U.S. & Japan: a tale of two overweights
Market take
Weekly video_20240318
Nicholas Fawcett
Opening frame: What’s driving markets? Market take
Camera frame
Inflation is in the spotlight again, thanks to some recent data surprises and the U.S. Federal Reserve and Bank of Japan both holding meetings this week.
Title slide: U.S. & Japan: a tale of two overweights
Markets see a positive near-term macro backdrop in the U.S. and Japan. We eye risks for both ahead – but for different reasons.
1: U.S. inflation
U.S. inflation has eased over the past few years thanks to rapidly falling goods prices.
Inflation will likely fall further toward 2% this year, in our view. But persistent services inflation will likely pull it back up in 2025 as the drag from falling goods prices fades. We see U.S. inflation settling closer to 3% than 2% over the medium term, as a result.
2: Market sentiment
Markets are, for now, comfortable that U.S. inflation will cool enough to allow the Fed to make three quarter-point rate cuts this year.
We think upbeat market sentiment can persist as inflation cools and rate cuts come through.
3: BOJ policies
The Bank of Japan, meanwhile, is focused on keeping inflation sustainably at 2% after decades of low or no inflation.
We expect the BOJ to end its emergency policy of negative rates, but to remain cautious - and not start tightening policy too aggressively.
Outro: Here’s our Market take
We’re overweight U.S. and Japan stocks.
Yet resurgent inflation in the U.S. could spoil sentiment. So we stay nimble.
Japan’s outlook remains positive to us as we don’t think the BOJ will raise rates aggressively and given ongoing corporate reforms.
Closing frame: Read details:
www.blackrock.com/weekly-commentary
Markets see a positive near-term macro and corporate backdrop for the U.S. and Japan. We eye risks ahead but remain overweight stocks in both countries.
U.S. stocks were largely flat last week after hotter-than-expected inflation data. Both 10-year U.S. Treasury and Japanese government bond yields rose.
The Fed policy decision is in focus this week. We see Fed rates staying higher for longer than pre-pandemic. We watch how the Bank of Japan interprets inflation.
Federal Reserve and Bank of Japan (BOJ) meetings this week and recent data put a spotlight on the U.S. and Japanese macro environments. U.S. markets are pricing in a positive macro backdrop as inflation cools. We don’t see upbeat risk appetite being seriously challenged in coming months. By contrast, Japan’s macro and corporate outlook is positive longer term. We see the BOJ simply ending negative interest rates, not starting to tighten. We stay overweight U.S. and Japan stocks.
An inflation rollercoaster
U.S. core CPI inflation breakdown three-month annualized, 2017-2024
Source: BlackRock Investment Institute, U.S. Bureau of Labor Statistics, with data from Haver Analytics, March 2024. Notes: The chart shows core U.S. CPI goods and services inflation measured by the change in the most recent three-month average, at an annualized rate. Core goods inflation covers all goods, excluding energy and food costs. Core services inflation covers all services, excluding energy and shelter costs.
We’ve said before that this new macro and market regime is marked by persistent, structural inflation pressures. We think U.S. inflation can fall further toward 2% this year due to falling goods prices. See the orange line in the chart. Yet we see it on a rollercoaster back up in 2025 as the drag from goods deflation fades and elevated wage growth in a tight labor market keeps services inflation higher than pre-pandemic. Inflation is likely to settle above the Fed’s 2% target in 2025. The spike in services inflation for January (yellow line) now looks like a one-off, but we think it keeps inflation on an elevated track that is inconsistent with overall inflation at 2%. And after months of falling good prices driving inflation lower, they suddenly rose in February. We see more goods deflation to come in the near term. Yet these one-offs may be offering a glimpse of the trickier inflation environment ahead later this year.
