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Stumbling to new inflation fight phase

Market take

Weekly video_20230206

Alex Brazier

Opening frame: What’s driving markets? Market take

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Inflation is falling thanks to lower energy and goods prices.

And last week, major central banks seemed to signal that they are now entering phase two of their rate hike cycles.

1: Phase two in the inflation fight

Phase one was about raising rates quickly and sounding as if they’d do whatever it took to bring down inflation.

We saw them pausing and shifting their message to be more nuanced in a second phase once the damage of rate hikes came into view.

2: Mixed messages from central banks

Last week brought some mixed messages from central banks.

That could be a subtle sign that they are stumbling into that second phase a little sooner than expected.

We believe a pause in rate hikes is now nearing. And that reinforces our view of mild recessions this year.

3: Labor markets to keep inflation high

Labor markets will be key to this.

We see worker shortages in the U.S. and Europe keeping wage growth and inflation high, even amid weak economic growth.

Inflation is set to linger for longer above central banks’ 2% targets.

Outro frame: Here’s our Market take

And although no longer rising sharply, we expect interest rates to stay higher for longer in this next phase for monetary policy.

That’s why we like high-quality credit and short-term government bonds for income.

Closing frame: Read details:

www.blackrock.com/weekly-commentary

A new phase

We see central banks stumbling into a more nuanced phase of the inflation fight and nearing a pause on hikes. We like short-term bonds and credit for income.

Market backdrop

U.S. stocks rose but trimmed gains and Treasury yields jumped after U.S. jobs data showed a tight labor market, reviving expectations for Fed rate hikes.

Week ahead

China inflation data out this week may show early signs of how the rapid restart from Covid lockdowns is affecting China’s economy.

Central banks are stumbling into a nuanced phase of policy tightening after major macro events last week. Lower energy and goods prices are pulling down overall inflation. Yet tight job markets should keep wage growth above levels needed for core inflation to fall to 2% targets, reflected in a 54-year low for unemployment in the U.S. We see central banks close to pausing hikes: Major economies will see mild recessions but lingering inflation. We like short-term bonds and credit.

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Wages key for core inflation

Services inflation and private sector wages, 2005-2022

Source: BlackRock Investment Institute, U.S. Bureau of Economic Activity, U.S. Bureau of Labor Statistics, with data from Haver Analytics, February 2023. Notes: The chart shows annualized quarter-over-quarter inflation of U.S. personal consumer expenditure (PCE) services inflation excluding energy services and the U.S. Employment Cost Index measure of annual private sector compensation.

Last year, major central banks took a “whatever it takes” stance on inflation. We saw this as phase one of their policy response in a new regime. We thought they’d one day pause their hikes and shift to more nuanced messaging when economic damage became clearer, then live with some inflation – phase two. Last week’s mixed messages imply they’re stumbling into phase two sooner than we thought and before the damage is fully clear – but we’re not there yet. Inflation is cooling, but it’s not on track to return to target. Some supply disruptions that fed inflation are resolving, and falling goods and energy prices are lowering headline inflation. The outlook for labor markets and wages is key now. We see a shortage of labor in the U.S. and Europe keeping wage growth (yellow line), inflation in the wages-sensitive services sector (orange line) and overall inflation persistently higher.

Headline inflation, including food and energy, has been falling as consumer spending returns to services from goods. Core services inflation will drive overall inflation as spending normalizes, with the labor market central to how phase two plays out, in our view. Central banks seem to think wage growth can fall with headline inflation as workers dial down demands for pay raises to keep up with prices. The Bank of England (BOE) did so explicitly in forecasts last week, implying a deep recession isn’t needed to get inflation to target. Recent job data has been sending inconsistent signals. Notably, Friday’s data showed a still-tight labor market that could keep wage pressures high, notwithstanding recent softer data from ECI and payroll firm ADP. We think wage growth could be more persistent: It reflects a tight job market, difficulty hiring and low unemployment.

Signs of the phase ahead

Signs the Fed is stumbling into phase two: Chair Jerome Powell made inconsistent statements after the Fed hiked 0.25% last week. Powell made clear in his scripted remarks that rates will rise, the Fed isn’t eyeing rate cuts and its job to fight inflation isn’t done. He also stressed that services inflation – the Fed’s main focus – has not shown signs of falling. Yet his unscripted responses sent mixed messages. Powell failed to push back against easing financial conditions that work against the Fed’s efforts to bring down inflation. He also seemed to imply the Fed’s December economic forecasts were stale. While perhaps unintentional, this disconnect suggests the Fed may be nearing a pause, making communication challenges even trickier.

