A scuba diver in deep blue waters
Q2 2022 GLOBAL OUTLOOK

Navigating the new market regime

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.

Investment themes

01

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.

02

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.

03

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.

Read details of our Q2 market outlook:

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Entering a new market regime

We said at the end of last year that we were entering a new market regime, and expected a second consecutive year of negative bond returns and global stock gains – what would be a first since data started in 1977.

We thought bonds would suffer from high supply-driven inflation that central banks would be forced to live with. We also expected equities to do well amid a restart of economic activity and low real, or inflation-adjusted, interest rates. A lot has changed since.

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

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

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.

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.

We take risk in equities

Credit spreads remain tight – particularly in the context of our views around the path of interest rates. We don’t think investors are adequately compensated for risks at these levels.

This chart shows that credit spreads remain tight compared to equities.

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 in an index.

Source: BlackRock Investment Institute and Refinitiv Datastream, data as of 16 March 2022. The chart shows the equity risk premium and historical ranges since 1995 for major equity regions based on MSCI indices and the credit spreads for the U.S. Investment Grade and High Yield markets based on Bloomberg indices. We calculate the equity risk premium based on our expectations for nominal interest rates and the implied cost of capital for respective equity markets. Credit spreads are calculated by taking the difference between the credit market yields.

Meet the authors
Jean Boivin
Head of BlackRock Investment Institute
Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head of BlackRock Investment Institute
Vivek Paul
Senior Portfolio Strategist, BlackRock Investment Institute
Elga Bartsch
Elga Bartsch
Head of Macro Research
Scott Thiel
Scott Thiel
Chief Fixed Income Strategist