Market insights

Weekly market commentary

We keep risk low amid volatile macro

Market take

Weekly video_20221003

Wei Li

Opening frame: What’s driving markets? Market take

Camera frame

Central to our asset allocation is the end of the Great Moderation – characterized by much tougher trade-offs facing central banks.

Title slide: Keeping risk low amid new volatile regime

In this environment, fighting inflation carries real damages to growth and also through financial disruptions. And this trade-off is not really avoidable, which is why a soft landing is unrealistic.

1: UK at epicenter of growth-inflation trade-off

The UK is one case in point, whereby the fiscal authorities tried to boost growth through unfunded tax cuts and additional spending.

But because the Bank of England recognizes that it needs to bring about a recession in order to bring down inflation, we’re not really expecting more growth but we are expecting more rate hikes.

2: Central banks to overtighten policy

In the near term we believe this increases the resolve of other central banks to overtighten [policy] in order to stay on top of the inflation narrative. But that carries real damages and as that damage becomes clear in 2023, we do believe central banks will pause [rate hikes] and not go all the way.  And at that point we will have to live with higher inflation as well.

Outro frame: Here’s our Market take 

Tactically, given the very tough rate and growth environment, we’re comfortable with our dialed-down risk taking. But strategically, as we believe central banks will not go all the way [on rate hikes] and they will pause in 2023, there is a case to be strategically a bit more positive on risk.  

Closing frame: Read details: 

www.blackrock.com/weekly-commentary

Dialed-down risk

The new regime poses an unavoidable trade-off for central banks: tame inflation by hiking or preserve growth. We see them overtightening rates so keep risk low.

Market backdrop

UK gilt yields reached 14-year highs before the Bank of England intervened to halt the selloff. Yields on 10-year U.S. treasuries topped 4%, a first since 2010.

Week ahead

The U.S. jobs report will be a key gauge of whether labor force participation is increasing. ISM manufacturing data should give perspective on recession risks.

We’ve said a period of steady growth and inflation known as the Great Moderation is over – and made this central to our investment views. Central banks face a brutal trade-off in this new regime: either live with inflation or the economic damage needed to tame it quickly. There’s no way around this, or no “soft landing,” in our view. Case in point: the UK’s fiscal splurge. It didn’t push up growth expectations; it only resulted in higher rates. We stick with dialed-down risk.

Paragraph-2,Paragraph-3,Image-1
Key Points-1,Paragraph-4,Advance Static Table-1,Advance Static Table-2,Paragraph-5,Advance Static Table-3,Paragraph-6,Advance Static Table-4

Investment themes

01

Bracing for volatility

We have entered a regime of higher macro and market volatility. This implies that market views may have to change more quickly and get more granular.

02

Living with inflation

We see the Fed ultimately living with higher inflation as it sees the effect of its rate hikes on growth and jobs. For now, the Fed seems to be responding solely to the politics of inflation. This has caused us to reduce portfolio risk.

03

Positioning for net zero

Investing in high-carbon-emitting companies with credible transition plans or that are key to the transition can give investors exposure to the transition as well as mitigate the impact of its bumps.


UK rates surge as policy forces clash

Market pricing of future policy rates, 2022

The chart shows that the market's expectations for the Bank of England's rate hikes have jumped above rate path expectations for the Federal Reserve and European Central Bank.

Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, October 2022. Notes: the chart shows the pricing of expected central bank policy rates via forward overnight index swaps. The rate is the one-year OIS rate expected starting one year from now.

The trade-off central banks face in a regime of heightened macro volatility and a world shaped by production constraints came into sharper focus last week. Fiscal authorities in the UK tried to boost growth with unfunded tax cuts and spending increases. Markets shook. Rate expectations for the Bank of England surged above other major central banks (see pink line in chart). Growth expectations did not – the pound plummeted to all-time lows and stocks fell. This all shows how we are in a new regime, where authorities can’t spend to avoid recession. We think getting inflation down quickly would take aggressive rate hikes and recession. Central banks are trying to do whatever it takes to tame inflation, but they haven’t acknowledged what it will take, in our view. We expect them to break growth as a result, but then stop in 2023 once the economic damage is clear.

The macro picture has worsened as a result. We expect recessions in major developed markets (DM). That could be next year in the U.S. but sooner and deeper in the euro area given the energy crunch. Central banks prioritizing the pressure to bring inflation down quickly over the economic implications implies deeper recessions overall, in our view.

