Looking through the Fed’s signals
Market take
Weekly video_20240506
Nicholas Fawcett
Opening frame: What’s driving markets? Market take
Camera frame
The past few months of inflation surprises have confirmed that we’re in a fundamentally more volatile environment – creating greater uncertainty for both markets and the Fed.
Title slide: Looking through the Fed’s signals
That’s why we watch incoming economic data, not Fed policy signals, to gauge the policy path.
1: Evolving policy signals
In December, the Fed saw inflation falling toward 2% by the end of 2024, signaling a green light to cut rates this year. Markets priced in seven cuts. Yet goods and services inflation have since been hotter than expected.
The Fed now accepts rates need to stay high for longer given sticky inflation. It also pushed back against hikes. But greater uncertainty just makes it harder for both markets and policymakers to predict what’s ahead.
We see high-for-longer interest rates, a view markets now reflect.
2: Corporate earnings offer support
Markets pricing out rate cuts usually hurts stock valuations. Yet U.S. firms beating Q1 earnings forecasts by 10% has supported stocks.
Tech stocks and artificial intelligence beneficiaries have kept up their robust growth, while other sectors see recoveries as well.
Outro: Here’s our Market take
We see interest rates staying high for longer. We remain overweight U.S. stocks on a six- to 12-month tactical horizon.
We’re tactically neutral long-term bonds because yields could go up or down as markets adjust their policy expectations.
Closing frame: Read details:
www.blackrock.com/weekly-commentary.
Data dependent
We look to incoming data to determine where the Federal Reserve will go, rather than its policy signals. Solid corporate earnings keep us overweight U.S. stocks.
Market backdrop
U.S. stocks clawed higher thanks to earnings beating expectations, even as the Fed meeting confirmed we’re in a structurally higher interest rate environment.
Week ahead
We expect the Bank of England to hold rates steady this week. Markets have pared back their expectations of rate cuts this year due to slowly falling inflation.
Q1 inflation surprises have pushed the Fed to flip on its December view and accept that interest rates will have to stay high for longer at last week’s meeting. We’re in a world shaped by structural forces and supply – creating greater uncertainty for the Fed and markets. That’s why we eye new data, not Fed signals, to gauge the policy path. We see high-for-longer rates, a view markets now reflect. We stay overweight U.S. stocks as solid corporate earnings help offset pressure from high rates.
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Moving on up
Market pricing of the fed funds rate, 2023-2024
Forward looking estimates may not come to pass. Source: BlackRock Investment Institute, with data from LSEG Datastream, May 2024. Notes: The chart shows the current fed funds policy rate and market expectations of the fed funds rate via SOFR futures pricing. The fed funds rate shown is the midpoint of the Federal Reserve’s target range.
At its December meeting, the Fed’s communications and its economic forecasts all signaled that inflation would fall toward 2% by the end of this year, meaning the central bank would be able to cut rates in 2024. Markets took that as a blessing to price in roughly seven quarter-point rate cuts, predicting the fed funds rate would fall as low as roughly 3.6% by the end of this year and 3% by 2025. See the yellow and green lines in the chart. Any forecast for inflation falling steadily toward 2% assumes that goods prices will keep sliding and that services inflation will ease materially from elevated levels. Those outcomes are highly uncertain, we believe. Instead, both goods and services inflation have been hotter than expected – a reality check for the Fed and markets alike. Market pricing of where rates will be by the end of this year and next has jumped in response to such sticky inflation.
On our part, we had expected goods deflation to pull inflation briefly toward 2%, before stubborn services inflation moved it back further above target in 2025. Our view on inflation’s destination likely holds. But the ramp-up in goods prices suggests it will be difficult to achieve even a near-term dip. The Fed is now accepting rates need to stay high for longer given sticky inflation. It also pushed back against hikes. Yet greater macro volatility makes it harder for both markets and policymakers to predict what’s ahead. That’s why we rely on new data, instead of Fed policy signals, to shape our view of the likely policy path.
Earnings keeping stocks afloat
Higher interest rates usually hurt U.S. stock valuations. Instead, strong Q1 earnings have supported stocks even as high rates and lofty expectations raise the bar for what can keep markets sanguine. Some 77% of S&P 500 firms reporting have beat the consensus, LSEG data show. Tech stocks and artificial intelligence beneficiaries have kept up their robust growth, while other sectors also see recoveries. Given volatile data and policy uncertainty, we think long-term U.S. Treasury yields can swing in either direction for now and stay neutral on a six- to 12-month tactical horizon. In the longer run, we think long-term yields will climb as investors demand more term premium, or compensation for the risk of holding bonds. With the U.S. Treasury boosting borrowing, we see rising debt leading to term premium’s return.
