Weekly market commentary

The Federal Reserve signaled its focus is on taming inflation without flagging the big economic costs this will entail. As long as this is the case and markets believe it, we don’t see the basis for a sustained rebound in risk assets. We think the Fed will consider the costs to growth at some point, especially if inflation cools, and expect a dovish pivot later this year. China’s slowdown is a large shock that will be felt over time. We further trim risk and downgrade DM equities to neutral.

Chart of the week

China slowdown to ripple across globe

Composite PMIs 2008-2022

Sources: BlackRock Investment Institute, S&P Global and Caixin, with data from Refinitiv Datastream, May 2022. Notes: 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 US and Euro area, Caixin for China.

The Fed stepped up its rhetoric last week by vowing to bring inflation down at any cost. We think reality will be more complex. First, supply-driven inflation implies the sharpest policy trade-off in decades: between choking off growth via sharply higher rates or living with supply-driven inflation. Second, this trade-off is even more stark amid a weaker global macro outlook. The hit to Chinese growth is starting to rival its 2020 shock and already surpasses the one from the global financial crisis. See the chart. We think 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. We had already seen Europe at risk of recession, which prompted us to reduce risk a few weeks ago. As a result, we further downgrade DM equities to neutral from overweight.

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 just last week 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 of 3.1% 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 getting to nearly 1.4% next year, well above our estimate of neutral and 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.

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 stopping to evaluate the effects. We still see the US 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.

The upshot

We further reduce portfolio risk after having trimmed it to a benchmark level a few weeks ago with the downgrade of European equities. We are now neutral DM equities, including US stocks. But a dovish pivot by the Fed would spur us to consider leaning back into equities. Our change in view prompts us to keep an overweight to inflation-linked bonds from a whole-portfolio perspective. We prefer short-term government bonds for carry, and see scope for long-term yields to rise further as investors demand greater term premium for the risk of holding such debt in this inflationary environment. Overall we remain underweight US Treasuries.

Market backdrop

Stocks plumbed new 2022 lows and bond yields edged down last week on concerns that higher rates are causing a growth slowdown. Earnings updates from large US retailers underscored inflation is pinching demand – and eroding profit margins through higher costs. We see this year’s equity pullback in line with the hawkish repricing of the policy rate path. We believe the market will ultimately ease its expectations for policy tightening – but this won’t be clear for months.

This week’s US PCE report is expected to show monthly US inflationary pressures softening as spending shifts back to services and away from goods. Early May global PMI data could give an early read on spillovers from China’s slowdown and the knock-on impact on supply chains. We expect China’s deteriorating economic outlook to be a drag on global growth – and we think consensus forecasts for China’s 2022 GDP growth are likely to get revised down.   

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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