Weekly market commentary

MARKET INSIGHTS

Sep 18, 2023 | Blackrock Investment Institute

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Seizing new regime opportunities

Market take

Weekly video_20230918

Wei Li

Opening frame: What’s driving markets? Market take

Camera frame

Today, I want to talk about getting the framing right as we think about investing in a new regime.

Title card: Seizing opportunities in the new regime

1: Getting the macroeconomic framing right

There is this real temptation to view developments through a cyclical lens that we are in a new regime of structural shocks.

So don't over interpret, don't extrapolate.

And what we have heard so far and what we're likely to have is a stealth stagnation.

2: Stagnation and strong job growth

There is again, this real temptation to view everything through what's happening in equities, but equities have been very concentrated so far this year.

And when we dig under the hood, it's not really a macro story.

And what's happening in bond, in yields, in term premia is super interesting.

You look at the drivers for a term premia coming back. It's not just structurally higher inflation. It's not just central banks holding tight. There's also the additional dimension of higher debt levels, greater issuance and greater macro and political uncertainty.

So, when you bring all of that together in the Treasury market, we are longer short end, and short the long end.

Outro frame: Here’s our Market take

Some opportunities are presenting themselves because of market mispricing, in our review, so, we get now more positive on gilt markets as well as European government bond market.

And some calls we had are moving to our target. So, we are taking them off, such as the preference for investment grade. We’re further adding to our conviction in Japan by our closing our view on the emerging market equities.

Closing frame: Read details:

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Tactical take

We see the new regime playing out and a high interest rate world, with stagnant activity and persistent inflation. We shift our tactical views to reflect this outlook.

Market backdrop

European stocks rose last week after the likely last European Central Bank rate hike. U.S. stocks were flat after in-line CPI and strong retail sales data releases.

Week ahead

Markets expect the Federal Reserve to keep policy rates unchanged this week. We see the Fed holding tight as inflationary pressures persist.

We see the new regime of greater volatility playing out: higher interest rates, stagnating activity and structural forces set to push inflation back up. Flip-flops in the market narrative make that clear. We stick with our core underweight to long-term U.S. Treasuries but adjust other key tactical views. We see reasons to favor European bonds and further upgrade Japanese stocks to an overweight. We downgrade high quality credit on tighter spreads and emerging market stocks.

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Volatile markets
Selected asset performance 2022 vs. 2023 year-to-date

2022’s equity selloff mostly reversed this year. But fixed income – especially long-term bonds – has largely not recovered. See the chart. We have conviction on factors that will drive bond yields higher: central banks holding policy rates tight as inflation pressures persist; growing bond supply as government debt balloons; and macro and geopolitical volatility. We expect that will spur investors to demand higher term premium, or compensation for the risk of holding long-term bonds, further pushing up yields. That’s why we don’t expect a sustained, joint rally of bonds and stocks as in the Great Moderation of stable activity and inflation. Higher yields challenge the relative attraction of broad equity allocations. Yet markets can run with alternative narratives as we have seen this year, creating opportunities on horizons shorter than our six- to 12-month tactical one. We think this environment offers different opportunities from those in the past.

Taking stock of tactical views

We take stock of our tactical views given recent market moves. Our underweight to long-term Treasuries – our view for roughly three years since yields were below 1% – has served us well as 10-year yields surged to 16-year highs above 4% last month. We stay underweight and expect yields to march even higher as term premium returns. We stick with short-term bonds for income. We also now see opportunity to upgrade euro area sovereign bonds and UK gilts to overweight from neutral. That change locks in higher yields as markets price in policy rates staying high for even longer than we expect.

On risk assets, we offset our government bond upgrades by downgrading high quality credit to underweight given tighter spreads. We also cut emerging market (EM) stocks, including Chinese equities, to neutral from overweight as China’s property sector remains a drag even with growth showing signs of stabilizing. Our moderately risk averse stance keeps us underweight DM and broad U.S. stocks. The S&P 500 is up more than 16% this year. But a handful of firms are carrying market performance, with the equal-weighted S&P 500 up just about 4% this year. Rising valuations account for more than 80% of year-to-date global equity returns, LSEG Datastream data show. Earnings growth accounts for only about 4%, with U.S. earnings stagnating this year.

It may seem that the new regime offers few return opportunities due to greater volatility. Yet we see plenty that don’t require a rosy view of the macro outlook. First, we harness mega forces – structural shifts we think can drive returns now and in the future – such as digital disruption and artificial intelligence (AI). We are overweight the AI theme that has excited markets as we see an AI-centered investment cycle that is set to support revenues and margins. Second, we get granular with regions and sectors to go beyond broad indexes. For example, we turn even more positive on Japanese equities, going overweight due to strong earnings, share buy backs and other shareholder-friendly corporate reforms. Third, we believe timing swings in market narratives creates opportunities on shorter horizons. It’s not easy to seize these opportunities, in our view, and that makes the case for investment strategies focused on above-benchmark returns.