High-for-longer U.S. interest rates have implications globally, like in Japan, where the yen has slid to 34-year lows against the dollar. Suspected efforts by Japanese authorities to buy dollars may slow the slide, but the divergence between Bank of Japan and Fed policy is the source of yen weakness. Yet the European Central Bank may be able to cut rates even if the Fed keeps policy tight for longer. Europe’s inflation is cooling further toward 2% and economic activity has been weak since 2022, even with a surprise bump in Q1 GDP. The muted growth and weak earnings backdrop keeps us underweight European stocks.
Our bottom line
We see interest rates staying high for longer and keep eyeing incoming data. We remain tactically overweight U.S. stocks due to support from earnings and neutral long-term bonds given ongoing yield volatility. Professional investors can visit our Capital market assumptions page to learn more about our long-run view on developed market long-term bonds.
Market backdrop
The S&P 500 rose slightly last week and is up about 8% this year thanks to corporate earnings topping high expectations. U.S. 10-year Treasury yields dropped to around 4.50%, about 25 basis points below their 2024 high hit in late April, after U.S. payrolls undershot expectations and the Fed said its next move was unlikely to be a hike. Yet last week’s Fed meeting also confirmed we’re in a structurally higher interest rate environment.
We expect the BOE to hold rates steady this week. Markets have pared back their expectations of rate cuts this year due to slowly falling inflation. We watch UK GDP data out this week for signs growth momentum is starting to pick up from a period of stagnation. U.S. consumer sentiment data and data on China’s services sector, trade activity and domestic credit lending are also due for release.
Week ahead
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 May 2, 2024. Notes: The two ends of the bars show the lowest and highest returns at any point 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 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.
May 6
China Caixin services PMI
May 9
Bank of England (BOE) policy decision; China trade data
May 10
University of Michigan consumer sentiment survey; UK GDP data
May 10-17
China total social financing
Read our past weekly market commentaries here.
Big calls
Our highest conviction views on tactical (6-12 month) and strategic (long-term) horizons, May 2024
| Reasons | ||
|---|---|---|
| Tactical | ||
| U.S. equities | Our macro view has us neutral at the benchmark level. But the AI theme and its potential to generate alpha – or above-benchmark returns – push us to be overweight overall. | |
| Income in fixed income | The income cushion bonds provide has increased across the board in a higher rate environment. We like short-term bonds and are now neutral long-term U.S. Treasuries as we see two-way risks ahead. | |
| Geographic granularity | We favor getting granular by geography and like Japan equities in DM. Within EM, we like India and Mexico as beneficiaries of mega forces even as relative valuations appear rich. | |
| Strategic | ||
| Private credit | We think private credit is going to earn lending share as banks retreat – and at attractive returns relative to public credit risk. | |
| Inflation-linked bonds | We see inflation staying closer to 3% in the new regime on a strategic horizon. | |
| Short- and medium-term bonds | We overall prefer short-term bonds over the long term. That’s due to more uncertain and volatile inflation, heightened bond market volatility and weaker investor demand. | |
Note: Views are from a U.S. dollar perspective, May 2024. 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, May 2024
Our approach is to first determine asset allocations based on our macro outlook – and what’s in the price. The table below reflects this. It leaves aside the opportunity for alpha, or the potential to generate above-benchmark returns. The new regime is not conducive to static exposures to broad asset classes, in our view, but it is creating more space for alpha. For example, the alpha opportunity in highly efficient DM equities markets historically has been low. That’s no longer the case, we think, thanks to greater volatility, macro uncertainty and dispersion of returns. The new regime puts a premium on insights and skill, in our view.
