Weekly market commentary

MARKET INSIGHTS

Sep 25, 2023 | Blackrock Investment Institute

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Yields surge as new regime plays out

Market take

Weekly video_20230925

Jean Boivin

Opening frame: What’s driving markets? Market take

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We saw significant market moves last week.

The 10-year U.S. Treasury yield briefly broke the 4.5% mark, reaching its highest level since the global financial crisis. This year’s climb higher accelerated this week even as major central banks paused rate hikes – but left the door open for more.

Title slide: Yields surge as new regime plays out

The main story last week was expected to have been central banks. Instead, it’s that bond yields are resetting higher as markets reassess risks in the new volatile macro regime.

Markets are coming around to the idea rates will stay higher for longer.

1: Volatile regime and bond yields

Policy rate cuts have been pushed out in line with our view, but more broadly we believe the reassessment of central bank expectations is putting a sharper focus on the greater outlook uncertainty and duration risk this environment entails. We expect that will spur investors to demand more compensation for the interest rate risk of holding long-term bonds, and further push up yields.

The Bank of Japan stands apart from other major central banks for now. It appears reluctant to withdraw stimulus. We think economic growth can boost company earnings.

2: New opportunities

In the new volatile regime, markets are repricing as they adjust to the higher rate environment. That will create opportunities, in our view.

We’ve turned positive on UK gilts and European government bonds where we think that adjustment is well advanced. But we’re not yet ready to jump back into long-term U.S. Treasuries.

Outro frame: Here’s our Market take

We prefer short-term bonds for income in the U.S., long-term European bonds and Japanese stocks within developed market equities.

Closing frame: Read details:

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Yield surge

Bond yields are surging as the volatile macro regime brings uncertainty over central bank policy and risks ahead. We get granular in bonds and equities.

Market backdrop

The 10-year U.S. Treasury yield jumped to 16-year highs and stocks slumped over 2% last week. We think yields can go higher but see regional opportunities.

Week ahead

U.S. and euro area inflation is in focus this week. Inflation has cooled as pandemic mismatches resolve, but we see demographics starting to bite.

Yields on benchmark 10-year U.S. Treasuries last week briefly rose to 16-year highs above 4.50% as major central banks paused rate hikes but left the door open for more. Markets are coming around to our view that rates will stay high – and now even exceed our expectations in Europe. Rising long-term bond yields show markets are adjusting to risks in the new regime of greater macro and market volatility. We get granular in bonds and equities.

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Going up
U.S. Treasury yields and policy rate, 1985-2023

All eyes initially were on monetary policy last week amid a blitz of central bank decisions. Then the main story quickly became surging 10-year bond yields to 16-year highs (dark orange line in chart) – even as the Fed and other central banks left policy rates unchanged (yellow line). We think the market is adjusting to the new regime and its implications – especially higher macro volatility. This is bringing to light just how uncertain the outlook is as well as the risks to longer-term bonds. As markets adjust to the new regime, we see opportunities. We’ve turned positive on long-term UK gilts and European government bonds, where that adjustment is more advanced. But we’re not yet ready to jump back into long-term U.S. Treasuries. We think term premium – the compensation investors seek to hold long-term bonds – can return and push yields higher still, as can quantitative tightening and the step-up in Treasury issuance.

Rate hikes are weighing on economies. Major central banks are administering the medicine of tighter monetary policy and economies have slowed. The medicine is still working its way through the system – and effects have varied across regions. PMI data across Europe has shown stagnation. GDP data suggest activity has held up in the U.S. But we think activity has actually stagnated there as well. That seems to have gone under the radar: a stealth stagnation. The average of GDP and another official measure of activity, gross domestic income, shows the U.S. economy has flatlined since the end of 2021.

Central bank blitz

The market narrative hasn’t been one of U.S. stagnation though. One reason: We’ve avoided the short and sharp drop of recession for now. Instead, it’s felt like a rolling effect of hikes rippling through the economy – that may be why the market feels different, too. The weakness we’re seeing isn’t a normal business cycle slowdown, in our view. Unemployment is still low. That suggests something structural is at play, so we don’t think a purely cyclical lens applies. We’ve long said we’re in a world shaped by supply – and this is playing out. We see constraints on supply building over time – especially from a shrinking workforce in the U.S. as the population ages. Central banks need to keep a lid on growth to avoid resurgent inflation once pandemic-era mismatches unwind. That’s why we see them holding tight, not cutting rates like they did in past slowdowns.

Our long-held underweight to long-term U.S. Treasuries has served us well as yields climb. Markets have come around to our view on policy rates. Yet there is still little term premium. We prefer short-term Treasuries given comparable income to high-quality credit without the same credit or interest-rate risk. We also like long-term bonds in Europe and the UK. Ten-year yields there are around three percentage points higher than the pre-pandemic average, versus about two in the U.S.

