2022 Global Outlook - Institutional

Q2 2022 GLOBAL OUTLOOK

Much has changed since our 2022 outlook - a war, energy shock and the Federal Reserve’s pivot on monetary policy. We stay underweight bonds, even as yields have sprinted upward, and overweight equities – with new regional differences.

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Investment themes

Living with inflation

We expect central banks to quickly normalize policy, with rates rising to historically low levels. We see a higher risk of the Fed slamming the brakes on the economy as it has struck a hawkish tone. Implication: We prefer equities over fixed income and overweight inflation-linked bonds.

Cutting through confusion

The Ukraine war has aggravated inflation pressures and has put central banks in a bind. Trying to contain inflation will be costly to growth and employment, and they can’t cushion the growth shock. Implication: We have tweaked our risk exposure to favor equities at the expense of credit.

Navigating net zero

Europe’s drive to wean itself off Russian gas should reinforce the net-zero transition. Yet some regions will produce more fossil fuels in the near-term as global energy systems are rewired. Implication: We favor developed market equities over emerging markets.

Global Outlook Asset class views The new nominal

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Energy shock, Fed spur outlook update

Bond returns have been even more negative than we expected, 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 – even after shooting up in the first quarter. We believe investors will start questioning bonds’ perceived safety premium – and demand extra compensation for holding them in the inflationary environment.

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

This chart shows that both bonds and equities have underperformed year to date.

Sources: BlackRock Investment Institute with data from Refinitiv Datastream and Bloomberg, March 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).

Equities have also had negative returns (see the chart above). The reasons: Central banks’ hawkish pivot and the tragic war in Ukraine. Russia’s invasion resulted in a commodities price shock felt around the globe. We see more challenges ahead as the West seeks to wean itself off Russian fossil fuels. We expect lower growth this year, especially in Europe, and higher and more persistent inflation.

What are the risks?

The war has spurred a drive for energy security – and created an energy supply shock that came on top of an existing one from the Covid-19 shock. The result: higher and more persistent inflation.

The Fed is projecting a large and faster increases in rates over the next two years in an attempt to tame inflation. It’s easy to talk tough, but in a world shaped by supply – with manufacturing bottlenecks and high commodities prices – monetary policy can only tame inflation at a high cost to growth and jobs.

And yet the Fed still projects low unemployment. To us, this signals its true intent: live with inflation to maintain economic activity and jobs.

What are the risks? Central banks could slam the brakes on the economy by rapidly raising rates to a level that destroys growth and jobs. Inflation expectations could become unanchored: Markets and consumers could lose faith that central banks can keep a lid on prices. This possibility makes the first risk more real.

Our bottom line: The Fed is ready to normalize, and we see it delivering on its projection of large and rapid increases in rates this year. We expect it to then pause to evaluate the effects on growth. As a result, we expect the sum total of rate hikes to be historically low given the level of inflation.

An upgrade and a downgrade

We remain pro risk on a tactical horizon and prefer equities over credit. The inflationary environment favors stocks, in our view, and many Developed markets (DM) companies have been able to pass on rising costs and keep margins high.

We see more downside risk for government bonds – even as 10-year U.S. Treasury yields are hovering near three-year highs. DM government bonds are less effective portfolio diversifiers in periods when supply shocks dominate, as they do now. Within the asset class, we prefer short-maturity bonds over long-term ones.

We prefer equities over credit. We also like the combination of low real rates, the restart’s economic growth cushion and reasonable equity valuations. We reduce our overweight to European equities as we see the energy shock hitting that region hardest. Also, prices have rebounded from the year’s lows. Why not shift to an underweight? We expect the European Central Bank to only slowly normalize policy. We increase our overweight to Japanese stocks on prospects of higher dividends and buybacks, and supportive policy. We like the U.S. stock market as we see its quality factor resilient to a broad range of economic scenarios.

Equities over credit and bonds

We remain pro risk on a tactical horizon and prefer equities over credit and bonds. The inflationary environment favors stocks, in our view, and many DM companies have been able to pass on rising costs and keep margins high.

Directional views

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

Asset	Tactical view	Commentary
Equities		We increased our strategic equities overweight in the early 2022 selloff. We saw an opportunity for long-term investors in equities because of the combination of low real rates, strong growth and a change in valuations. 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 favor developed market equities over emerging market stocks, with a preference for the U.S. and Japan over 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 U.S. dollar perspective, May 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, May 2022

Asset	Tactical view	Commentary
Equities
Developed markets		We overweight DM stocks amid supportive fundamentals, robust earnings and low real yields. We see many DM companies well positioned in the inflationary backdrop thanks to pricing power. We prefer the U.S. and Japan over Europe.
United States		We overweight U.S. equities due to still strong earnings momentum. We see the Fed not fully delivering on its hawkish rate projections. We like the market’s quality factor for its resiliency to a broad range of economic scenarios.
Europe		We are moderately overweight European equities as we expect the energy shock to hit European growth hard. We like the market’s cyclical bend in the inflationary backdrop and expect the ECB to only slowly normalize policy.
U.K.		We are neutral UK equities. We see the market as fairly valued and prefer other DM equities such as U.S. and Japanese stocks.
Japan		We are overweight Japan equities on supportive monetary and fiscal policies - and the prospect of higher dividends and share buybacks.
China		We recently downgraded 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
U.S. Treasuries		We underweight U.S. 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 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 yet to take easing actions to avoid a slowdown, and yields have fallen below U.S. Treasuries.
Global investment grade		We are neutral investment grade credit 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 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

We see the energy shock hitting growth in Europe the hardest because of the region’s heavy reliance on Russian gas. Europe’s energy burden is more than twice that of the U.S.

This chart shows that energy as a share of GDP has recently spiked in Europe and the U.S. Europe's energy burden is twice that of the U.S.

Sources: BlackRock Investment Institute and BP Statistical Review of World Energy 2021, with data from Haver Analytics, March 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 bank policies

The Fed struck a surprisingly hawkish tone in kicking off its hiking cycle. We see a higher risk of the Fed slamming the brakes on the economy as it may have talked itself into a corner.

This chart shows that the Federal Reserves projected fed funds rate path is higher than the current market pricing and what markets expected in March 2021.

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, March 2022. Notes: The 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.