Markets are, for now, comfortable that inflation will cool enough to allow the Fed to make three quarter-point rate cuts this year and keep cutting. We think upbeat sentiment can persist as inflation keeps falling. That’s why we stay overweight U.S. stocks and lean into the artificial intelligence theme as tech drives corporate earnings growth. The earnings recovery in other sectors is supporting risk appetite. Yet inflation could come in stronger than markets expect again and challenge risk-taking. That outcome would limit how far and how fast the Fed can cut rates from restrictive levels. We see Fed policy rates staying higher than before the pandemic as inflation likely settles closer to 3%. We believe that calls for staying nimble in portfolios.
The macro outlook for Japan
Meanwhile, the BOJ is focused on keeping inflation sustainably at 2% after decades of ultra-low inflation. Its challenge: gauging how to normalize monetary policy without undermining its hard-won revival of expectations for sustained inflation, in our view. Rising import prices have helped Japan’s inflation rise above 2%. Yet keeping inflation there will require such expectations to feed through domestic prices and wages. The good news: Annual union wage negotiations resulted in pay gains topping 5%, the largest since the early 1990s. That should boost the BOJ’s conviction of overcoming a decades-long undershoot of its inflation target. Markets are pricing that the BOJ could end negative interest rates as soon as this week. If markets see the policy shift as normalizing policy, we think that would support risk appetite. Yet if this policy change is viewed as the BOJ getting nervous about inflation, that could spell bad news for sentiment.
Without buffering for swings in the yen, we’re overweight Japanese stocks. Their outlook seems positive given mild inflation, strong earnings growth and ongoing corporate reforms. Our overweight there will likely remain for longer than our U.S. stock overweight over a six- to 12-month tactical horizon. We’ve been underweight Japanese government bonds since July 2022. We expect yields to rise as the BOJ winds down loose policy, including yield curve control, even if likely in a measured manner.
Our bottom line
U.S. inflation has been volatile recently, but we expect it to fall further this year before resurging in 2025. We see the BOJ ending negative interest rates – but eye risks to market sentiment. We’re overweight U.S. and Japan stocks.
Market backdrop
U.S. stocks retreated from near all-time highs to end the week largely unchanged, surrendering gains after the U.S. CPI and other inflation gauges surprised to the upside. U.S. 10-year yields jumped more than 20 basis points to near 4.30% after February CPI was hotter than expected, prompting markets to price out Fed rate cuts. Japanese 10-year yields reached this year’s high near 0.8% as markets eye an end to negative rates this week. U.S. crude oil prices gained 4% on supply concerns.
The Fed policy decision is the main event this week. Although markets don’t expect the first rate cut until midyear, we think they’ll focus on how the Fed is responding to recent higher-than-expected inflation data. Markets may also assess whether Fed projections indicate a more persistent inflation outlook. Meanwhile, the BOJ could end its negative interest rate policy as soon as this week, with markets pricing a small hike. We also await the Bank of England policy decision.
Week ahead
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from LSEG Datastream as of March 14, 2024. Notes: The two ends of the bars show the lowest and highest returns at any point year to date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, LSEG Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
BOJ policy decision
Fed policy decision; UK CPI; euro area consumer confidence
BOE policy decision; global flash PMIs; Japan trade data
Japan CPI
Read our past weekly market commentaries here.
Big calls
Our highest conviction views on tactical (6-12 month) and strategic (long-term) horizons, March 2024
Reasons | ||
---|---|---|
Tactical | ||
U.S. equities | Our macro view has us neutral at the benchmark level. But the AI theme and its potential to generate alpha – or above-benchmark returns – push us to be overweight overall. | |
Income in fixed income | The income cushion bonds provide has increased across the board in a higher rate environment. We like short-term bonds and are now neutral long-term U.S. Treasuries as we see two-way risks ahead. | |
Geographic granularity | We favor getting granular by geography and like Japan equities in DM. Within EM, we like India and Mexico as beneficiaries of mega forces even as relative valuations appear rich. | |
Strategic | ||
Private credit | We think private credit is going to earn lending share as banks retreat – and at attractive returns relative to credit risk. | |
Inflation-linked bonds | We see inflation staying closer to 3% in the new regime on a strategic horizon. | |
Short- and medium-term bonds | We overall prefer short-term bonds over the long term. That’s due to more uncertain and volatile inflation, heightened bond market volatility and weaker investor demand. |
Note: Views are from a U.S. dollar perspective, March 2024. 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, March 2024
Our approach is to first determine asset allocations based on our macro outlook – and what’s in the price. The table below reflects this. It leaves aside the opportunity for alpha, or the potential to generate above-benchmark returns. The new regime is not conducive to static exposures to broad asset classes, in our view, but it is creating more space for alpha. For example, the alpha opportunity in highly efficient DM equities markets historically has been low. That’s no longer the case, we think, thanks to greater volatility, macro uncertainty and dispersion of returns. The new regime puts a premium on insights and skill, in our view.