Japan stands apart. First, the Bank of Japan is seeking to ensure it has got inflation up sustainably to 2%. Keeping policy unchanged last week suggests it would rather hike too late than risk being too early. Japanese bond yields have been relatively stable, but we expect a jump as suggested in market pricing with the BOJ loosening its yield cap over time. Second, Japan is not suffering the same structural downshift in growth – and corporate reforms are taking shape. We think strong growth can boost earnings and shareholder-friendly actions may keep attracting foreign investors to Japanese equities.

Bottom line

Bond yields are surging as the market adjusts to the implications of the new macro regime. We tactically prefer short-term bonds in the U.S. for income, long-term bonds in Europe and the UK – and Japanese stocks.

Market backdrop

The 10-year U.S. Treasury yield jumped to 16-year highs and U.S. stocks slumped over 2% last week – with the S&P 500 steadying some on Friday after its worst day since the March banking tumult. The Fed, the Bank of England and BOJ all kept rates unchanged. We think surging bond yields show markets reassessing the greater uncertainty and volatility in the new macro regime. We expect persistent inflationary pressures to play into this as demographic changes start to bite.

U.S. and euro area inflation is in focus this week, including the Fed’s preferred PCE gauge. Inflation has cooled as the spending shift back to services helps resolve some the pandemic-era mismatches in supply. But we expect core inflation to stay on a rollercoaster as aging populations keep the labor market tight and keep up inflationary pressures.

Week ahead

The chart shows that U.S. equities are the best performing asset year-to-date among a selected group of assets, while the U.S. 10-year Treasury 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 LSEG Datastream as of Sept. 21, 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 year-to-date 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, LSEG 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.

Sept. 26

U.S. consumer confidence

Sept. 29

Flash euro area inflation; U.S. PCE

Sept. 30

China manufacturing PMI

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Investment themes

Holding tight

We believe supply constraints will keep inflation sticky and compel central banks to keep policy tight long term. We think this new economic regime provides different but abundant investment opportunities.

Pivoting to new opportunities

Greater volatility has brought more divergent security performance relative to the broader market. We think that creates other opportunities to generate returns by getting more granular with exposures and views.

Harnessing mega forces

Mega forces are shaping investment opportunities today, not far in the future. We think the key is identifying catalysts that can supercharge these forces and how they interact with each other.

Directional views

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

Asset		Tactical view	Commentary
Equities	Developed market		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. Tactically, we stay underweight DM stocks but upgrade Japan. We are underweight the U.S. and Europe. Corporate earnings expectations don’t fully reflect the economic stagnation we see. We see other opportunities in equities.
	Emerging market		Strategically, we are neutral as we don’t see significant earnings growth or higher compensation for risk. We go neutral tactically given a weaker growth trajectory. We prefer EM debt over equity.
Developed market government bonds	Nominal		Higher-for-longer policy rates have bolstered the case for short-dated government debt in portfolios on both tactical and strategic horizons. We stay underweight U.S. nominal long-dated government bonds on both horizons as we expect investors to demand more compensation for the risk of holding them. Tactically, we are overweight on euro area and UK bonds as we think more rate cuts are coming than the market expects.
	Inflation-linked		Our strategic views are maximum overweight DM inflation-linked bonds where we see higher inflation persisting – but we have trimmed our tactical view to neutral on current market pricing in the euro area.
Public credit and emerging market debt	Investment grade		Strategically, we’re underweight due to limited compensation above short-dated government bonds. We’re underweight tactically to fund risk-taking elsewhere as spreads remain tight.
	High yield		Strategically, we are neutral high yield as we see the asset class as more vulnerable to recession risks. We’re tactically underweight. Spreads don’t fully compensate for slower growth and tighter credit conditions we expect.
	EM debt		Strategically, we're neutral and see more attractive income opportunities elsewhere. Tactically, we’re overweight hard currency EM debt due to higher yields. It is also cushioned from weakening local currencies as EM central banks cut policy rates.
Private markets	Income	-	We are strategically overweight private markets income. For investors with a long-term view, we see opportunities in private credit as private lenders help fill a void left by a bank pullback.
	Growth	-	Even in our underweight to growth private markets, we see areas like infrastructure equity as a relative bright spot.

Note: Views are from a U.S. dollar perspective, September 2023. 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, September 2023

