

First, production constraints – stemming from a massive shift in spending and labor shortages – are hampering the economy and driving inflation.

Record debt levels

Second, record debt levels mean small changes in interest rates have an outsized impact on governments, households and companies.

Everything is political

Third, we find the hyper-politicization of everything amplifies simplistic arguments, making for poorer policy solutions.

Outlook in charts (PDF) Outlook in charts (PDF)

Bracing for volatility

This new market environment has echoes of the early 1980s. We are bracing for volatility in this regime. Central banks are rushing to raise rates to contain inflation that’s rooted in production constraints. They are not acknowledging the stark trade-off: crush economic growth or live with inflation.

The Fed, for one, is likely to choke off the restart of economic activity - and only change course when the damage emerges. We see this driving high macro and market volatility, with short economic cycles. Equities would suffer if rate hikes trigger a growth downturn. If policymakers tolerate more inflation, bond prices would fall. Either way, the macro backdrop is no longer conducive for a sustained bull market in both stocks and bonds, we believe. We see higher risk premia across the board and think portfolio allocations will need to become more granular and nimble.

Living with inflation

We think we will be living with inflation. For all the noise about containing inflation, we see policymakers ultimately living with some of it. We remain overweight equities and underweight government bonds in long-term portfolios. We expect investors to demand more compensation to hold long-term bonds in this new regime. We see a high risk of growth stalling and reduce equities to underweight. We now prefer to take risk in credit because we don’t see contained default risk.

Positioning for net zero

We see the bumpy transition to net-zero carbon emissions shaping the new regime – and believe investors should start positioning for net zero. We think investors can be bullish on both fossil fuels and sustainable assets, as we see a key role for commodities in the transition. Yet our work finds that changing societal preferences can give sustainable assets a return advantage for years to come.

Ready to shift views

We stay pro-equities on a strategic horizon but are underweight in the short run.

Biases built up during the Great Moderation, like buying risk asset dips, won’t work as well as before, in our view. A new regime of greater macro volatility, shorter cycles and more volatile markets, means a dynamic approach to portfolio positioning. Our conviction is that portfolios will need to change more quickly.

Ready to shift views

Our conviction is that portfolios will need to change more quickly. For example, on equities and credit, central banks slamming on the policy brakes as inflation remains persistently above target could make us more negative. Download the full report above to learn more about the signposts for changing our investment views.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, July 2022

Asset	Tactical view	Commentary
Equities		We are overweight equities in our strategic views of five years or longer. We expect central banks to ultimately live with some inflation and look through the near-term risks. Tactically, we cut DM equities to underweight as we see activity stalling as central banks appear set to overtighten policy. Historically elevated corporate profit margins are at risk from rising input costs.
Credit		We are underweight publicly traded credit on a strategic basis and prefer to take risk in equities. Tactically, we have upgraded credit to overweight given the jump in yields and credit spreads – and our view of contained default risk. We overweight local-currency EM debt on attractive valuations and potential income. A large risk premium compensates investors for inflation risk.
Government bonds		We are strategically underweight nominal government bonds, with a preference for short-dated maturities. We stay firmly underweight long-dated bonds as we see investors demanding higher compensation amid rising inflation and debt levels. We prefer inflation-linked bonds instead. Tactically, we are also underweight as we see the direction of travel for long-term yields as higher – even as yields have surged in 2022. We prefer inflation-linked bonds as portfolio diversifiers amid higher inflation.
Private markets	-	We believe non-traditional return streams have the potential to add value and diversification. Our neutral view is based on a starting allocation that is much larger than what most qualified investors hold. We underweight private equity, favoring income assets such as private credit instead. Many institutional investors are underinvested in private markets as they overestimate liquidity risks, in our view. Private markets are a complex asset class and not suitable for all investors.

Note: Views are from a U.S. dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, July 2022

Asset	Tactical view	Commentary
Equities
Developed markets		We cut DM stocks to underweight on a worsening macro picture and risks to corporate profit margins from higher costs. Central banks appear set on reining in inflation by crushing growth – increasing the risk of the post-Covid restart being derailed.
United States		We are underweight U.S. equities. The Fed intends to raise rates into restrictive territory. The year-to-date selloff partly reflects this. Yet valuations have not come down enough to reflect weaker earnings.
Europe		We are underweight European equities as the fresh energy price shock in the aftermath of the tragic war in Ukraine puts the region at risk of stagflation.
U.K.		We are underweight UK equities following their strong performance vs. other DM markets thanks to energy sector exposure.
Japan		We are neutral Japan stocks. We like still-easy monetary policy and increasing dividend payouts. Slowing global growth is a risk.
China		We are neutral Chinese equities. Activity is restarting, but we see 2022 growth below official targets. Geopolitical concerns around China’s ties to Russia warrant higher risk premia, we think.
Emerging markets		We are neutral EM equities on the back of slowing global growth. Within the asset classes, we lean toward commodity exporters over importers.
Asia ex-Japan		We are neutral Asia ex-Japan equities. China’s near-term cyclical rebound is a positive yet we don’t see valuations compelling enough to turn overweight.
Fixed income
U.S. Treasuries		We underweight U.S. Treasuries even with the yield surge. We see long-term yields moving up further as investors demand a greater term premium. We prefer short-maturity bonds instead and expect a steepening of the yield curve.
Global inflation-linked bonds		We are overweight global inflation-linked bonds and now prefer Europe. The pullback in euro area breakeven rates since May suggests markets are underappreciating the inflationary pressures from the energy shock.
European government bonds		We are neutral European government bonds. We think market pricing of euro area rate hikes is too hawkish.
UK Gilts		We upgrade U.K. gilts to overweight. Gilts are our preferred nominal government bonds. We believe market pricing of the Bank of England’s rate hikes is unrealistically hawkish in light of deteriorating growth.
China government bonds		We are neutral Chinese government bonds. Policymakers have been slow to loosen policy to offset the slowdown, and yields are no longer attractive relative to DM bonds.
Global investment grade		We upgrade investment grade credit to overweight on attractive valuations. Strong balance sheets among higher quality corporates suggest IG credit could weather a weaker growth outlook better than equities.
Global high yield		We are neutral high yield. We prefer up-in-quality credit exposures amid a worsening macro backdrop. We find parts of high yield offering attractive income.
Emerging market - hard currency		We are neutral hard-currency EM debt. We expect it to gain support from higher commodities prices but remain vulnerable to rising U.S. yields.
Emerging market - local currency		We are modestly overweight local-currency EM debt on attractive valuations and potential income. Higher yields already reflect EM monetary policy tightening, in our view, and offer compensation for inflation risk.
Asia fixed income		We are neutral Asia fixed income amid a worsening macro outlook. Valuations are not compelling enough yet to turn more positive on the asset class, in our view.

