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Market take
Weekly video_20220523
Wei Li
Opening frame: What’s driving markets? Market take
Camera frame
The Fed this past week really signaled a sole focus on inflation without properly acknowledging the significant impact that this entails on growth.
And it feels that they have really boxed themselves in for now, and for as long as this is the case, and also for as long as markets believe it.
Title slide: Caution on equity risk
It’s hard to make the case for equities to rebound from here because year-to-date rate repricing very much justifies the equity correction that we have seen in the U.S.
1: Growth tradeoff to spur Fed pivot on rates
Now, further down the line we do expect the growth consideration – the growth tradeoff – to bite and we do expect the dovish pivot later in the year.
2: Quantifying spillover risks
We are quantifying the spillover effect from a China slowdown to the global economy, cutting growth and nudging up inflation.
And this followed us acknowledging and realizing these stagflationary risks that Europe faces because of the Ukraine war, which led to us reducing portfolio level risk-taking back to benchmark level a few weeks ago.
Video outro branding: Here’s our Market take
We still expect the Fed to live with higher inflation and we also do not see a recession anytime soon.
But because of the uncertainties we just spoke about, we are reducing our conviction on equities from overweight to neutral in the near-term.
Closing frame: Read details:
www.blackrock.com/weekly-commentary
We cut developed market (DM) equities to neutral on a risk of the Fed talking itself into overtightening policy and China adding to a weaker global outlook.
Stocks plumbed new 2022 lows on fears steep rate rises will trigger a growth slowdown. We see a brighter picture, but this may not become clear for months.
US PCE inflation data this week are expected to show pressures are slowing. We think inflation will settle higher than pre-Covid levels.
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.
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.
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.
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.
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.
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 Refinitiv Datastream as of May 19, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point this 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 US dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE US Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (US, 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.
Global May flash PMIs
US durable goods; Germany GDP
US PCE inflation and spending; Japan CPI
Read our past weekly commentaries here.
Living with inflation
Central banks are facing a growth-inflation trade-off. Hiking interest rates too much risks triggering a recession, while tightening not 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.
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 determination to slow growth, the commodities price shock and China’s growth slowdown. Implication: We are underweight US Treasuries and overweight inflation-linked bonds.
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 DM equities over emerging markets.
Strategic (long-term) and tactical (6-12 month) views on broad asset classes, May 2022
Asset | Strategic view | Tactical view | Commentary |
---|---|---|---|
Equities | We stay overweight equities in our strategic views, yet are trimming our overall tilt as the relative appeal versus bonds has 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 downgrade DM equities to neutral 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 sell-off 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 given their diminished ability to act as portfolio diversifiers with yields near lower bounds. 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 US dollar perspective. 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.
Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, May 2022
Asset | Tactical view | Commentary | ||
---|---|---|---|---|
Equities | ||||
Developed markets | We downgrade DM stocks to neutral 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 cut US equities to neutral. 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 cut European equities to neutral 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 prefer other DM equities such as US and Japanese stocks. | |||
Japan | We cut Japan stocks to neutral as part of a broader push to take more caution across DM equities. | |||
China | We cut our modest overweight to Chinese equities to neutral 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 and prefer DM equities, given more challenged restart dynamics, higher inflation pressures and tighter policies in EM. | |||
Asia ex-Japan | We are neutral Asia ex-Japan equities. We prefer more targeted exposure to China because of easing monetary and regulatory policy. | |||
Fixed income | ||||
US Treasuries | We underweight US Treasuries even as yields have surged this year. We see long-term yields move up further as investors demand a higher premium for holding governments bonds. We prefer short-maturity bonds instead. | |||
Treasury Inflation-Protected Securities | We overweight US 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 upgrade European government bonds to neutral. 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 cut Chinese government bonds to neutral. Policymakers have yet to take easing actions to avoid a slowdown, and yields have fallen below US Treasuries. | |||
Global investment grade | We upgrade investment grade credit to neutral as this year’s sell-off 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. We prefer to take risk in equities. | |||
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 US yields. | |||
Emerging market - local currency | We are neutral hard-currency EM debt. We expect it to gain support from higher commodities prices but remain vulnerable to rising US. yields. | |||
Asia fixed income | We downgrade Asia fixed income to neutral. 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 US 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.
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Sources: Bloomberg unless otherwise specified.
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