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Markets now accept rate cuts unlikely

­Market take

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 realizing 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 U.S. inflation in April.

Week ahead

U.S. 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 U.S. 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

U.S. 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 U.S., 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.

Inflation and wage growth remain sticky, even with this deteriorating growth picture. Why? U.S. 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.

What's ahead for central banks

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 U.S. 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 U.S. 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 U.S. 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 U.S. stocks slightly higher – even as the U.S. potentially facing a technical default dominated market attention. Meanwhile, long-term Treasury yields climbed after data showed that April U.S. PCE inflation remained hot. A credit rating agency warning it could downgrade the top notch Treasuries rating if the U.S. 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 U.S. 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 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.

May 31

China manufacturing PMI

June 1

Euro area inflation; U.S. manufacturing PMI

June 2

U.S. payrolls

Investment themes


Pricing the damage

Financial cracks and economic damage are emerging from the fastest rate hiking cycle since the 1980s. What matters: how much damage is in the price and our assessment of market risk sentiment.


Rethinking bonds

We see higher yields, especially in short-term government paper, as a gift to investors after years of being starved of income.


Living with inflation

The Federal Reserve is likely to stop its rapid rate hikes without inflation being back on track to return fully to 2% targets, so we think we are going to be living with inflation.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, May 2023

Asset Strategic view Tactical view Commentary
Equities Equities: strategic Overweight +1 Equities: tactical Underweight -1 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 U.S. dollar.
Credit Credit: strategic Neutral +1 Credit: tactical Neutral +1 Strategically, we are neutral global investment grade. We don’t think yields compensate investors for tightening credit conditions. 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 Government bonds: strategic Underweight -Neutral Government bonds: tactical Underweight -1 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 stay underweight nominal long-term bonds: Markets are underappreciating the persistence of high inflation and investors likely demanding a higher term premium, in our view. Tactically, we’re 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 Private markets: strategic neutral -1 - We’re underweight private growth assets and overweight on private credit from a starting allocation that is much larger than what most qualified investors hold. We find private credit yields more attractive than in public credit, and we like its floating-rate nature given our view that policy rates will remain higher for longer than markets expect. We think private credit can help fill a lending gap left by banks after sector turmoil. Overall, 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.

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 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.

Meet the Authors
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