Thriving in a new market regime
Investment themes
Living with inflation
We expect inflation to be persistent and settle above pre-Covid levels. We expect central banks to kick off rate hikes but remain more tolerant of price pressures, keeping real interest rates historically low and supportive of risk assets. Implication: We prefer equities over fixed income and remain overweight inflation- linked bonds.
Cutting through confusion
A unique mix of events – the restart, new virus strains, supply-driven inflation and new central bank frameworks – could cause markets and policymakers to misread inflation. We keep the big picture in mind but acknowledge risks – to the upside and downside - around our core view. Implication: We trim risk amid an unusually wide range of outcomes.
Navigating net zero
The journey for the world to achieve net-zero emissions by 2050 is happening now, and is part of the inflation story. We believe a smooth transition is the least inflationary outcome, yet even this still amounts to a supply shock playing out over decades. Implication: We favor developed market (DM) equities over emerging markets (EM).
Learn more about our 2022 Outlook:
A new market regime
We see 2022 heralding a new regime by delivering global stock gains and bond losses for a second year – what would be a first since data started in 1977. This unusual outcome is the next phase of our new nominal theme that is still playing out: Central banks and bond yields have been slower to respond to higher inflation in the powerful restart than in the past. That should keep real, or inflation-adjusted, bond yields historically low and support stocks.
The big change in 2022: Central banks will be withdrawing some monetary support as the restart does not need stimulus. We see more moderate equities returns as a result. We expect the Fed to kick off rate hikes but remain more tolerant of inflation. The Fed has achieved its inflation target, so its interpretation of its employment mandate will determine the timing and pace of higher rates. The European Central Bank, facing a weaker inflation outlook, is likely to stay easier on policy.
We had flagged inflation - now we’re Living with inflation.
A restart like none other
We’ve never had an economic restart like this. Add repeated, outsized data surprises to the mix – both to the upside and the downside – and confusion is natural among policymakers and markets adapting to a new reality.
At the same time, central banks are implementing new frameworks that change how they react to inflation. The risks arising from new Covid-19 strains only add to the confusion. We cut through numerous possibilities to ask: What would it take for us not to be in this new market regime?
What could go wrong?
We see two ways our new market regime view could be wrong. First, central banks might react differently. They could – in the face of persistent inflation pressures, perhaps tied to new Covid-19 strains, revert to their old response to inflation.
Central banks could also be forced to be more aggressive if inflation expectations become de-anchored. We would be faced with inflation significantly above target, rising interest rates and falling growth: a classic stagflation scenario that is bad for both bonds and equities. Second, we could be wrong about growth prospects.
The chart shows how different our and the market’s view of future Fed rate hikes is from how the Fed might have reacted historically to the current mix of slack and inflation. In the past, we believe the Fed would have been pushing up rates in 2021 - again helping confirm this is a new regime.
It’s different this time
U.S. CPI inflation, federal funds rate and estimates, 1990-2025
Forward-looking estimates may not come to pass. Source: BlackRock Investment Institute, Federal Reserve Board, U.S. Bureau of Labor Statistics, Bloomberg, with data from Haver Analytics, December 2021. Notes: The chart shows the U.S. nominal federal funds rate (orange line), year on year headline CPI inflation (yellow) and some projected paths of the nominal federal funds rate. The U.S. CPI shown from 2022 - 2025 are our estimate embedded in our Capital Market Assumptions. The dotted red line shows our own projection of the federal funds rate. The purple line shows the path that would have been implied by a simple monetary policy rule linking the choice of policy rate to the rate of inflation and the level of the output gap. The pink line shows the current market-implied path.
Staying invested
How to thrive in this new market regime? We prefer equities in the inflationary backdrop of the strong restart. We favor DM stocks over as we dial down risk slightly amid rising risks to our base case.
We are underweight DM government bonds – we see yields gradually heading higher but staying historically low. We prefer inflation- linked bonds, partly as portfolio diversifiers. On a strategic horizon, we like private markets for their diversification and return potential.
