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  • BlackRock Investment Institute

Markets now accept rate cuts unlikely

Weekly video_20230530

Nicholas Fawcett

Opening frame: What’s driving markets? Market take

Camera frame

Growth in developed markets is already weakening, and yet inflation remains stubbornly high. Even as the U.S. debt ceiling is in focus, markets are getting to grips with the implications: Central banks are set to keep interest rates higher – and for longer.

 Title slide: Inflation, growth: What we’ve learned

1: Economic drags

Data last week showed Germany is already in recession, and on some measures U.S. activity too has contracted over the past six months.

2: Persistent inflation

Yet labor markets remain tight even as overall activity softens. That’s keeping wage pressures elevated and making overall inflation stubbornly high, in Europe, the UK and the U.S. 

We see central banks staying with higher policy rates for longer as a result, with rate cuts this year unlikely.

3: Markets starting to reflect this?

Markets are adjusting to this.

Expectations of Fed rate cuts in the U.S. have dwindled. And markets are pricing in more hikes in Europe.

And stripping out mega-cap tech names, U.S. equities are actually down on the year.

Outro frame: Here’s our Market take

We turn to high quality income in the short term.

We close the underweight on UK gilts as yields climb back to near the levels reached during last September’s turmoil.

We stay cautious on risk assets. And we like inflation-linked bonds as inflation proves persistent.

Closing frame: Read details:

No cuts this year

Inflation has proven sticky, even as growth weakens. Markets are realising that policy rates are set to stay higher for longer. We like quality in stocks and bonds.

Market backdrop

Tech stocks surged further last week even as debt ceiling talks spurred bouts of volatility. Long-term bond yields climbed on still hot US inflation in April.

Week ahead

US jobs data this week should show a tight labor market is keeping wage pressures elevated. We think that keeps inflation sticky and above policy targets.

We’ve been saying since the end of 2022 that rate cuts this year would be unlikely as inflation sticks around. Markets are waking up to our view as a look under the hood reveals signs of weaker growth in major economies and market weakness due to rate hikes. Debt ceiling talks and the US Treasury potentially being unable to pay its bills by early June have added to recent market volatility. We like quality in portfolios. We upgrade UK gilts to neutral as yields price in more rate hikes.

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A big divergence

US equities market cap vs. equal weighted price change year-to-date

The dark orange line in the chart shows that the S&P 500 index is up by around 8% so far this year through May 25. The yellow line shows that after applying equal weighting to all companies in the index regardless of size, the index is down about1% this year.

Source: BlackRock Investment Institute, with data from Refintiv Datastream, May 2023. Notes: The chart shows the price index change for the S&P 500 Composite Index (market-capitalization weighted) and S&P 500 Equal-weighted Index since the start of 2023 through May 25, 2023.

Stubbornly high inflation has prompted the Fed’s fastest rate hike campaign since the 1980s. Markets are no longer pricing in repeated Fed rate cuts, a sign they’re grasping inflation’s persistence, in our view. And the full effect of central banks’ rate hikes is kicking in. Data last week showed Germany has entered recession even with a smaller-than-feared energy shock. In the US, GDP has held up but it has arguably entered recession based on gross domestic income, which assesses the economy’s performance on an income rather than spending basis. A deeper look reveals stocks reflect worsening growth: The S&P 500 index was up nearly 10% so far this year (dark orange line in the chart). But a few large technology firms valued above $200 billion are driving those gains as they benefit from artificial intelligence buzz. Applying equal weighting to all companies in the index regardless of size shows it’s down over 1% this year (yellow line) – extending 2022’s hefty losses.

What's ahead for central banks

Inflation and wage growth remain sticky, even with this deteriorating growth picture. Why? US consumer spending’s shift back to services from goods caused core inflation to fall at first. Yet labor constraints persist, with unemployment still near historic lows. We think tight labor markets are keeping wage gains high, making overall inflation stubborn. April PCE inflation data out last week confirmed that. Inflation is running even hotter in Europe, especially the UK. Central banks face a clear trade-off, in our view: crush activity to ease labor constraints and curb inflation – or live with some above-target inflation.

We see the Fed nearing a pause in rate hikes and living with some inflation to avoid the deep recession needed to get inflation near its target. But we don’t see the Fed coming to the rescue of a faltering economy with rate cuts later this year due to the sharp trade-off between inflation and growth. Markets are coming around to our long-held view after having until recently priced in repeated rate cuts in 2023. We think the European Central Bank will hike more, regardless of the economic damage. The Bank of England (BOE) is in a similar position. Markets have priced in as many as four more BOE hikes. We think that might be a bit overdone, as it would be equivalent to the Fed hiking to around 7-7.5% – enough to trigger a severe recession.

We have a relative preference for UK gilts given this outlook. We close our previous underweight on UK gilts as yields return near levels reached during last September’s turmoil. We favor quality in our portfolio. We’re neutral investment grade credit and think yields above 5% compensate for wider spreads due to any downturn. We’re overweight emerging market (EM) local currency debt given peaking EM rates and a broadly weaker US dollar. We also look for quality in equities, with a preference for companies that are able to grow their earnings and wield pricing power to pass on higher costs. Cushioning portfolios from inflation is also key. We like inflation-linked bonds as markets underestimate the persistence of US inflation but better appreciate it in Europe, we think. On a strategic horizon of five years or more, we lean into real assets that can buffer inflation like infrastructure and industrial properties. Strategically, we see returns for developed market (DM) stocks above bonds’ as growth returns and inflation lingers in the US DM stocks look riskier to us in the near term than fixed income given current yields. Debt ceiling concerns have upped market volatility, but we see the growth-inflation trade-off as a bigger driver of volatility longer term. We prefer EM stocks as they better price in the damage, yet China’s growth stalling would pose risks.

