Q2 market outlook update | BlackRock Investment Institute

A surfer bracing for the impact from the incoming wave

Q2 2022 GLOBAL OUTLOOK

MAY UPDATE | Much has changed since our 2022 outlook - a war, an energy shock, the Federal Reserve’s pivot on monetary policy and a worsening macro outlook. We have reduced our portfolio risk-taking as a result and brace for market volatility ahead.

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Investment themes

01

Living with inflation

Central banks are facing a growth-inflation trade-off. Hiking interest rates too much risks triggering a recession, while not tightening enough risks causing runaway inflation. The Fed has made it clear it is ready to dampen growth. Implication: We are neutral developed market (DM) equities after having further trimmed risk.

02

Cutting through confusion

The Russia-Ukraine conflict has aggravated inflation pressures. Trying to contain inflation will be costly to growth and jobs. We see a worsening macro outlook due to the Fed’s hawkish pivot, the commodities price shock and China’s growth slowdown. Implication: We stay underweight U.S. Treasuries and overweight inflation-linked bonds.

03

Navigating net zero

Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story; it's a now story. Implication: We favor equity sectors better positioned for the green transition.

Read details of our Q2 market update:

Global Outlook Asset class views Growth trade-off

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A worsening market outlook

Both stocks and bonds are down year-to-date as policy confusion, the war in Ukraine, an energy shock and a worsening growth outlook in China roil markets. This is why we brace for more volatility in the short run.

We still see stocks up and bonds down for a second year in a row in the long term – that would be a first since data started in 1977.

Strategically underweight bonds

Bond returns have been historically poor because the Fed, along with other major central banks, has pivoted to normalize rates faster than expected. Rates are normalizing to pre-Covid levels as economies no longer need stimulus – this is a big change from central banks’ guidance at the end of last year. We remain underweight bonds as we see long-term yields climbing further. We believe investors will start questioning bonds’ perceived safety premium – and demand extra compensation for the risk of holding them in the inflationary environment.

Equities have also had negative returns (see the chart below) amid a worsening macro picture. We expect lower growth this year, especially in Europe, and higher and more persistent inflation.

Global equities vs. global bonds, annual returns, 1977-2022

This chart shows that both bonds and equities have seen negative returns so far this year.

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. Sources: BlackRock Investment Institute with data from Refinitiv Datastream and Bloomberg, May 2022. Notes: The chart shows annual returns for global equities and bonds in U.S. dollar terms from 1977-2021. Index proxies are the MSCI All-Country World index for equities (MSCI World before 1988) and Bloomberg Global Aggregate index for bonds (U.S. Aggregate before 1991).

A hawkish pivot

The Fed’s hawkish pivot this year has been stunning, and pronouncements on reining in inflation have become regular fare. Chair Jerome Powell in May 2022 said the Fed would keep hiking rates until inflation is “tamed” – a comment that dismisses any trade-off or the lagged effect of monetary policy on the economy.

The Fed now appears to be constraining itself to the hawkish side of policy options with such language, just as talking about the jump in inflation being “transitory” last year boxed it in when inflation proved more persistent and forced a sharp pivot. We think the Fed could be forced into another sharp pivot later this year, which we expect rather than a recession. These Fed pivots are driving market volatility, in our view.

Market expectations are now calling for the Fed funds rate to zoom up to a peak around 3% over the next year, more than doubling since the start of the year. For the European Central Bank, market pricing reflects four hikes this year and nearly 1.4% next year. That is well above our estimate of neutral for an economy at real risk of stagflation this year. The equity selloff this year makes sense from this perspective – if you believe that the market’s view of the Fed and ECB rate paths are right.

A complex reality

The growth reality will be more complex – both from the policy trade-off it faces amid a deteriorating macro backdrop, especially China’s slowdown, and Europe facing stagflation. That’s why we expect a dovish pivot later in the year.

We stick to our view of the Fed raising rates to around 2.5% by the end of this year – and then pausing to evaluate the effects. We still see the U.S. economy’s momentum as strong – we expect growth of around 2.5% this year, slightly below consensus and far from recession. Equities may have short-term, technical rebounds. Yet until the Fed starts to pivot, we don’t see a catalyst for a sustained rebound in risk assets.

Reducing portfolio risk-taking

We have further reduced portfolio risk after having trimmed it to a benchmark level with the downgrade of European equities. We are now neutral DM equities, including U.S. stocks. But a dovish pivot by the Fed would spur us to consider leaning back into equities.

Reducing portfolio risk-taking

We have cut our portfolio risk-taking in light of a worsening economic outlook: a war, an energy shock, central banks’ hawkish pivot and a growth slowdown in China.