Staying pro-risk
The broadening economic restart, coupled with global central banks’ resolve to maintain easy financial conditions, keeps us pro-risk. We favor equities over credit and government bonds on both a strategic and tactical investment horizon.
Directional views
Strategic (long-term) and tactical (6-12 month) views on broad asset classes, December 2021
| Asset | Strategic view | Tactical view | Commentary |
|---|---|---|---|
| Equities |  |
|
We keep our overweight equities on a strategic horizon. We see a better outlook for earnings amid moderate valuations. Incorporating climate change in our expected returns brightens the appeal of developed market equities given the large weights of sectors such as tech and healthcare in benchmark indices. Tactically, we stay overweight equities as we expect the restart to re-accelerate and interest rates to stay low. We tilt toward cyclicality and maintain a quality bias. |
| Credit |  |
 |
We stay underweight credit on a strategic basis as valuations are rich and we prefer to take risk in equities. On a tactical horizon, we are neutral credit following the tightening in spreads in investment grade and high yield. |
| Government bonds | |
|
We are strategically underweight nominal government bonds given their diminished ability to act as portfolio ballasts with yields near lower bounds. Rising debt levels may eventually pose risks to the low rate regime. This is part of why we underweight government debt strategically. We prefer inflation-linked bonds – particularly in the U.S. relative to the euro area on valuations. We add to our underweight on U.S. Treasuries on expectations of gradually rising yields. |
| Cash | - | |
We are moderately pro-risk and keep some cash to potentially further add to risk assets on any market turbulence. |
| Private markets | |
- | We believe non-traditional return streams, including private credit, have the potential to add value and diversification. Our neutral view is based on a starting allocation that is much larger than what most qualified investors hold. Many institutional investors remain underinvested in private markets as they overestimate liquidity risks, in our view. Private markets are a complex asset class and not suitable for all investors. |
Note: Views are from a U.S. dollar perspective, December 2021. 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, December 2021
| Asset | Tactical view | Commentary | ||
|---|---|---|---|---|
| Equities | ||||
| United States |  |
We are neutral U.S. equities. We see U.S. growth momentum peaking and expect other regions to be attractive ways to play the next leg of the restart as it broadens to other regions, notably Europe and Japan. | ||
| U.S. small caps |  |
We stay overweight U.S. small-caps. We see potential in this segment of the U.S. equity market to benefit from the cyclical rebound in domestic activity brought about an accelerated vaccination rollout. | ||
| Europe | |
We are overweight European equities on the back of the broadening restart. We see a sizeable pickup in activity helped by accelerating vaccinations. Valuations remain attractive relative to history and investor inflows into the region are only just starting to pick up. | ||
| U.K. | |
We are neutral UK equities following their strong performance. We see the market as fairly valued and prefer European equities. | ||
| Japan | |
We are neutral Japanese equities. We see a global cyclical rebound helping boost earnings growth in the second-half of the year. The country’s virus dynamics are also improving. | ||
| China |  |
We turn moderately positive on Chinese equities as we see a gradual dovish shift in monetary and fiscal policy in response to the cyclical slowdown and anticipate that the regulatory clampdown will become less intense. | ||
| Emerging markets | |
We are neutral EM equities. We see more uncertainty on the U.S. dollar outlook due to a risk premium from Fed communication. Many EMs have started tightening policy, showing less policy support and a greater risk of scarring. | ||
| Asia ex-Japan | |
We are neutral Asia ex-Japan equities. Potential knock-on effects from slower growth in China and broader geopolitical risks dampen the outlook, in our view. | ||
| Fixed income | ||||
| U.S. Treasuries |  |
We are underweight U.S. Treasuries, primarily on valuations. We see the balance of risks is for gradually higher yields as markets continue to price in the economic restart, especially given the pullback in yields in recent months. | ||
| Treasury Inflation-Protected Securities | |
We are overweight U.S. TIPS. We believe the recent pullback in the asset class presents an attractive opportunity, particularly on a relative basis against European inflation breakevens as the outlook for euro area inflation remains sluggish. | ||
| German Bunds | |
We are neutral on bunds. Although the ECB may begin tapering this year given inflation dynamics, we see little room for a substantive change in policy in the near term. | ||