Other major central banks are facing the same communication challenges. European Central Bank President Christine Lagarde seemed to back down from previous whatever-it-takes language by not repeating that a shallow recession is “not enough” to hit the ECB’s inflation goals. She said the risk of ultra-high inflation had receded and lower headline inflation may lessen wage pressures in nearing annual pay negotiations. The BOE upped its 2023 GDP forecast and lowered its inflation forecast. The ECB and BOE raised rates by 0.5% last week, with the ECB set to do so again in March. The Fed, ECB and BOE pausing slightly sooner would reinforce our view they will face milder recessions this year and live with inflation that’s fallen a lot but is likely to settle above their targets. That means central banks are unlikely to cut rates as markets increasingly expect.

Out bottom line

We like high-quality credit, short-end government bonds and agency mortgage-backed securities for income as interest rates stay higher for longer. We have a relative preference for emerging market stocks. They’ve largely outperformed developed market (DM) stocks so far this year even as DM peers have rallied on hopes of a growth rebound, prompting some investors to jump in for fear of missing out. DM stocks aren’t fully pricing the recession hit we see ahead.

Market backdrop

U.S. stocks rose on the week, shaking off disappointing earnings, while Treasury yields reversed their drop after the Fed meeting. The U.S. jobs data this week brought back expectations the Fed was set to raise rates further in coming months. We think the key for the market outlook is whether inflation is on track to fall back to 2% targets and whether there will be a recession. Jobs data suggest the Fed has more work to do, even as the market still prices in rate cuts starting later in 2023.

We’re watching China inflation data for the first signs of effects from the economy’s restart after Covid lockdowns. Low inflation has allowed policymakers in China to keep policy supportive – but the rapid restart may prompt a change. China’s total social financing will be closely watched to see how current policy is translating into credit flowing into the economy.

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-yeasr 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 Feb. 2, 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, 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.

Feb. 6

UK PMI

Feb. 10

China CPI; UK GDP; University of Michigan consumer sentiment survey

Feb. 10-17

China total social financing

Investment themes

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.

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.

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, February 2023

Asset	Tactical view	Commentary
Equities		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		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		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	-	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. 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, February 2023

Asset	Tactical view	Commentary
Equities
Developed markets		We are underweight. Neither earnings expectations nor valuations fully reflect the coming recession. We prefer to take a sectoral approach – and prefer energy, financials and healthcare.
United States		We are underweight. The Fed is set to raise rates into restrictive territory. Earnings downgrades are starting, but don’t yet reflect the coming recession.
Europe		We are underweight. The energy price shock and policy tightening raise stagflation risks.
U.K.		We are underweight. We find valuations expensive after the strong relative performance versus other DM markets thanks to energy sector exposure.
Japan		We are neutral. We like still-easy monetary policy and increasing dividend payouts. Slowing global growth is a risk.
China		We are neutral. Activity is restarting, but we see China on the path to lower growth. Tighter state control of the economy makes Chinese assets riskier, in our view.
Emerging markets		We are neutral. Slowing global growth will weigh on EMs. Within the asset classes, we lean toward commodity exporters over importers.
Asia ex-Japan		We are neutral. China’s near-term cyclical rebound is a positive, yet we don’t see valuations compelling enough to turn overweight.
Fixed income
Long U.S. Treasuries		We are underweight. We see long-term yields moving up further as investors demand a greater term premium.
Short U.S. Treasuries		We are neutral. We remain invested in the front end due to attractive income potential.
Global inflation-linked bonds		We are overweight. We see breakeven inflation rates underpricing the persistent inflation we expect.
European government bonds		We are underweight the long end. We expect term premium to raise long-term yields and high inflation to persist. Rate hikes are a risk to peripheral spreads.
UK Gilts		We are underweight. Perceptions of fiscal credibility have not fully recovered. We prefer short-dated gilts for income.
China government bonds		We are neutral. Policymakers have been slow to loosen policy to offset the slowdown, and they are less attractive than DM bonds.
Global investment grade credit		We are significantly overweight. High quality corporates’ strong balance sheets imply IG credit could weather a recession better than stocks.
U.S. agency MBS		We are overweight. We see the asset class as a high-quality exposure within a diversified bond allocation. Soaring U.S. mortgage rates have boosted potential income.
Global high yield		We are neutral. We prefer up-in-quality credit exposures amid a worsening macro backdrop.
Emerging market - hard currency		We are neutral. We see support from higher commodities prices yet it is vulnerable to rising U.S. yields.
Emerging market - local currency		We are neutral EM debt after its strong run. We see better opportunities for income in DMs.
Asia fixed income		We are neutral amid a worsening macro outlook. We don’t find valuations compelling enough yet to turn more positive on the asset class.

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.