Weekly market commentary

Equities have fallen hard this year on the prospect of rapid rate increases to rein in inflation, the tragic Ukraine war and a slowdown in China. We recently reduced risk, yet keep our modest stocks overweight. Why? The selloff means more of these risks are now priced.  We also believe the Fed’s sum total of rate hikes will be historically low and see recession fears as overblown. We think equities remain more attractive than bonds, even as the historic sell-off in bonds has cut the gap between the two

Chart of the week

Caution: steep rate path ahead

GMarket pricing of the fed funds rate, Dec. 2021 vs. current

Sources: BlackRock Investment Institute, with data from Bloomberg, May 2022. Notes: The chart shows expectations for the path of US short-term interest rates based on futures market prices compared to the market’s December expectations of the rate path.

We started the year with an overweight in equities and underweight in bonds. The macro outlook has worsened since then. The Ukraine war added to already high inflation stemming from pandemic-related supply constraints. The Fed started to talk tough on inflation, and the market has quickly priced in a series of steep rate rises (the red line in the chart), whereas it was still expecting a shallow trajectory in December (the yellow line). And we now see a rising risk the Fed will raise policy rates to a level that slows the economy. The latest: Growth in China has slowed amid widespread Covid lockdowns. Both stocks and bonds have sold off in the face of these mounting challenges. We stick with our equities overweight for now. Why? First, much of the risks to growth are now reflected in stock prices, we believe, keeping valuations attractive. Second, we still think the cumulative total of Fed rate hikes will be historically low, given the level of inflation. We see the Fed ultimately choosing to live with core inflation that’s a bit higher than its 2% target, rather than fight it because of the costs to growth and jobs.

Reducing risk

The worsening economic outlook has prompted us to reduce portfolio risk this year. We downgraded European equities in March on the energy shock. We followed with a downgrade of Asian assets last week, coupled with an upgrade of investment grade credit and European government bonds. The sell-off in the bond market has narrowed the gap between the stocks and bonds, in our view, and created pockets of value. We still see longer-term yields rising further as investors demand a higher term premium, or compensation for the risk of holding government bonds amid high inflation and debt loads. As a result, we are not changing our overall bonds underweight and maintain our relative preference for equities.

What are the risks? Today’s inflation is very different from the past 30 years, and central banks need a new playbook. Inflation is always caused by excess demand over a certain amount of supply. That doesn’t mean excessive demand is driving inflation, as has been mostly the case since the 1990s. The real question: Is demand unusually high or is supply abnormally low? We think it’s the latter. The economy is working its way through two major shocks: the pandemic and the war in Ukraine. This has created supply constraints such as a tight labor market (caused by the “Great resignation”) that will take time to resolve. Why does all of this matter? If inflation is caused by supply factors, the Fed faces a stark choice: choke off growth with higher rates – the old playbook - or live with more persistent inflation. The risk is that the Fed fails to recognize the trade-off and pushes rates to such levels they destroy growth and jobs.

Markets are waking up to the risks surrounding this trade-off, and now look to be pricing in a fed funds rate of close to 3.5% in the very long run. If that’s true, equities may have more room to fall: Higher discount rates make future cash flows less attractive. We think the Fed ultimately won’t go this high for fear of hurting growth, but recognize hawkish policy pronouncements can lead markets to believe differently. This is why we brace for more volatility in the short run – and why we are not adding to our equities overweight despite improved valuations.

The bottom line

We stay overweight equities and underweight bonds, but have reduced risk to reflect the worsening macro outlook. The momentum of the restart of economic activity is still strong, especially in the US, so we don’t see a recession ahead.  We prefer developed market stocks, especially US and Japanese equities. We particularly like the US market’s quality bent featuring companies with strong cashflows and balance sheets. We would turn more negative on equities should the risk of the Fed slamming the brakes on the economy materialise and trigger a material slowdown.

Market backdrop

Markets are coming to grips with the stark growth-inflation trade-off central banks are facing to rein in supply-driven inflation: choke off growth or live with higher inflation. Last week, markets started to price in the risk that the Fed will push ahead with the first option. Yields on 10-year US Treasuries fell, and stocks bounced off new 2022 lows. We believe the sharp trade-off will ultimately give the Fed pause before taking rates up to levels that trigger a material slowdown.

US activity data and surveys will shed light on the ongoing restart of economic activity and the shift in consumer spending back to services, from goods. Market concerns around a pronounced slowdown in the US miss the key point that the restart has further room to play out, in our view.

Read our past weekly commentaries here.

Directional views

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

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

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

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