Financial cracks show: What to do now
Market take
Weekly video_20230320
Jean Boivin
Opening frame: What’s driving markets? Market take
Camera frame
What a week! Bank troubles on both sides of the Atlantic were roiling markets. This is the latest fallout from the most rapid rate hikes since the early 1980s.
1: Markets scrutinizing banks via a high-rates lens
We have argued that bringing inflation down would be costly, creating economic damage and cracks in the financial system.
Cross-Atlantic banking troubles are very different – but what they have in common is that markets now scrutinize them through the lens of high interest rates.
2: This is not 2008, but…
We don’t see this as a 2008 redux. But this is about a recession foretold. Why?
Not because of growth weaknesses we could see, but because rapid rate hikes were the only way central banks could bring inflation down and that has to cause damage.
Financial cracks are likely to tighten credit, dent confidence – and eventually hurt growth.
3: A recession without rescue
We believe, this time, central banks won’t come to the recession rescue by aggressively cut rates. They’ll instead try to use other tools to safeguard financial stability.
Case in point: The ECB hiked 50 basis points last week. And we see the Fed raising rates this week.
The biggest disconnect we see right now is that markets are expecting the Fed to cut 3 or 4 times this year. We think persistent inflation won’t allow them to do this.
Outro frame: Here’s our Market take
Overall, this is the macro regime we said would play out.
We’re keeping an underweight to equities because they don’t yet reflect the damage to come. We go even shorter horizon – 1 year and below – on government debt for income. And we allocate to emerging markets given the positive economic restart in Asia.
Closing frame: Read details:
www.blackrock.com/weekly-commentary
More financial cracks from rapid rate hikes are emerging. We stay underweight equities, downgrade credit and prefer short-term government bonds for income
Bank troubles on both sides of the Atlantic hit the sector’s shares last week. Short-term bond yields plunged on hopes for sharp central bank rate cuts.
We don’t see central banks coming to the rescue with rate cuts but using other tools to ensure financial stability. The Federal Reserve is set to hike this week.
The US and European bank tumult is the latest sign rapid rate hikes are causing financial cracks, reinforcing our recession view. We expect central banks to keep hiking to fight higher inflation – not come to the rescue. We stay risk-off: underweight developed market (DM) stocks and trim credit to neutral. But we are ready to seize opportunities as macro damage gets priced in. We overweight very short-term government paper for income and prefer emerging markets.
Rethinking rates
Market pricing of fed funds rate, March 2023
Source: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2023. Notes: The chart shows the forward fed funds rate through December 2024 as implied by SOFR futures prices as of March 8 and March 17.
Banking troubles on both sides of the Atlantic were roiling markets last week. That’s the latest fallout from the most rapid rate hikes since the early 1980s. We have argued that bringing inflation down would be costly, creating economic damage and cracks in the financial system. This week’s events will crimp bank lending, reinforcing our recession view. As the cracks emerged, market expectations for peak rates plummeted, as the pink line in the chart shows. The reason: hopes that central banks will come to the rescue and cut rates, as they did in the past. That’s the old playbook – and it no longer works. Central banks are set to keep fighting stubbornly higher inflation, and use other tools to safeguard financial stability. Case in point: The European Central Bank raised rates by 0.5% last week. And we see the Fed raising rates this week. Our conclusion: Investors need a new investment playbook and to stay nimble in this new market regime.
The banking stresses that are roiling markets are very different – but what they have in common is that markets are now scrutinizing bank vulnerabilities through a lens of high interest rates. We don’t see a repeat of the 2008 global financial crisis. Some of the troubles that emerged recently were longstanding and well-known, and banking regulations are much stricter now. Instead, this is about a recession foretold. Why? The only way central banks could bring inflation down was to hike rates high enough to cause economic damage. The latest financial cracks are likely to tighten credit, dent confidence – and eventually hurt growth. What does this mean for investing? We see three clear takeaways:
Three takeaways
First, we stay underweight equities and downgrade credit to neutral. We believe risk assets are not pricing the coming recession. This is why we stay underweight DM equities on a tactical horizon of six- to 12-months. We expect reduced bank lending in the wake of the sector’s troubles. The recession is likely to see more credit tightening now. We downgrade our overall credit view to neutral as a result, trimming investment grade (IG) credit to neutral and high yield to underweight. We have a relative preference for European IG because of more attractive valuations versus U.S. peers.
Second, we overweight short-term government bonds. We think this recession will be different. Central banks will not try to resuscitate growth by cutting rates. The reason: persistent inflation. We think major central banks will distinguish their inflation fights from any actions taken to shore up the banking system. The ECB did so last week by hiking rates as it originally telegraphed – even as markets had started to doubt its resolve. We expect the Fed to take a similar approach when it hikes rates this week. The U.S. CPI last week confirmed core inflation is not on track to fall to the Fed’s target. That’s why we could see a reversal of the recent sharp drop in two-year and other short-term government bond yields. As a result, we now prefer even shorter maturities for income in this asset class. We stay underweight long-term government bonds and upgrade inflation-linked bonds given our view inflation is likely to stay well above current market pricing.
Third, we prefer emerging market (EM) assets. Markets have focused on the mayhem in the developed world. Under the radar has been confirmation that the economic restart in Asia from Covid restrictions is powerful. In addition, China’s monetary policy is supportive as the country has low inflation compared with DM. This should benefit EM assets, in our view. As a result, we keep our relative preference for EM stocks. We also go overweight on EM local-currency debt as EM central banks near the end of their hiking cycles and possibly cut rates.
Market backdrop
Short-term government bond yields plunged as the emergence of financial cracks spurred the market’s hopes for sharp rate cuts. Bank shares led losses in Europe and were a drag in the U.S. after the troubles at U.S. medium-sized banks and concerns over a large Swiss financial institution. We think central banks will keep hiking as they both seek to bolster banking systems but distinguish those efforts from the need to keep fighting inflation.
We expect the Fed to press ahead with another rate hike, as the ECB did last week. The Fed’s updated forecasts may prompt markets to price back in rate hikes after the February CPI data showed sticky core inflation. But the Bank of England could pause hikes next week. Global PMIs will help gauge how much rate hikes are denting economic activity.
Week ahead
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 17, 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.
US existing home sales
Fed policy decision; UK CPI
US jobless claims; Bank of England policy decision
Global flash PMIs; Japan CPI
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 assessment of market risk sentiment. Investment implication: We’re tactically underweight DM equities. Markets are not pricing the recession we expect.
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 prefer very short-term government paper over 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.
Read our past weekly commentaries here.
Directional views
Strategic (long-term) and tactical (6-12 month) views on broad asset classes, March 2023.
| Asset | Strategic view | 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. The Fed is set to raise rates into restrictive territory. Earnings downgrades are starting but don’t yet reflect the coming recession. | ||
| Europe | |
We are underweight. The energy price shock and policy tightening raise stagflation risks. | ||
| 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 breakeven inflation rates underpricing the persistent inflation we expect. | ||
| European government bonds | |
We are underweight the long end. We expect term premium to raise long-term yields and high inflation to persist. Rate hikes are a risk to peripheral spreads. | ||
| UK Gilts | |
We are underweight. Investors could demand more compensation for long-term bonds amid high inflation and fiscal challenges. We like short-dated gilts. | ||
| 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. We prefer income in EM debt with central banks closer to turning to cuts than developed markets – even with potential currency risks. | ||
| 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. Investors could demand more compensation for long-term bonds amid high inflation and fiscal challenges. We like short-dated gilts. | ||
| 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.
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