Our bottom line

Markets are reassessing policy rate expectations as sticky inflation makes clear central banks won’t cut them this year – or will keep hiking. We turn to high quality sources of income in the short term and stay cautious on risk assets. 

Market backdrop

Major tech stocks surged further last week, leading US stocks slightly higher – even as the US potentially facing a technical default dominated market attention. Meanwhile, long-term Treasury yields climbed after data showed that April US PCE inflation remained hot. A credit rating agency warning it could downgrade the top notch Treasuries rating if the US defaults reinforces our view investors will demand more compensation for holding long-term bonds given higher policy rates.

We’re watching key inflation and labor market data in developed markets this week. We see wage pressures from a tight labor market in the US and euro area keeping core inflation above policy targets for some time. We expect some easing of labor market tightness as the lagged effect of rate hikes by major central banks starts to hit economic activity.

Week ahead

The chart shows that European equities are the best performing asset year-to-date among a selected group of assets, while Brent crude 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 May 25, 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 US dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE US Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (US, 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 31

China manufacturing PMI

June 1

Euro area inflation; US manufacturing PMI

June 2

US payrolls

Read our past weekly commentaries here.

Investment themes


Pricing in 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, May 2023. 

Legend Granular

Note: Views are from a US 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, May 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 US 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, May 2023. 

Legend Granular

Asset Tactical view Commentary
 Europe ex UK Europe ex-UK: tactical Underweight -1 We are underweight. We don’t think consensus earnings expectations are pricing in heightened risks of a deep recession. We see a sharp hit to euro area growth from the energy price shock alone. The European Central Bank looks intent on squeezing out inflation via policy overtightening, making a recession likely.
Germany Germany: tactical Underweight -1 Valuations are supportive relative to peers, but near-term headwinds to earnings prospects remain significant. They include uncertainty on energy supply, rapid ECB tightening and slower growth in major trading partners. Looking further ahead, opportunities may arise from political ambitions to bring the economy to net zero.
France France: tactical Underweight -1 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, favorable energy mix and boost to the luxury sector from China's near-term reopening.
Italy Italy: tactical Underweight -1 While valuations and earnings trends are attractive versus peers, the economy’s relatively weak credit fundamentals amid a global tightening financial conditions keep us cautious.
Spain Spain: tactical Underweight -1 The market’s outperformance in 2022 – driven largely by its greater relative exposure to rate-sensitive financials – leaves it vulnerable to profit-taking amid a broader, regional downturn, in our view.
Netherlands Netherlands: tactical Underweight -1 The earnings outlook has weakened more than in other European markets, resulting in a negative earnings outlook over the next 12 months. Dutch stocks are trading at a comparable valuation but offer a relatively low dividend yield.
Switzerland UK: tactical Neutral 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 UK: tactical Underweight -1 We are underweight. We see UK activity contracting as explicitly acknowledged by the Bank of England – and yet not reflected in consensus earnings expectations. The market has outperformed other DMs in 2022 due to energy sector exposure flattered by a weaker currency – and is not immune to a global downturn.
Fixed income    
Euro area government bonds Euro area government bonds: tactical Underweight -1 We are underweight. We expect the ECB to keep tightening even after the recession has started. Global trend of higher term premium being priced in should also push long term yields up. We see inflation coming down to target only very slowly and tight monetary policy remains a risk to peripheral spreads.
German bunds German bunds: tactical Underweight -1 The ECB is likely to keep overtightening policy even after a recession starts, while inflation is likely to return close target only very slowly. The new investment regime of higher macro volatility globally should translate into higher risk premia for holding long term government bonds, a trend from which Germany will struggle to decouple from.
French OATs Italian BTPs: tactical Underweight -1 We are neutral. Valuations look 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 Italian BTPs: tactical Underweight -1 BTP-Bund spread is too tight given the weakening in Italy’s credit fundamentals and a now negative current account balance. Yet a relatively prudent fiscal stance from the new government should keep any spread widening limited, with investors compensated by the higher carry of Italian government bonds.
Swiss government bonds Swiss government bonds: tactical Neutral We prefer Swiss bonds relative to euro area bonds. The Swiss National Bank has quickly hiked policy rates back to positive. Further upward pressure on yields appears limited given global macro uncertainty, still relatively subdued underlying inflation and a strong currency. We don’t see the SNB hiking rates as much as the ECB.
UK gilts UK gilts: tactical neutral We are neutral. We find gilt yields attractive as they have risen back near levels reached during 2022’s budget turmoil. We prefer short-dated gilts for income.
European inflation-linked bonds European inflation-linked bonds: tactical Neutral We turn neutral. We see euro area inflation falling to the ECB target over a multi-year period, supporting breakeven pricing, but policy tightening into a recession is a headwind to the asset class.
European investment grade credit European investment grade credit: tactical Overweight +2 We are overweight European investment-grade credit. We still find valuations attractive in terms of both overall yield and the spread, especially when considering the lower duration compared with US credit.
European high yield European high yield: tactical Neutral 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, May 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.

Jean Boivin
Head – BlackRock Investment Institute
Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Nicholas Fawcett
Macro Research – BlackRock Investment Institute

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Bronnen: Bloomberg, tenzij anders aangegeven


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