| Euro area peripherals | |
We are neutral euro area peripheral bonds despite recent outperformance given stability in ECB policy, low volatility in peripherals and better value elsewhere. | ||
| China government bonds | |
We initiate a view on Chinese government bonds with an overweight. We see the relatively stability of interest rates and the carry on offer as brightening their appeal. | ||
| Global investment grade |  |
We remain underweight investment grade credit. We see little room for further yield spread compression and favor more cyclical exposures such as high yield and Asia fixed income. | ||
| Global high yield | |
We are neutral high yield credit after the asset class’ strong performance. Spreads are now below where we see high yield as attractively valued. We prefer to take risk in equities. | ||
| Emerging market - hard currency | |
We are neutral hard-currency EM debt. We expect it to gain support from the vaccine-led global restart and more predictable U.S. trade policies. | ||
| Emerging market - local currency | |
We upgrade local-currency EM debt to overweight. We believe the asset class offers attractive valuations and carry in a world starved for income. | ||
| Asia fixed income | |
We are overweight Asia fixed income. Outside of China, we like Asia sovereigns and credit for their yield and income given the region’s fundamental outlook. | ||
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Source: BlackRock Investment Institute Notes: Views are from a U.S. dollar perspective as of December 2021. 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.
Our base case: New nominal
We expect mildly higher inflation with a muted central bank response, keeping real rates historically low. Stocks can thrive, but bonds still suffer as the yield curve modestly steepens.
A wide range of potential outcomes
2022 is the next phase of the new nominal story. Even if new Covid strains delay the restart, central banks are poised to nudge up policy rates because the restart does not require monetary support. Yet we don’t see them responding aggressively to persistent inflation. Though a wide range of potential outcomes exist. See the chart.
BlackRock Investment Institute, December 2021. Notes: The schematic shows hypothetical macro and policy outcomes. These are our views on the implications for equities and government bonds as of December 2021. For illustrative purposes only. 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 funds, strategy or security in particular.
A rare combination
It’s rare for global stock returns to be positive and bonds negative in one calendar year – and this hasn’t happened since data started in 1977. See the chart. This signals we are entering a new market regime – and why it’s important to cut through the confusion sparked by the powerful economic restart in 2021.
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute with data from Refinitiv Datastream and Bloomberg, December 2021. Notes: The chart shows annual returns for global equities and bonds in U.S. dollar terms from 1977-2021. Index proxies are the MSCI All-Country World index for equities (MSCI World before 1988) and Bloomberg Global Aggregate index for bonds (U.S. Aggregate before 1991).
Other regimes explained
Safety premium questioned
The perceived safety of government bonds is questioned amid rising debt levels. Investors demand a larger compensation for the risk of holding long-term bonds. The yield curve steepens sharply. Yet this is a relative asset shift: equities can still do well.
Productivity boom
Sustained capital investment boosts potential growth, keeping the macro environment disinflationary. The Fed is patient and keeps policy loose, with rates below neutral. The yield curve steepens, real yields stay low, and risk assets do well.
Slamming the brakes
Delays to the restart, perhaps due to a new vaccine-resistant virus strain, result in weaker growth but persistently higher inflation. Central banks aggressively push against inflation, initially sparking a surge in yields. Result: recession with high inflation. The yield move hits stocks hard.
Runaway inflation
Inflation expectations become unanchored in the post-Covid confusion. A messy transition to net zero could exacerbate this. 1970s-style stagflation is back. Yields surge across the curve and risk assets sell off.
Stagnation
Growth slumps. Inflation pressures abate because labor market slack holds back wage growth. Central banks are unsuccessful in reviving growth and inflation. The yield curve flattens, and equities take a hit as earnings slump.
Classic risk-off
Asset bubbles form and burst. Trade wars flare up again and hurt global activity. Central banks struggle to respond. Long- term yields fall sharply from a flight to perceived safety and the term premium turns negative again. Risk assets suffer.
