MARKET INSIGHTS

Weekly market commentary

Jan 30, 2023 | Blackrock Investment Institute

Higher rates reinforce income’s appeal

Market take

Weekly video_20230130

Nicholas Fawcett

Opening frame: What’s driving markets? Market take

Camera frame

The Federal Reserve and European Central Bank are set to raise rates again this week to fight inflation.

Title slide: Rate hikes reinforce why yield is back

But markets are pricing rate cuts in 2023 even as both central banks insist that they will stay the course.

1: Policy rates higher for longer

We see the disconnect resolving in favor of central banks.

Inflation is set to fall a lot – but not all the way to 2% in our view.

Like central banks – we are looking for wage pressures to sustainably subside. They’ll want to see this before declaring victory on inflation – so rate cuts are a long way off.

2: Risks underpinning higher long-term yields

That’s one reason we prefer short-term bonds. Another is that we see investors demanding more to hold long-term bonds.

That might happen if the Bank of Japan changes its yield curve control policy and that causes market dislocations.

That may also happen amid the tussle to lift the U.S. debt ceiling, though we do expect negotiations to be resolved.

3: Opportunity in short-term fixed income

Short-term government bonds and investment grade credit now offer some of the highest yields in the last two decades.

We prefer them for income. We also like agency mortgage-backed-securities to diversify income.

Global investment grade credit offers even more yield than short-term bonds, and should weather a downturn.

Outro frame: Here’s our Market take 

We like short-term government bonds and high-grade credit for their income potential.

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Favoring fixed income

We don’t see major central bank rate cuts this year, so we prefer to earn income in short-term bonds, high-grade credit and agency mortgage-backed securities.

Market backdrop

U.S. stocks rose and Treasury yields were mostly steady. U.S. Q4 GDP was resilient but declining consumer spending suggests growth is slowing quickly.

Week ahead

The Fed and the European Central Bank anchor policy decisions this week. We see them hiking and holding rates higher for longer than markets expect.

Major central banks are set to hike policy rates again this week and keep them higher, counter to market views for cuts this year. We see this disconnect resolving and favoring higher rates. That’s because we think inflation will fall fast but stay above target. Rates staying high plus the political tussle over raising the U.S. borrowing limit are market risks. We prefer to earn income and like short-term government bonds, high-grade credit and mortgage-backed securities.

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Yield is back

Investment grade and short-term government debt yields, 2002-2022

The chart shows that yields for two-year U.S. Treasury bonds, represented by a yellow line, and investment grade credit, represented by a red line, have spiked since 2022 to some of the highest levels in last two decades.

Source: BlackRock Investment Institute, with data from Refinitiv, January 2023. Notes: The chart shows yields for the Bloomberg Global Aggregate Corporate Index and benchmark two-year U.S. Treasuries.

Income is finally back in fixed income thanks to higher yields and coupons. Short-term government bonds and investment grade (IG) credit now offer some of the highest yields in the last two decades. See the chart. We prefer to earn income right now from these high-quality fixed income assets as rates rise and stay high. Fixed income’s appeal remains intact the longer central banks keep rates near their peak. The lack of duration – or the sensitivity of bond prices to interest rates – in short-term paper also helps preserve income even if yields rise anew. Global IG credit offers high-grade, liquid income – and we think the strong balance sheets of high-quality companies that refinanced debt at lower rates can weather the mild recession we see ahead. We also like agency mortgage-backed securities (MBS) to diversify income.

We see major central banks on a path to overtighten policy because they’re worried about the persistence of underlying core inflation, excluding food and energy prices. PCE data in the U.S. confirmed the outlook for core inflation hasn’t improved, and it’s tracking to be well above policy targets into 2024. Core services inflation is proving sticky even as goods prices fall. That stickiness is tied to wage pressures in the labor market that we see remaining tight. We think central banks will want more evidence that core inflation and wage pressures are sustainably subsiding before they declare victory on inflation and think about easing policy. This will take a long time – and is unlikely to happen this year, in our view.

This week, the Fed and ECB are set to push rates further up again. We see the Fed hiking 0.25% and the ECB raising 0.5%, with more hikes likely to follow. Then we see them keeping rates high. But markets are pricing rate cuts in 2023 even as both central banks insist they will stay the course. That disconnect needs to be resolved, and we think it will be in favor of higher rates as inflation persists above central banks’ 2% target. Rates staying high is one reason we prefer earning income with shorter duration paper.

Term premium's return 

Another reason is term premium – the compensation investors demand for holding long-term government bonds. We see investors seeking more term premium with higher inflation and other near-term risks on the horizon. Political pressure on the Bank of Japan to change its yield curve control policy is likely to ramp up with inflation running at a four-decade high. The risk: a global spillover from higher Japanese government bond yields to global yields. We think moving away from yield curve control would be like a move away from a currency peg – even tweaks could lead to abrupt market dislocations. Risks over raising the U.S. borrowing cap are also in focus now after the U.S. hit its debt ceiling this month – this reinforces our view that investors will once again demand term premium. Negotiations are likely to go down to the wire this summer and could be as fraught as 2011, when S&P Global downgraded the U.S. triple-A credit rating. We ultimately expect a resolution. If a U.S. default were to occur, it would likely be technical in nature, meaning the U.S. would prioritize debt payments over other obligations. We would expect only a temporary rise in selected Treasury bill yields as the default date nears. Another debt ceiling impasse could also pressure risk assets as in past episodes – this keeps us cautious on U.S. equities.

