Global Weekly Commentary | Insights

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:

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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.

Market commentary Asset class views

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The trade-off

Federal Reserve projections for Q4 2023 GDP growth and inflation

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.

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’ rate hikes cause financial cracks and economic damage. Corporate earnings expectations have yet to fully reflect even a modest recession. We are overweight EM stocks and have a relative preference due to China’s restart, peaking EM rate cycles and a broadly weaker US dollar.
Credit		Strategically, we are overweight global investment grade but have reduced it given the tightening of spreads in recent months. We are neutral high yield as we see the asset class as more vulnerable to recession risks. Tactically, we’re neutral investment grade due to tightening credit and financial conditions. We’re underweight high yield as we see a recession coming and prefer to be up in quality. We’re overweight local-currency EM debt – we see it as more resilient with monetary policy tightening further along than in DMs
Government bonds		We are neutral in our strategic view on government bonds. This reflects an overweight to short-term government bonds and max overweight to inflation-linked bonds. We remain underweight nominal long-term bonds: We think markets are underappreciating the persistence of high inflation and investors likely demanding a higher term premium. Tactically, we are underweight long-dated DM government bonds for the same reason. We favor short-dated government bonds – higher yields now offer attractive income with limited risk from interest rate swings.
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 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.

Asset	Tactical view	Commentary
Equities
Developed markets		We are underweight. Earnings expectations and valuations don’t fully reflect recession risk. We prefer a sectoral approach: energy and healthcare.
United States		We are underweight. Financial cracks are emerging from Fed rate hikes. We don’t think earnings expectations reflect the recession we see ahead.
Europe		We are underweight. The impact of higher interest rates and elevated inflation pose a challenge for earnings, even as the energy shock fades.
U.K.		We are underweight. We find valuations expensive after their strong relative performance versus other developed markets thanks to energy sector exposure.
Japan		We are underweight. The Bank of Japan looks set to wind down its ultra-loose policy. Japan is exposed to the weaker activity we see in other DM economies.
Emerging markets		We are overweight and have a relative preference over DM stocks due to China’s powerful restart, peaking EM rate cycles and a broadly weaker US dollar.
China		We see short-term opportunities from China’s restart. But geopolitical risks have risen, and we still see long-term, structural challenges and risks.
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 US Treasuries		We are underweight. We see long-term yields moving up further as investors demand a greater term premium.
Short US Treasuries		We are overweight. We prefer very short-term government paper for income given the potential for a sharp jump in Fed rate expectations.
Global inflation-linked bonds		We are overweight. We see market pricing underestimating the risk of persistently higher inflation.
European government bonds		We are underweight. We see investors demanding greater term premium, with peripheral bonds at risk from tighter financial conditions.
UK Gilts		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.
China government bonds		We are neutral. We find their yield levels less attractive than those on DM short-term government bonds.
Global investment grade credit		We are neutral. We see tighter credit and financial conditions. We prefer European investment grade over the US given more attractive valuations.
US agency MBS		We’re neutral. We see agency MBS as a high-quality exposure within diversified bond allocations. But spreads near long-term averages look less compelling.
Global high yield		We are underweight. We think spreads are still too tight, given our expectation for tighter credit and financial conditions – and an eventual recession.
Emerging market - hard currency		We are neutral. We see support from higher commodities prices yet it is vulnerable to rising US yields.
Emerging market - local currency		We are overweight due to China’s restart, and we see EM debt as more resilient to tightening financial conditions than DM as EM hiking cycles near peaks.
Asia fixed income		We are neutral. We don’t find valuations compelling enough yet to turn more positive.

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.

Asset	Tactical view	Commentary
Equities
Europe ex UK		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		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’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		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		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		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		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		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		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		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		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		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		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		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		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		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		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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Weekly market commentary

Recession – but no central bank rescue

The trade-off

No rate cuts this year

Our Bottom line

Market backdrop

Week ahead

Investment themes

Directional views

Tactical granular views

Euro-denominated tactical granular views