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Recession – but no central bank rescue

Market take

Weekly video_20230327

Nicholas Fawcett

Opening frame: What’s driving markets? Market take

Camera frame:

The trade-off for central banks between crushing activity and living with persistently higher inflation is now front and center.

1: Financial stability vs. monetary policy objectives

We have long argued that economic damage and financial cracks would emerge from the fastest interest rate hikes since the 1980s.

In the past two weeks, major central banks clearly separated monetary policy from their efforts to deal with banking turmoil, and continued with further rate hikes.

2: A new phase of the inflation fight

The Federal Reserve, like other central banks, is now approaching a new phase of the inflation fight: stopping rate hikes as the evidence emerges of the economic damage caused.

But we do not see the Fed coming to the rescue with the repeated rate cuts the market is now pricing in. That’s the old playbook.

3: No rescue from recession

The Fed’s new forecasts show a recession this year and yet inflation is set to remain far above its 2% target.

That means the Fed won’t come to the rescue with rate cuts even as the economy contracts.

And we think inflation will prove even more persistent than the Fed expects.

Outro frame: Here’s our Market take 

This backdrop supports our move to go even more overweight inflation-linked bonds. We also prefer very short-term government paper as we expect markets to price out rate cuts.

Closing frame: Read details:


No ignoring trade-off

Central banks confront the growth-inflation trade-off, with the Federal Reserve seeing recession but no rate cuts. We agree – and prefer inflation-linked bonds.

Market backdrop

Bank stocks remained under pressure last week. The two-year US Treasury yield slid further as the market priced in a series of Fed rate cuts.

Week ahead

We’re watching inflation data on both sides of the Atlantic this week for further signs of it staying elevated, while monitoring the ongoing banking sector woes.

The central bank trade-off between crushing activity or living with inflation is now impossible to ignore as economic damage and financial cracks emerge. That was evident in the Federal Reserve’s forecast of recession this year and sticky inflation in years to come. Central banks have clearly separated responses to the banking tumult and kept hiking rates. We see a new, more nuanced phase of curbing inflation ahead: less fighting but still no rate cuts. We favor inflation-linked bonds.

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The trade-off

Federal Reserve projections for Q4 2023 GDP growth and inflation

 chart shows that the Fed's projection for 2023 growth fell from near 3% at its September 2021 meeting to near 0% after its March 2023 meeting. Its forecast for 2023 core PCE rose from near 2% to near 4% in that same time.

Source: BlackRock Investment Institute and Federal Reserve, March 2023. The chart shows the progression of the median Federal Open Market Committee projection for Q4 2023 US real GDP growth and core PCE inflation year-over-year, from September 2021 through March 2023.

The progression of the Fed’s forecasts shows it has been repeatedly too optimistic on both growth and inflation – that’s the trade-off in action. See the chart. Its latest projections imply a recession in the months ahead, with growth stalling later in 2023 after a strong start to the year (red line). The Fed still doesn’t plan to cut rates because inflation is persistently above its 2% target. So it is expecting to live with lingering inflation even with recession – it sees PCE inflation remaining above 3% at the end of 2023 (yellow line). It doesn’t see inflation falling back near its target until 2025. Even so, we think the Fed is underestimating how stubborn inflation is proving due to a tight labor market: Inflation could remain above its target for even longer than that if the recession is as mild as the Fed projects.

The Fed and other central banks made clear banking troubles would not stop them from further tightening. US authorities acted swiftly to help stem contagion by protecting depositors from bank failures. By clearly separating financial and price stability goals and tools, major central banks carried on with rate hikes through the tumult. The Fed, European Central Bank and the Bank of England all did so. Even the Swiss National Bank lifted rates by 0.5% just days after facilitating a takeover of long-troubled Credit Suisse. The bank troubles imply higher borrowing costs and tighter credit availability – and are part of the economic and financial damage we’ve long argued would come. That damage is now front and center – central banks are finally forced to confront it. We think this means they are set to enter the new phase of curbing inflation that we’ve been flagging. We see major central banks moving away from a “whatever it takes” approach, stopping their hikes and entering a more nuanced phase that’s less about a relentless fight against inflation but still one where they can’t cut rates. 

No rate cuts this year

Markets have been quick to price in rate cuts as a result of the banking sector turmoil and the Fed signaling a coming pause. We don’t see rate cuts this year – that’s the old playbook when central banks would rush to rescue the economy as recession hit. Now they’re causing the recession to fight sticky inflation – and that makes rate cuts unlikely, in our view. Stocks have held up due to hopes for rates cuts that we don’t see coming. We think the Fed could only deliver the rate cuts priced in by markets if a more serious credit crunch took hold and caused an even deeper recession than we expect. We stay underweight developed market (DM) stocks because we don’t think they reflect the damage we see ahead.

Inflation is likely to prove even stickier than the Fed expects without a deep recession, in our view. The February US CPI data confirmed our view that inflation is still not on track to settle at the Fed’s target. Current market pricing of US and euro area inflation just above 2% on a 10-year horizon has edged lower recently – we think levels are likely to stay much higher than that. This is why we see value in inflation-linked bonds and prefer them to nominal peers. We also find very short-term government paper attractive for income given the potential for the market to price out rate cuts quickly. Strong money market demand provides additional support, in our view. We’re underweight long-term government bonds as we see yields rising with investors demanding more compensation for holding them, or term premium, given persistent and volatile inflation.

Our Bottom line

We overweight inflation-linked bonds and like very short-term government paper for income. We stay nimble in the new regime of greater macro and market volatility – and are ready for opportunities as rate-hike damage gets priced in.

Market backdrop

US and Europe stocks steadied, even as bank and financial shares remained under pressure. Some European bank default protection costs jumped on the week. The US two-year Treasury yield extended its historic drop and is down about 1.4 percentage points from a 16-year high hit earlier this month, causing a further steepening of the yield curve. The market is now pricing in about 1 percentage point of Fed rate cuts by the end of the year. We don’t think such cuts are coming.

We’re watching inflation on both sides of the Atlantic – including the Fed’s preferred PCE inflation gauge and flash inflation in the euro area. We expect services inflation to keep core inflation elevated. We’re watching US consumer confidence as well for more signs of damage from still-rising rates, sticky inflation and banking sector troubles.

Week ahead

The chart shows that Italian 10-year BTPs are the best performing asset year-to-date among a selected group of assets, while the 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 March 23, 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.

March 28

US consumer confidence

March 31

US PCE inflation and spending; euro area inflation and unemployment

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, March 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, March 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, March 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 France’s more favorable energy mix and the stock market’s tilt to energy could help insulate portfolios against elevated inflation. Yet high electricity prices should be a drag on corporate margins despite government energy policy relief. The pace of structural reforms looks set to slow after the 2022 parliamentary elections.
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 neutral. The index sports a defensive tilt, with high sector weights to health care and consumer goods providing a cushion amid heightened global macro uncertainty. Yet relative earnings revisions momentum looks less favorable, and a strong currency remains a drag on competitiveness versus global competitors.
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 Elevated French public debt and a slower pace of structural reforms remain negatives even as French spreads to German bonds are above historical averages.
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 Underweight -1 We are underweight. Gilts won’t be immune to the factors we see driving DM bond yields higher. 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, March 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.

Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Nicholas Fawcett
Macro research – BlackRock Investment Institute
Ann-Katrin Petersen
Senior Investment Strategist – BlackRock Investment Institute

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Bronnen: Bloomberg, tenzij anders aangegeven


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