Asset | Tactical view | Commentary | ||||
---|---|---|---|---|---|---|
Equities | ||||||
United States | Benchmark | We are neutral in our largest portfolio allocation. Falling inflation and coming Fed rate cuts can underpin the rally’s momentum. We are ready to pivot once the market narrative shifts. | ||||
Overall | We are overweight overall when incorporating our U.S.-centric positive view on artificial intelligence (AI). We think AI beneficiaries can still gain while earnings growth looks robust. | |||||
Europe | We are underweight. The ECB is holding policy tight in a slowdown. Valuations are attractive, but we don’t see a catalyst for improving sentiment. | |||||
U.K. | We are neutral. We find attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to fight sticky inflation. | |||||
Japan | We are overweight. We see a positive outlook given mild inflation, strong earnings growth, stock buybacks and other shareholder-friendly actions. Policy tightening is a near-term risk. | |||||
Emerging markets | We are neutral. We see growth on a weaker trajectory and see only limited policy stimulus from China. We prefer EM debt over equity. | |||||
China | We are neutral. Modest policy stimulus may help stabilize activity, and valuations have come down. Structural challenges such as an aging population and geopolitical risks persist. | |||||
Fixed income | ||||||
Short U.S. Treasuries | We are overweight. We prefer short-term government bonds for income as interest rates stay higher for longer. | |||||
Long U.S. Treasuries | We are neutral. The yield surge driven by expected policy rates has likely peaked. We now see about equal odds that long-term yields swing in either direction. | |||||
U.S. inflation-linked bonds | We are neutral. We see higher medium-term inflation, but cooling inflation and growth may matter more near term. | |||||
Euro area inflation-linked bonds | We are underweight. We prefer the U.S. over the euro area. We see markets overestimating how persistent inflation in the euro area will be relative to the U.S. | |||||
Euro area government bonds | We are neutral. Market pricing reflects policy rates in line with our expectations and 10-year yields are off their highs. Widening peripheral bond spreads remain a risk. | |||||
UK Gilts | We are neutral. Gilt yields have compressed relative to U.S. Treasuries. Markets are pricing in Bank of England policy rates closer to our expectations. | |||||
Japan government bonds | We are underweight. We see upside risks to yields from the Bank of Japan winding down its ultra-loose policy. | |||||
China government bonds | We are neutral. Bonds are supported by looser policy. Yet we find yields more attractive in short-term DM paper. | |||||
U.S. agency MBS | We are neutral. We see agency MBS as a high-quality exposure in a diversified bond allocation and prefer it to IG. | |||||
Global investment grade credit | We are underweight. Tight spreads don’t compensate for the expected hit to corporate balance sheets from rate hikes, in our view. We prefer Europe over the U.S. | |||||
Global high yield | We are neutral. Spreads are tight, but we like its high total yield and potential near-term rallies. We prefer Europe. | |||||
Asia credit | We are neutral. We don’t find valuations compelling enough to turn more positive. | |||||
Emerging market - hard currency | We are overweight. We prefer EM hard currency debt due to its relative value and quality. It is also cushioned from weakening local currencies as EM central banks cut policy rates. | |||||
Emerging market - local currency | We are neutral. Yields have fallen closer to U.S. Treasury yields. Central bank rate cuts could hurt EM currencies, dragging on potential returns. |
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. 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 or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.
Read our past weekly market commentaries here.