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Keeping our equity overweight

Opening frame: What’s driving markets? Market take

Title slide: 2022 equity drawdown

This month’s equity drawdown highlights the confusion over the outlook for policy, growth and inflation. What started out as a jittery sector rotation is showing signs of broadening out.

The question top of mind now is whether this is an opportunity to lean more aggressively into equities.

Our answer is not yet.

And we see three reasons…

1: Policy confusion likely to persist

First, we think policy confusion is likely to persist due to the unusual supply-driven nature of inflation.

In a world shaped by supply, central banks’ traditional tool to fight inflation – interest rates – is less effective, and there’s a greater chance of a policy mistake which will hurt growth, in our view

2: Geopolitical risks could weigh on sentiment

Second, geopolitical risks – that markets had been less attuned to – could weigh on sentiment as the situation unfolds in the Ukraine.

3: Uncertainty around corporate earnings

Third, market reaction to corporate results this earnings season reflects earnings uncertainty. So, we believe we are likely past the peak of earnings growth momentum and now investors’ focus is on how companies will cope with higher input costs.

Video outro branding: Here’s our Market take

So, we hold to our view that the unusual market regime will deliver a second year of positive equity returns and negative bond returns.

And we maintain our modest overweight to equities, but lingering confusion keeps us from going more overweight.

Buying the dip?

We stick with our modest equities
overweight but are not buying the recent
dip yet. The main reason: confusion over
the supply-driven macro environment.

Market backdrop

Stocks fell further as the Fed flagged a
likely rate hike in March and suggested it
could front-load rate hikes even more than
previously indicated.

Week ahead

U.S. jobs data this week will show Omicron’s
impact on the restart – but is unlikely to
dissuade the Fed from kicking off rate hikes
in March.

Coming into 2022, we dialed down overall risk to have a modest overweight to equities on concerns about confusion over the macro environment. We don’t see a need to reduce risk further: the confusion has materialized. The roughly 10% drop in U.S. equities – against our unchanged view of fundamentals – makes them more attractive on the surface. Yet accounting for higher expected interest rates, we don’t think equities have dropped enough for a valuation-driven upgrade.

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JAN 31 market commentary Asset class views

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Putting the equity selloff in context

Global equities rolling one-year price drawdown, 2010-2022

This chart shows that the recent equity pull-back is modest compared with some of the drops seen over the past decade.

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, Jan. 28, 2022. Notes: The chart shows the price fall from the maximum level of the MSCI All-Country World Index over the previous one-year period.

Context is crucial. The equity retreat is far from magnitudes that warrant a wholescale reassessment of our views. The chart above shows the major drawdowns – calculated as the peak-to-trough moves over a rolling one-year period – for the MSCI All-Country World index. The takeaway: This pull-back is modest compared with some of the drops seen over the past decade. It also comes after a particularly strong run for risk assets. We believe the drawdown is consistent with our expectation for confusion and heightened volatility. The market has front-loaded pricing of Fed rate hikes over the next two years. Yet importantly, the sum total of Fed rate hikes hasn’t changed – only the timing. That’s why we think the move in equities cannot be explained by this repricing alone. The U.S. equity risk premium – our preferred valuation gauge as it takes into account both earnings expectations and the interest rate environment – has moved up. It reflects confusion about whether the Fed will go further than priced and deliberately destroy demand to get inflation down, as well as worries on the geopolitical front.

A new market regime

We hold to our view that the unusual market regime we outlined in our 2022 Global Outlook will deliver a second successive year of equity gains and bond losses. The underlying drivers are unchanged. Yet we are also seeing the confusion we had flagged in action, the risk that central banks and markets might misinterpret the unusual restart and supply-driven inflation. The confusion is playing out via a swift market repricing of Fed policy expectations and surging short-term yields.

What might prompt us to change our modest overweight to equities? For an upgrade, we would need to see a deeper retreat or the Fed acknowledging that it will live with some inflation to keep the restart going in a trade-off of its objectives. For a downgrade, we would look to see if the Fed prioritizes fighting inflation over activity – with or without acknowledging a trade-off between its objectives. We got a hint of a tougher inflation stance last week but would need to see more evidence of a more forceful shift in tactics on inflation.

We see uncertainty lingering for a few reasons. First, we think policy confusion can persist. The Fed is rightly intent on normalizing policy quickly. The restart does not need stimulus, so the Fed should take its foot off the accelerator. Our worry: The Fed likens the current normalization to a previous episode in 2015. We think such logic could lead the Fed to overtighten policy. This is a restart, not a typical recovery. The restart will quickly slow down on its own. Inflation is driven by supply constraints following a huge shift in demand during the pandemic, not an overheating economy – so the traditional policy playbook does not apply. We think the Fed will eventually back off but are prepared for a bumpy ride in markets. Second, geopolitical risks – while typically not long-lasting market events – could weigh on investor sentiment, including the stand-off over Ukraine and the Iran nuclear deal. Third, equity valuations by our measure are only modestly cheaper and reflect some of the confusion we describe. With market attention on the Fed repricing, companies beating estimates have not yet been rewarded this earnings season. Yet we think fundamentals will prevail, and that’s one reason why we are not downgrading our modest equities overweight.

Our bottom line

We maintain our modest equities overweight, with a preference for developed markets and China. We prefer balanced exposures to beneficiaries of long-term trends such as tech and healthcare on the one hand and cyclicals on the other. We need to see a deeper equity selloff and more clarity on near-term uncertainties to add to our equities overweight.

Market backdrop

Fed Chair Jerome Powell flagged a likely rate hike in March and suggested the Fed could front-load rate hikes even more than previously indicated. Stocks extended their volatile run into the last week of the month, with U.S. tech leading losses. U.S. Treasury yields are also sharply higher across the board this month. The short-end has surged because of a sharp pulling forward of policy rate hikes, while we see the 10-year yield driven more by a resurgence of the term premium.

Market attention this week will be on the flash estimates of GDP for the U.S., euro area and Germany. We will be looking out to assess the impact from supply disruptions on the growth outlook.

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 January 28, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point over the last 12-months and the dots represent current 12-month 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, MSCI Europe Index, MSCI USA Index, ICE U.S. Dollar Index (DXY), Bank of America Merrill Lynch Global High Yield Index, spot gold, J.P. Morgan EMBI Index, Refinitiv Datastream Germany 10-year benchmark government bond index, Refinitiv Datastream Italy 10-year benchmark government bond index, Refinitiv Datastream U.S. 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI Emerging Markets Index.

Feb. 1

Euro area unemployment rate

Feb. 2

Euro area flash inflation

Feb. 3

ECB, BoE monetary policy meetings

Feb. 4

U.S. employment report

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.

Cutting Through confusion

A unique mix of events - the restart of economic activity, virus strains, supply driven inflation and new central bank frameworks - could cause markets and policymakers to misread the current surge in inflation.

Navigating net zero

Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story, it's a now story.

Read our past weekly commentaries here.

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 U.S. 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 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, 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. Earnings expectations don’t fully reflect the economic damage we see ahead.
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 U.S. 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 U.S. Treasuries		We are underweight. We see long-term yields moving up further as investors demand a greater term premium.
Short U.S. 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. Yields are less attractive relative to those on short-term DM government bonds.
Global investment grade credit		We are neutral. We see tighter credit and financial conditions. We prefer European investment grade over the U.S. given more attractive valuations.
U.S. 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 U.S. 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 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.