Our bottom line

Rates staying high and the political tussle over the U.S. debt ceiling are market risks. We take a granular view on fixed income at this juncture. We tactically like short-term government bonds, high-grade credit and agency mortgage-backed securities for attractive income.

Market backdrop

U.S. stocks climbed and bond yields were mostly steady, with European and emerging market shares outperforming the U.S. on investor inflows. U.S. GDP was resilient in the last quarter of 2022. Consumer spending helped prop up growth, but we see signs of weakness beneath the surface. The U.S. PCE data showed consumer spending was losing momentum at the end of the year and suggests that growth is slowing more quickly than we expected.

The Fed and the European Central Bank anchor this week’s central bank decisions. We see them both pushing up rates further and pushing back against market expectations for rate cuts. The U.S. services PMI and payrolls data will give the latest view on recession risks. We think further resilience in activity and the labor market could embolden the Fed.

Week ahead

The chart shows that the U.S. dollar index is the best performing asset at any point in the last 12-months among a selected group of assets, while the Italian 10-year BTP is the worst.

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 Jan. 19, 2023. Notes: The two ends of the bars show the lowest and highest returns at any point in the last 12-months, and the dots represent current 12-month returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., 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.

Jan. 31

Euro area flash Q4 GDP; U.S. consumer confidence

Feb. 1

Fed policy decision; U.S. job openings; euro area inflation

Feb. 2

European Central Bank, Bank of England policy decisions

Feb. 3

U.S. payrolls, U.S. ISM services PMI; China services PMI

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Investment themes

01

Pricing the damage

Central banks are deliberately causing recession by overtightening policy to tame inflation, in our view. That makes recession foretold. What matters: our view on the pricing of economic damage and our assessment of market risk sentiment. Investment implication: We stay underweight DM equities but expect to turn more positive at some point in 2023.

02

Rethinking bonds

We see higher yields as a gift to investors long starved of income in bonds. And investors don’t have to go far up the fixed income risk spectrum to receive it. Investment implication: We like short-term government bonds, investment grade credit and agency mortgage-backed securities for income. We stay underweight long-term government bonds.

03

Living with inflation

Long-term trends of the new regime, such as aging workforces and geopolitical fragmentation, will keep inflation persistently above pre-pandemic levels, in our view. Investment implications: We stay overweight inflation-linked bonds on both tactical and strategic horizons. We are strategically overweight DM equities.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, January 2023

Asset Strategic view Tactical view Commentary
Equities Equities: strategic Overweight +1 Equities: tactical Underweight -1 We are overweight equities in our strategic views as we estimate the overall return of stocks will be greater than fixed-income assets over the coming decade. Valuations on a long-horizon do not appear stretched to us. Tactically, we’re underweight DM stocks as central banks look set to overtighten policy – we see recessions looming. Corporate earnings expectations have yet to fully reflect even a modest recession.
Credit Credit: strategic Overweight +1 Credit: strategic Overweight +1 Strategically, we are significantly overweight global investment grade on attractive valuations and income potential given higher yields. We turn neutral high yield as we see the asset class as more vulnerable to recession risks. Tactically, we’re also overweight investment grade and neutral high yield. We prefer to be up in quality. We are neutral EM debt after its strong run. We see better opportunities for income in DMs.
Government bonds Government bonds: strategic Underweight -1 Government bonds: tactical Underweight -1 The underweight in our strategic view on government bonds reflects a big spread: max underweight nominal, max overweight inflation-linked and an underweight on Chinese bonds. We think markets are underappreciating the persistence of high inflation and the implications for investors demanding a higher term premium. Tactically, we are underweight long-dated DM government bonds as we see term premium driving yields higher, yet we are neutral short-dated government bonds as we see a likely peak in pricing of policy rates. The high yields offer relatively attractive income opportunities.
Private markets Private markets: strategic Underweight -1 - We’re underweight private growth assets and neutral on private credit, from a starting allocation that is much larger than what most qualified investors hold. Private assets are not immune to higher macro and market volatility or higher rates, and public market selloffs have reduced their relative appeal. Private allocations are long-term commitments, however, and we see opportunities as assets reprice over time. Private markets are a complex asset class not suitable for all investors.

Note: Views are from a U.S. dollar perspective, December 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.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, January 2023

Legend Granular

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.

Euro-denominated tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, January 2023

Legend Granular

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 euro perspective, December 2022. 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.

Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Kurt Reiman
Senior Strategist for North America – BlackRock Investment Institute
Nicholas Fawcett
Macro research – BlackRock Investment Institute