Bottom line

The new regime of greater volatility is why we remain cautious on risk-taking but lean into tactical opportunities as market pricing presents opportunities. We get selective and like long-term European government bonds, EM debt, the AI theme and turn more positive on Japanese stocks relative to DM equities.

Market backdrop

European stocks rose about 2% on the week after the European Central Bank raised policy rates 0.25% – seen as likely its last rate hike. The S&P 500 was flat and has largely stalled over the past few months. U.S. Treasury yields climbed back near 16-year highs – highlighting that we’re in a new regime of higher rates. U.S. CPI data confirmed goods prices are still falling. We see inflation easing further before a sustained climb higher next year as an aging population bites.

Markets expect the Fed to keep policy rates unchanged this week. We see the Fed holding policy tight as inflationary pressures persist. Inflation data out of Japan is also in focus as the Bank of Japan may pave the way for more policy changes. We expect ongoing weakness in global PMIs as the rapid rise in rates takes a toll.

Week ahead

The chart shows that U.S. equities are the best performing asset year-to-date among a selected group of assets, while the U.S. 10-year Treasury is the worst.

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 Sept. 14, 2023. Notes: The two ends of the bars show the lowest and highest returns at any point in the last 12-months, 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.

Sept. 20

Fed policy decision; UK inflation; Japan trade data

Sept. 21

Bank of England monetary policy decision

Sept. 22

BOJ policy decision; Japan inflation; Global flash PMIs

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Investment themes

Holding tight

We believe supply constraints will keep inflation sticky and compel central banks to keep policy tight long term. We think this new economic regime provides different but abundant investment opportunities.

Pivoting to new opportunities

Greater volatility has brought more divergent security performance relative to the broader market. We think that creates other opportunities to generate returns by getting more granular with exposures and views.

Harnessing mega forces

Mega forces are shaping investment opportunities today, not far in the future. We think the key is identifying catalysts that can supercharge these forces and how they interact with each other.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, September 2023

Asset		Tactical view	Commentary
Equities	Developed market		We are overweight equities in our strategic views as we estimate the overall return of stocks will be greater than fixed-income assets over the coming decade. Valuations on a long horizon do not appear stretched. Tactically, we stay underweight DM stocks but upgrade Japan. We are underweight the U.S. and Europe. Corporate earnings expectations don’t fully reflect the economic stagnation we see. We see other opportunities in equities.
	Emerging market		Strategically, we are neutral as we don’t see significant earnings growth or higher compensation for risk. We go neutral tactically given a weaker growth trajectory. We prefer EM debt over equity.
Developed market government bonds	Nominal		Higher-for-longer policy rates have bolstered the case for short-dated government debt in portfolios on both tactical and strategic horizons. We stay underweight U.S. nominal long-dated government bonds on both horizons as we expect investors to demand more compensation for the risk of holding them. Tactically, we are overweight on euro area and UK bonds as we think more rate cuts are coming than the market expects.
	Inflation-linked		Our strategic views are maximum overweight DM inflation-linked bonds where we see higher inflation persisting – but we have trimmed our tactical view to neutral on current market pricing in the euro area.
Public credit and emerging market debt	Investment grade		Strategically, we’re underweight due to limited compensation above short-dated government bonds. We’re underweight tactically to fund risk-taking elsewhere as spreads remain tight.
	High yield		Strategically, we are neutral high yield as we see the asset class as more vulnerable to recession risks. We’re tactically underweight. Spreads don’t fully compensate for slower growth and tighter credit conditions we expect.
	EM debt		Strategically, we're neutral and see more attractive income opportunities elsewhere. Tactically, we’re overweight hard currency EM debt due to higher yields. It is also cushioned from weakening local currencies as EM central banks cut policy rates.
Private markets	Income	-	We are strategically overweight private markets income. For investors with a long-term view, we see opportunities in private credit as private lenders help fill a void left by a bank pullback.
	Growth	-	Even in our underweight to growth private markets, we see areas like infrastructure equity as a relative bright spot.

Note: Views are from a U.S. dollar perspective, September 2023. 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, September 2023