Note: Views are from a U.S. dollar perspective, July 2022. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Massive sectoral reallocation

The U.S. has seen its largest sectoral shift on record as spending moved from services to goods – and it hasn’t normalized yet. Major spending shifts and production constraints are the driving force of inflation rather than excessive demand.

Absolute change in U.S. spending shares and averages, 1960-2022

This chart shows a massive an unprecendted of expenditure share during Covid relative to the normal shift in those shares historically.

BlackRock Investment Institute and U.S. Bureau of Economic Analysis, with data from Haver Analytics, March 2022. Notes: The chart shows the absolute quarterly change in the share of nominal consumer spending across 121 components of U.S. personal consumption expenditure. The spike shows the un usual shift to goods from services during the pandemic. The gray band shows the range of quarterly changes indicating a return to the pre-Covid spending mix over the next 6 to 18 months.

Rate sensitivity

The sensitivity of high debt levels to higher interest rates makes it harder to contain inflation via rates. Central banks are likely to veer between favoring activity over inflation, and vice versa. We may see higher inflation and short cycles.

U.S. net debt interest payments and scenarios, 1990-2025

This chart shows that higher projected policy rates may result in higher net interest rate payments, which is problematic for debt repayments.

Forward-looking estimates may not come to pass. Past performance is not a reliable indicator of current or future results. Sources: BlackRock Investment Institute, OECD and International Monetary Fund, with data from Haver Analytics, December 2021. Notes: The chart shows historical U.S. net interest payments and projections for U.S. net interest payments based on different interest rate scenarios on a five-year horizon. The scenarios are calculated based on IMF projections of U.S. debt and hypothetical calculations of debt interest costs based on different assumptions for the path of interest rates as indicated in the legend.

The return of yield

Investors benefit from owning credit nowadays. Most fixed income assets are yielding 4% or more for the first time in over a decade. The pandemic policy response allowed firms to boost cash buffers and issue longer-term debt at record-low interest rates.

Share of fixed income indices yielding 4% or more, 1999-2022

This chart shows that after more than a decade, most fixed income assets are now yielding 4% or more.

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Source: BlackRock Investment Institute, with data from Refinitiv Datastream, June 2022. Notes: The bars show market capitalization weights of assets with an average annual yield over 4% in a select universe that represents about 70% of the Bloomberg Mulitiverse Bond Index. Euro core is based on French and German government bonds indexes. Euro periphery is based on an average of government debt indexes for Italy, Spain and Ireland. Emerging markets combine external and local currency debt.

Higher risk premia

This stylized chart shows that since the Covid-19 shock, the underlying volatility of demand and supply shocks has risen.

Sources: Blackrock Investment Institute, July 2022. Notes: The chart shows a stylized depiction of the volatility of U.S. inflation and output during the Great Moderation (1985-2019; green line) and since the Covid-19 shock (2020 to now; orange line). The curves show potential combinations of output (x axis) and inflation (y axis) volatility that can be achieved when central banks react to demand and supply shocks hitting the economy. Since the Covid-19 shock, the underlying volatility of demand and supply shocks has risen, as the orange line shows. This means central banks now face starker trade-offs. They can try to rein in inflation, but this comes at a cost of higher output volatility- the Fighting inflation outcome bottom right. Or they can try to dampen fluctuations in output at a cost of more inflation volatility – the Living with inflation outcome upper left. For illustrative purposes only.

The Great Moderation fostered steady growth that led to decades-long bull runs for both stocks and bonds. Central banks could soften demand shocks and boost growth with looser policy – facing only a modest trade-off of inflation (the green line in the chart).

The end of this means much starker trade-offs, as the orange line shows. The entire curve shifted and grew, magnifying the impact of policy choices. At one end central banks crush growth to rein in inflation, raising recession risk and damaging equities.

At the other end, central banks go easy and face the risk of inflation soaring. Bond prices fall as investors demand a higher term premium. We expect this to be the main conundrum for 2023.

Bottom line: The Great Moderation is over.

Outlook in charts (PDF) Outlook in charts (PDF)