Asset	Tactical view	Commentary
Equities
United States		We are underweight the broad market – still our largest portfolio allocation. We don’t think earnings expectations reflect the macro damage we expect. We recognize momentum is strong near-term.
Europe		We are underweight. We see the European Central Bank holding policy tight in a slowdown, and the support to growth from lower energy prices is fading.
U.K.		We are neutral. We find that attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to deal with sticky inflation.
Japan		We are overweight. We think stronger growth can help earnings top expectations. Stock buybacks and other shareholder-friendly actions may keep attracting foreign investors.
Pacific ex-Japan		We are neutral. China’s restart is losing steam and we don’t see valuations compelling enough to turn overweight.
DM AI mega force		We are overweight. We see a multi-country and multi-sector AI-centered investment cycle unfolding set to support revenues and margins.
Emerging markets		We are neutral. We see growth on a weaker trajectory and see only limited policy stimulus from China. We prefer EM debt over equity.
China		We are neutral. Growth has slowed. Policy stimulus is not as large as in the past. Yet it should stabilize activity, and valuations have come down. Structural challenges imply deteriorating long-term growth. Geopolitical risks persist.
Fixed income
Short U.S. Treasuries		We are overweight. We prefer short-term government bonds for income as interest rates stay higher for longer.
Long U.S. Treasuries		We are underweight. We see long-term yields moving up further as investors demand greater term premium.
U.S. inflation-linked bonds		We are overweight and prefer the U.S. over the euro area. We see market pricing underestimating sticky inflation.
Euro area inflation-linked bonds		We prefer the U.S. over the euro area. Markets are pricing higher inflation than in the U.S., even as the European Central Bank is set to hold policy tight, in our view.
Euro area government bonds		We are overweight. Market pricing reflects policy rates staying higher for longer even as growth deteriorates. Widening peripheral bond spreads remain a risk.
UK Gilts		We are overweight. Gilt yields are holding near their highest in 15 years. Markets are pricing in restrictive Bank of England policy rates for longer than we expect.
Japan government bonds		We are underweight. We see upside risks to yields from the Bank of Japan winding down its ultra-loose policy.
China government bonds		We are neutral. Bonds are supported by looser policy. Yet we find yields more attractive in short-term DM paper.
Global investment grade credit		We are underweight. We take advantage of tight credit spreads to fund increased risk-taking elsewhere in the portfolio. We look to up the allocation if growth deteriorates.
U.S. agency MBS		We’re overweight. We see agency MBS as a high-quality exposure within diversified bond allocations.
Global high yield		We are underweight. Spreads do not fully compensate for slower growth and tighter credit conditions we anticipate.
Asia credit		We are neutral. We don’t find valuations compelling enough to turn more positive.
Emerging market - hard currency		We are overweight. We prefer emerging hard currency debt due to higher yields. It is also cushioned from weakening local currencies as EM central banks start to cut policy rates.
Emerging market - local currency		We are neutral. Yields have fallen closer to U.S. Treasury yields. Plus, central bank rate cuts could put downward pressure on EM currencies, dragging on potential returns.

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, September 2023

Asset	Tactical view	Commentary
Equities
Europe ex UK		We are underweight. We see the European Central Bank holding policy tight in a slowdown and the support to growth from lower energy prices is fading.
Germany		We are underweight. Valuations are moderately supportive relative to peers, but we see earnings under pressure from higher interest rates, slower global growth and medium-term uncertainty on energy supply. Longer term, we think the low-carbon transition may bring opportunities.
France		We are underweight. Relatively richer valuations and a potential drag to earnings from weaker consumption amid higher interest rates offset the positive impact from past productivity enhancing reforms and favorable energy mix.
Italy		We are underweight. The economy’s relatively weak credit fundamentals amid global tightening financial conditions keep us cautious even though valuations and earnings revision trends look attractive versus peers.
Spain		We are underweight. Valuations and earnings momentum are supportive relative to peers, but the uncertain outcome of Spanish elections is a temporary headwind.
Netherlands		We are underweight. The Dutch stock markets' tilt to technology and semiconductors, a key beneficiary of higher demand for AI, is offset by relatively less favorable valuations and earnings momentum than European peers.
Switzerland		We are overweight. We hold a relative preference. The index’s high weights to defensive sectors like health care and non-discretionary consumer goods provide a cushion amid heightened global macro uncertainty. Valuations remain high versus peers and a strong currency is a drag on export competitiveness..
UK		We are neutral. We find that attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to deal with sticky inflation.
Fixed income
Euro area government bonds		We are overweight. Market pricing reflects policy rates staying higher for longer even as growth deteriorates. Widening peripheral bond spreads remain a risk.
German bunds		We are neutral. Market pricing better reflects policy rates staying higher for longer. We prefer short-term government paper for income.
French OATs		We are neutral. Valuations look moderately compelling compared to peripheral bonds, with French spreads to German bonds hovering above historical averages. Elevated French public debt and a slower pace of structural reforms remain headwinds.
Italian BTPs		We are neutral. The spread over German Bunds looks tight amid deteriorating macro and restrictive ECB policy. Yet domestic factors remain supportive, namely a more balanced current account and prudent fiscal stance. We see income helping to compensate for the slightly wider spreads we expect.
UK gilts		We are overweight. Gilt yields are holding near their highest in 15 years. Markets are pricing in restrictive Bank of England policy rates for longer than we expect.
Swiss government bonds		We are neutral. We don’t see the SNB hiking rates as much as the ECB given relatively subdued inflation and a strong currency. Further upward pressure on yields appears limited given global macro uncertainty.
European inflation-linked bonds		We are underweight. We prefer the U.S. over the euro area. Markets are pricing higher inflation than in the U.S., even as the European Central Bank is set to hold policy tight, in our view.
European investment grade credit		We are modestly overweight European investment-grade credit for decent income. We prefer European investment grade over the U.S. given more attractive valuations. We monitor tighter credit and financial conditions.
European high yield		We are neutral. We find the income potential attractive yet prefer up-in-quality credit exposures amid a worsening macro backdrop.

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, September 2023. 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.