| Asset | Tactical view | Commentary | ||||
|---|---|---|---|---|---|---|
| Equities | ||||||
| United States | Benchmark |  |
We are neutral in our largest portfolio allocation. Falling inflation and coming Fed rate cuts can underpin the rally’s momentum. We are ready to pivot once the market narrative shifts. | |||
| Overall |  |
We are overweight overall when incorporating our U.S.-centric positive view on artificial intelligence (AI). We think AI beneficiaries can still gain while earnings growth looks robust. | ||||
| Europe |  |
We are underweight. While valuations look fair to us, we think the near-term growth and earnings outlook remain less attractive than in the U.S. and Japan – our preferred markets. | ||||
| U.K. | |
We are neutral. We find attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to fight sticky inflation. | ||||
| Japan |  |
We are overweight. Mild inflation, strong earnings growth and shareholder-friendly reforms are all positives. We see the BOJ policy shift as a normalization, not a shift to tightening. | ||||
| 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. Modest policy stimulus may help stabilize activity, and valuations have come down. Structural challenges such as an aging population and 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 neutral. The yield surge driven by expected policy rates has likely peaked. We now see about equal odds that long-term yields swing in either direction. | ||||
| U.S. inflation-linked bonds | |
We are neutral. We see higher medium-term inflation, but cooling inflation and growth may matter more near term. | ||||
| Euro area inflation-linked bonds |  |
We are neutral. Market expectations for persistent inflation in the euro area have come down. | ||||
| Euro area government bonds | |
We are neutral. Market pricing reflects policy rates in line with our expectations and 10-year yields are off their highs. Widening peripheral bond spreads remain a risk. | ||||
| UK Gilts | |
We are neutral. Gilt yields have compressed relative to U.S. Treasuries. Markets are pricing in Bank of England policy rates closer to our expectations. | ||||
| Japan government bonds |  |
We are underweight. We find more attractive returns in equities. We see some of the least attractive returns in Japanese government bonds, so we use them as a funding source. | ||||
| China government bonds | |
We are neutral. Bonds are supported by looser policy. Yet we find yields more attractive in short-term DM paper. | ||||
| U.S. agency MBS | |
We are neutral. We see agency MBS as a high-quality exposure in a diversified bond allocation and prefer it to IG. | ||||
| Global investment grade credit | |
We are underweight. Tight spreads don’t compensate for the expected hit to corporate balance sheets from rate hikes, in our view. We prefer Europe over the U.S. | ||||
| Global high yield | |
We are neutral. Spreads are tight, but we like its high total yield and potential near-term rallies. We prefer Europe. | ||||
| 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 EM hard currency debt due to its relative value and quality. It is also cushioned from weakening local currencies as EM central banks cut policy rates. | ||||
| Emerging market - local currency | |
We are neutral. Yields have fallen closer to U.S. Treasury yields. Central bank rate cuts could hurt 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, May 2024. 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, May 2024
| Asset | Tactical view | Commentary | ||
|---|---|---|---|---|
| Equities | ||||
| Europe ex UK | |
We are underweight. While valuations look fair to us, we think the near-term growth and earnings outlook remain less attractive than in the U.S. and Japan – our preferred markets. | ||
| Germany | |
We are neutral. Valuations remain moderately supportive relative to peers. The earnings outlook looks set to brighten as global manufacturing activity bottoms out and financing conditions start to ease. Longer term, we think the low-carbon transition may bring opportunities. | ||
| France | |
We are underweight. Relatively richer valuations offset the positive impact from past productivity enhancing reforms and favorable energy mix. | ||
| Italy | |
We are underweight. Valuations and earnings dynamics are supportive. Yet recent growth outperformance seems largely due to significant fiscal stimulus in 2022-2023 that cannot be sustained over the next few years, we think. | ||
| Spain | |
We are neutral. Valuations and earnings momentum are supportive relative to peers. The utilities sector looks set to benefit from an improving economic backdrop and advances in AI. Political uncertainty remains a potential risk. | ||
| 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 than European peers. | ||
| Switzerland | |
We are underweight in line with our broad European market positioning. Valuations remain high versus peers. The index’s defensive tilt will likely be less supported as long as global risk appetite holds up, we think. | ||
| 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 neutral. Market pricing reflects policy rates broadly in line with our expectations and 10-year yields are off their highs. | ||
| German bunds | |
We are neutral. Market pricing reflects policy rates broadly in line with our expectations and 10-year yields are off their highs. | ||
| French OATs | |
We are neutral. Valuations look less compelling following pronounced narrowing of French spreads to German bonds. Elevated French public debt and a slower pace of structural reforms remain challenges. | ||
| Italian BTPs | |
We are neutral. The spread over German bunds looks tight given Italy’s recently higher-than-expected deficit-to-GDP-ratio and a trajectory for the debt ratio in the next few years which is stable at best. Other domestic factors remain supportive, with growth holding up well relative to the rest of the euro area. Italian households are also showing a significant willingness to increase their direct holding of BTPs amid high nominal rates and yields. | ||
| UK gilts | |
We are neutral. Gilt yields have compressed relative to U.S. Treasuries. Markets are pricing in Bank of England policy rates closer to our expectations. | ||
| Swiss government bonds | |
We are neutral. The Swiss National Bank has started to cut policy rates given reduced inflationary pressure and the appreciation of the Swiss franc. | ||
| European inflation-linked bonds | |
We are neutral. Market expectations for persistent inflation in the euro area have come down. | ||
| European investment grade credit | |
We are neutral. We maintain our preference for European investment grade over the U.S. given more attractive valuations amid decent income. | ||
| European high yield | |
We are overweight. We find the income potential attractive. We still prefer European high yield given its more appealing valuations, higher quality and lower duration than in the U.S. Spreads compensate for risks of a potential pick-up in defaults, in our view. | ||
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, May 2024. 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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Meet the Authors
Jean Boivin
Head – BlackRock Investment Institute
Wei Li
Global Chief Investment Strategist — BlackRock Investment Institute
David Rogal
Portfolio Manager, Global Fixed Income — BlackRock
Nicholas Fawcett
Macro Research – BlackRock Investment Institute