Our short-term views

This is why we stick with reduced risk taking in our tactical investment views. We’re looking for the least bad options. We’re underweight DM equities. Stocks have yet to fully price in recession fears and higher rates, in our view. We think earnings expectations also seem optimistic. An energy crisis further dampens our view of European stocks. Japan is different – still easy monetary policy keeps us neutral. Valuation remains an important signpost for us to consider getting more positive on stocks. Relatively attractive valuations are also why we prefer credit over stocks. Higher yields and strong balance sheets suggest to us investment grade credit is better placed than equities to weather recessions.

We’re underweight DM bonds because we think inflation will persist above central bank targets after hiking stops. That said, we see some value in the shorter maturities because of the safety they provide as the closest cash-like investment. Persistent inflation also underpins our overweight on inflation-linked bonds. We’re overweight emerging market (EM) debt. Central banks are well ahead of others in their cycles. EM currencies have also held up fairly well in the risk-off environment. But we remain wary of the currency outlook as some central banks in EM have paused their tightening as growth deteriorates.

Looking at the long term

Strategic positioning is shaped by our view that central banks will stop hiking next year and not go as far as necessary to get inflation back to target quickly. Recent events reinforce our conviction they will halt rate hikes and live with inflation once confronted with economic damage – either in the form of recession or cracks in financial stability, or both. This will be more favorable to equity than bonds – so we’re overweight DM stocks. We prefer public to private equity. Inflation will persist, so we prefer inflation-linked bonds to nominal bonds. We’re overweight public credit on attractive valuations and income potential.

Our bottom line

We stick with reduced risk taking, tactically. Heightened macro volatility in a new regime creates stark trade-offs for central banks at risk of overtightening into recessions. Tactically, that means we prefer credit over stocks. Equities remain relatively attractive alongside credit longer term. Persistent inflation keeps us negative on nominal bonds and positive on inflation-linked bonds now and even more so further out into our strategic investment horizon.

Market backdrop

UK gilt yields eased from 14-year highs and the pound clawed back from all-time lows after the surprise government fiscal splurge forced the Bank of England to temporarily buy long-term bonds to stabilize yields. The events illustrate the sharp trade-off policymakers face on higher inflation – and the potential financial dislocations from higher rates. We see risks of central banks overtightening into recessions. U.S. 10-year Treasury yields briefly topped 4% and equities hit fresh lows.

The key release this week is the U.S. jobs report. A rapid pace of job gains has not disguised the fact that the overall level of labor supply remains low compared to pre-Covid – a key production constraint that's driving inflation higher, in our view. Survey data have softened over the past year. ISM manufacturing data should give more perspective on recession risk.

Week ahead

The chart shows that the U.S. dollar index is the best performing asset year to date among a selected group of assets, while EM equities are 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 Sept. 29, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point this year-to-date, 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.

Oct. 3

U.S. ISM manufacturing PMI

Oct. 6

India services PMI

Oct. 7

U.S. payrolls report

Oct. 8

China Caixin services PMI

Read our past weekly market commentaries here.

 

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, October 2022

Asset Strategic view Tactical view Commentary
Equities Equities: strategic Overweight +1 Equities: tactical Underweight -1 We are overweight equities in our strategic views. A higher risk premium and worsening macro backdrop lowers our expected equity returns. But we expect central banks to ultimately live with some inflation and look through the near-term risks. Tactically, we’re underweight DM stocks as central banks look set to overtighten policy – we see activity stalling. Rising input costs also pose a risk to elevated corporate profit margins.
Credit Credit: strategic Overweight +1 Credit: strategic Overweight +1 Strategically, we are overweight publicly traded credit – from high yield to global investment grade. Higher spreads and government bond yields push up expected returns, and we think default risk is contained. Additionally, income potential is attractive. Tactically, we’re overweight investment grade but neutral high yield. We prefer to be up in quality. We overweight local-currency EM debt on attractive valuations. A large risk premium compensates investors for inflation risk, in our view.
Government bonds Government bonds: strategic Underweight -1 Government bonds: tactical Underweight -1 A modest underweight in our strategic view on government bonds reflects a big spread: max underweight nominal, max overweight inflation-linked and an underweight on Chinese bonds. We see nominal yields in five year’s time higher than current levels. That repricing is a valuation drag on expected returns. We also think markets are underappreciating the persistence of high inflation. Tactically, we are also underweight as we see long-term yields going higher – even as yields have surged in 2022.
Private markets Private markets: strategic Underweight -1 - 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 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, October 2022

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, October 2022. 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, October 2022

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 euro perspective, October 2022. 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.

Jean Boivin
Head – BlackRock Investment Institute
Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Vivek Paul
Head of Portfolio Research – BlackRock Investment Institute