Asset	Tactical view	Commentary
Equities
United States		We are underweight the broad market – still our largest portfolio allocation. We don’t think earnings expectations reflect the macro damage we expect. We recognize momentum is strong near-term.
Europe		We are underweight. We see the European Central Bank holding policy tight in a slowdown, and the support to growth from lower energy prices is fading.
U.K.		We are neutral. We find that attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to deal with sticky inflation.
Japan		We are overweight. We think stronger growth can help earnings top expectations. Stock buybacks and other shareholder-friendly actions may keep attracting foreign investors.
Pacific ex-Japan		We are neutral. China’s restart is losing steam and we don’t see valuations compelling enough to turn overweight.
DM AI mega force		We are overweight. We see a multi-country and multi-sector AI-centered investment cycle unfolding set to support revenues and margins.
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. Growth has slowed. Policy stimulus is not as large as in the past. Yet it should stabilize activity, and valuations have come down. Structural challenges imply deteriorating long-term growth. 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 underweight. We see long-term yields moving up further as investors demand greater term premium.
U.S. inflation-linked bonds		We are overweight and prefer the U.S. over the euro area. We see market pricing underestimating sticky inflation.
Euro area inflation-linked bonds		We prefer the U.S. over the euro area. Markets are pricing higher inflation than in the U.S., even as the European Central Bank is set to hold policy tight, in our view.
Euro area government bonds		We are overweight. Market pricing reflects policy rates staying higher for longer even as growth deteriorates. Widening peripheral bond spreads remain a risk.
UK Gilts		We are overweight. Gilt yields are holding near their highest in 15 years. Markets are pricing in restrictive Bank of England policy rates for longer than we expect.
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.
Global investment grade credit		We are underweight. We take advantage of tight credit spreads to fund increased risk-taking elsewhere in the portfolio. We look to up the allocation if growth deteriorates.
U.S. agency MBS		We’re overweight. We see agency MBS as a high-quality exposure within diversified bond allocations.
Global high yield		We are underweight. Spreads do not fully compensate for slower growth and tighter credit conditions we anticipate.
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 emerging hard currency debt due to higher yields. It is also cushioned from weakening local currencies as EM central banks start to cut policy rates.
Emerging market - local currency		We are neutral. Yields have fallen closer to U.S. Treasury yields. Plus, central bank rate cuts could put downward pressure on 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.

Euro-denominated tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, September 2023

Asset	Tactical view	Commentary
Equities
Europe ex UK		We are underweight. We see the European Central Bank holding policy tight in a slowdown and the support to growth from lower energy prices is fading.
Germany		We are underweight. Valuations are moderately supportive relative to peers, but we see earnings under pressure from higher interest rates, slower global growth and medium-term uncertainty on energy supply. Longer term, we think the low-carbon transition may bring opportunities.
France		We are underweight. Relatively richer valuations and a potential drag to earnings from weaker consumption amid higher interest rates offset the positive impact from past productivity enhancing reforms and favorable energy mix.
Italy		We are underweight. The economy’s relatively weak credit fundamentals amid global tightening financial conditions keep us cautious even though valuations and earnings revision trends look attractive versus peers.
Spain		We are underweight. Valuations and earnings momentum are supportive relative to peers, but the uncertain outcome of Spanish elections is a temporary headwind.
Netherlands		We are underweight. The Dutch stock markets' tilt to technology and semiconductors, a key beneficiary of higher demand for AI, is offset by relatively less favorable valuations and earnings momentum than European peers.
Switzerland		We are overweight. We hold a relative preference. The index’s high weights to defensive sectors like health care and non-discretionary consumer goods provide a cushion amid heightened global macro uncertainty. Valuations remain high versus peers and a strong currency is a drag on export competitiveness..
UK		We are underweight. The Bank of England is hiking sharply to deal with sticky inflation. While equities price in more downside risk, we await policy clarity.
Fixed income
Euro area government bonds		We are overweight. Market pricing reflects policy rates staying higher for longer even as growth deteriorates. Widening peripheral bond spreads remain a risk.
German bunds		We are neutral. Market pricing better reflects policy rates staying higher for longer. We prefer short-term government paper for income.
French OATs		We are neutral. Valuations look moderately compelling compared to peripheral bonds, with French spreads to German bonds hovering above historical averages. Elevated French public debt and a slower pace of structural reforms remain headwinds.
Italian BTPs		We are neutral. The spread over German Bunds looks tight amid deteriorating macro and restrictive ECB policy. Yet domestic factors remain supportive, namely a more balanced current account and prudent fiscal stance. We see income helping to compensate for the slightly wider spreads we expect.
UK gilts		We are overweight. Gilt yields are holding near their highest in 15 years. Markets are pricing in restrictive Bank of England policy rates for longer than we expect.
Swiss government bonds		We are neutral. We don’t see the SNB hiking rates as much as the ECB given relatively subdued inflation and a strong currency. Further upward pressure on yields appears limited given global macro uncertainty.
European inflation-linked bonds		We are underweight. We prefer the U.S. over the euro area. Markets are pricing higher inflation than in the U.S., even as the European Central Bank is set to hold policy tight, in our view.
European investment grade credit		We are modestly overweight European investment-grade credit for decent income. We prefer European investment grade over the U.S. given more attractive valuations. We monitor tighter credit and financial conditions.
European high yield		We are neutral. We find the income potential attractive yet prefer up-in-quality credit exposures amid a worsening macro backdrop.

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 euro perspective, September 2023. 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.