Directional views

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

Asset	Tactical view	Commentary
Equities		We are overweight equities in our strategic views, yet trimmed our overall tilt as the relative appeal versus bonds diminished. Incorporating climate change in our expected returns brightens the appeal of developed market equities given the large weights of sectors such as tech and healthcare in benchmark indices. Tactically, we are neutral DM equities due to a higher risk of central banks overtightening policy and a deteriorating growth backdrop in China and Europe.
Credit		We are underweight credit on a strategic basis against a backdrop of rising interest rates. We prefer to take risk in equities instead. Tactically, we had upgraded credit to neutral as the dramatic selloff this year restored value in areas such as investment grade. We overweight local-currency EM debt on attractive valuations and potential income. A large risk premium compensates investors for inflation risk, in our view.
Government bonds		We are strategically underweight nominal government bonds, with a preference for shorter-dated maturities over long-dated bonds. We see yields broadly climbing higher. We stay firmly underweight the long-end as we see investors demanding higher compensation for holding government bonds amid rising inflation and debt levels. We prefer inflation-linked bonds instead. Tactically, we also underweight government bonds 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 in the higher inflation regime.
Private markets	-	We believe non-traditional return streams, including private credit, 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. Many institutional investors remain 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, June 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.

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, June 2022

Asset	Tactical view	Commentary
Equities
Developed markets		We are neutral DM stocks due to uncertainty over policy amid a worsening macro picture. Their appeal relative to bonds has also diminished. The risk has risen that central banks slam the policy brakes as they focus solely on inflation without fully acknowledging the high costs to growth and jobs.
United States		We are neutral U.S. equities. The Fed’s hawkish pivot has raised the risk that markets see rates staying in restrictive territory. The year-to-date selloff partly reflects this, yet we see no clear catalyst for a rebound.
Europe		We are neutral 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 neutral UK equities. We see the market as fairly valued, and we are not looking to chase the rally in the energy sector as transition to net zero unfolds.
Japan		We are neutral Japan stocks as part of a broader push to take more caution across DM equities.
China		We are neutral Chinese equities on a worsening macro outlook. China’s ties to Russia also have created a new geopolitical concern that requires more compensation for holding Chinese assets, we think.
Emerging markets		We are neutral EM equities given challenged restart dynamics, high inflation pressures and tight policies.
Asia ex-Japan		We are neutral Asia ex-Japan equities. China’s deteriorating macro outlook is a worry, and policymakers have yet to fully deliver on promises of easing.
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.
Treasury Inflation-Protected Securities		We overweight U.S. TIPS as we see inflation as persistent and settling above pre-Covid levels. We prefer TIPS as diversifiers in the inflationary backdrop.
European government bonds		We are neutral European government bonds. Market pricing of euro area rate hikes is too hawkish, we think, given the energy shock’s hit to growth.
UK Gilts		We are neutral UK Gilts. We see market expectations of rate hikes as overdone amid constrained supply and weakening growth.
China government bonds		We are neutral Chinese government bonds. Policymakers have been slow to loosen policy to offset the slowdown, and yields fell below U.S. Treasuries.
Global investment grade		We are neutral investment grade credit as this year’s selloff has made valuations more attractive. Coupon income is the highest in about a decade.
Global high yield		We are neutral high yield. We do not expect credit spreads to tighten but find the income potential attractive.
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 interest rate risk.
Asia fixed income		We are neutral Asia fixed income. A worsening macro outlook and geopolitical concern about China’s Russia ties make Chinese assets riskier, in our view. Outside China, we like Asian sovereigns and credit for income.

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.

Higher energy burdens

The hit to euro area growth, with its heavy reliance on Russian gas, could be large on top of higher inflation. The current energy burden in Europe is more than twice that of the U.S., risking stagflation.

This chart shows that energy as a share of GDP has recently jumped in the European Union and the U.S. Europe’s energy burden is now around twice that of the U.S.

Sources: BlackRock Investment Institute and BP Statistical Review of World Energy 2021, with data from Haver Analytics, May 2022. Notes: chart shows the cost of oil, gas and coal consumption in the European Union and U.S. as a share of GDP. We use regional energy prices and divide by GDP in U.S. dollars. Data for 2022 are based on IMF’s latest GDP forecasts and the year-to-date average of daily commodities prices

Hawkish central banks

Central banks face a tough growth-inflation trade-off. The Fed has projected a large and rapid increase in rates over the next two years, and raised rates by 0.5% in May - the largest increase since 2000. We see the Fed delivering on its projected rate path this year but then pausing to evaluate the effects on growth.

This chart shows that both markets and the Federal Reserve are projecting a rapid increase in the level of interest rates in the next two years.

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. Sources: BlackRock Investment Institute, with data from Haver Analytics and Refinitiv Datastream, May 2022. Notes: The left chart shows historical fed funds rate, current and year-ago market pricing in forward overnight index swaps and the Fed’s March 2022 projection based on the median dot of policymaker projections for the end of each year. The final green dot represents the Fed’s long-term policy rate expectation.

China slowdown to ripple across globe

China’s slowdown is set to ripple across the globe. The hit to Chinese growth is starting to rival its 2020 shock and already surpasses the one from the global financial crisis. This will reduce growth in major economies and nudge up DM inflation at a very inopportune time when higher inflation is already proving more persistent.

This chart shows a rapid fall in China’s Purchasing Managers’ Index in the last few months, this indicates a slowdown in activity that we think will also reduce growth in other major economies.

Sources: BlackRock Investment Institute, S&P Global and Caixin, with data from Refinitiv Datastream, May 2022. Notes: The chart shows composite (manufacturing and services) Purchasing Managers’ indexes (PMI). An index level above 50 indicates an improvement in economic activity, while an index level below 50 indicates a decline. S&P PMIs are used for U.S. and Euro area, Caixin for China.