GLOBAL WEEKLY COMMENTARY

Taking advantage of volatility

Key points

Risk opportunities
We could see more temporary risk-off episodes in light summer trading, and would view them as opportunities to re-adjust portfolios to a pro-risk stance.
Dovish ECB
The European Central Bank delivered a dovish tilt in its guidance on interest rates, likely to be followed by an increase in its asset purchases.
Fed watch
All eyes will be on the Federal Reserve’s policy meeting this week, with the central bank unlikely to flag an imminent tapering of asset purchases.

Market volatility is on the rise, as worries about new virus strains have been exacerbated by stretched positioning and light summer trading. Recent swings in market sentiment reflect the unusually wide range of potential outcomes beyond the current economic restart, in our view. Market overreactions may create opportunities to readjust portfolios to a pro-risk stance as we maintain high conviction in our new nominal investment theme that implies low real yields.

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Negative real yields underpin equities

U.S. 10-year Treasury yield breakdown, 2019-2021

Real or inflation-adjusted, yields have dropped back toward historic lows, as the chart shows.

 

Sources: BlackRock Investment Institute, with data from Refinitiv DataStream, July 2021. Notes: The purple line represents the nominal 10-year U.S. Treasury yield. The yellow line is the real, or inflation-adjusted, yield. The red line is the 10-year breakeven inflation rate, or the average inflation rate over the next decade implied by the pricing of Treasury Inflation-Protected Securities. Indexes are unmanaged. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest in an index.

Market sentiment has been swinging between extremes: One week the concern is runaway inflation; the next it’s the prospect of a deflationary spiral. Most recently, bond markets appear to have ignored the latest strong U.S. employment and inflation data, and are focusing more on virus fears. Real, or inflation-adjusted, yields have dropped back toward historic lows, as the chart shows. The drop in nominal yields was likely exacerbated by foreign buying and short covering – or investors force to close out bets that yields would head higher. Shifting sentiment drove equity market volatility too - with large sectoral moves that quickly reversed.

The big picture: We believe these swings are to be expected, given the wide range of potential outcomes beyond the current restart of economic activity. In a noisy and unprecedented economic restart, having an anchor is all the more important. We stick to our new nominal investment theme: Major central banks are slower to respond to rising inflation than in the past, keeping nominal bond yields lower and real rates negative – a positive for risk assets.

We believe the powerful restart of economic activity remains the key story for markets, and it’s too early to make the determination that new virus strains will derail this. The evidence on vaccines is still consistent with their expected effectiveness, in our view, as reflected in hospitalizations significantly lagging the recent rise in cases due to the delta variant. Rising cases in the U.S. are to be expected – given the swift reopening and the emergence of the delta variant. The increase in cases in Europe has come quicker than many foresaw, yet pressure on hospitals is limited so far. The UK remains a test case to monitor -- and we are watching for a decline in the rate of growth of new cases after a recent spike. Asian and emerging market economies struggling with vaccination rollouts are suffering most in terms of health outcomes and mobility restrictions. Yet vaccines remain the way out, barring vaccine-resistant variants or new evidence on vaccine effectiveness, in our view. Stay up-to-date with our Covid tracker.

While virus dynamics are uncertain, we remain confident that the policy paradigm has changed: many central banks are now attempting in different ways to overshoot inflation targets to make up for past misses. Our analysis suggests the drop in yields since May was primarily due to a decline in the term premium – the additional compensation that investors demand for moving further out the yield curve in duration. This represents a partial unwinding of a spike in the term premium seen since mid last year. We have also seen a reversal in market expectations of the U.S. “terminal” rate – or the neutral rate consistent with the Fed’s objectives. Markets are pricing in around four quarter percentage point rate hikes by 2025, roughly half what they priced in April – moving back toward our new nominal theme.

The bottom line? We believe the economic restart is real – but it is a restart, and will eventually taper back to the pre-covid trend. We see nominal yields rising far less in response to inflation than during similar episodes in the past. Yet still believe the direction of travel should be higher for nominal yields – and this is why we remain underweight Treasuries and government bonds overall, both on a tactical and strategic basis. Negative real interest rates provide a positive backdrop for equities, in our view. Markets may overreact to economic data and other news flow with thin liquidity in the summer, amid an unusually wide range of macro outcomes, in our view. Yet for now we see the restart intact and the new nominal holding – and would consider any temporary sell-offs as opportunities to readjust portfolios into a pro-risk stance.

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China inflationary pressures falling
In China, further easing may lie ahead and the tone of the upcoming Politburo meeting will provide an important signal. Read more in our macro insights.
BlackRock Investment Institute Macro insights

Assets in review

Selected asset performance, 2021 year-to-date and range

The chart shows that Brent crude oil is the best performing asset so far this year among a selected group of assets, while spot gold 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 July 15, 2021. 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, in descending order: spot Brent crude, MSCI USA Index, MSCI Europe Index, MSCI Emerging Markets Index, ICE U.S. Dollar Index (DXY), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Refinitiv Datastream Italy 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index, Refinitiv Datastream U.S. 10-year benchmark government bond index, Refinitiv Datastream Germany 10-year benchmark government bond index and spot gold.

Market backdrop

Risk assets have rebounded from their swoon earlier in the month, with bond yields bouncing off lows. Such sharp price swings are the latest example of markets overreacting while grappling with the unusually wide range of potential outcomes that lie beyond the restart of economic activity. The ECB tweaked its forward guidance by making a lift-off in rates conditional on inflation durably reaching 2%, well within its forecast horizon. This is consistent with our new nominal theme, which holds that central banks will be slower to raise rates in the face of rising inflation than in the past.

Week ahead

July 27 – U.S. consumer confidence
July 28 – FOMC policy decision
July 29 – U.S. second-quarter GDP
July 30 – Euro area second-quarter GDP and inflation

All eyes will be on the Fed this week. We see the central bank likely upholding its accommodative policy stance as the strong activity restart in the U.S has led to unusual supply and demand dynamics and volatile near-term growth and inflation data. We don’t see the Fed discussing a tapering of asset purchases imminently, and a discussion later this year doesn’t mean a lift-off from near zero policy rates is close, in our view.

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Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, July 2021

Note: Views are from a U.S. dollar perspective, July 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, July 2021

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.

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Read details about our investment themes and more in our 2021 Global outlook.

The new normal

 

The powerful economic restart is broadening, with Europe and other major economies catching up with the U.S. We expect a higher inflation regime in the medium term – with a more muted monetary response than in the past.

    • The new nominal has largely unfolded in 2021: the rise in long-term yields has been mainly driven by higher market pricing of inflation, with real yields remaining pinned well in negative territory.
    • We expect the Fed to start normalizing policy rates in 2023, a much slower pace than market pricing for lift-off in 2022 indicates. The market’s lack of confidence in the Fed’s commitment to its new framework poses a risk of tighter financial conditions in the near term. We would anticipate this uncertainty to dissipate over time – assuming the central bank regains control of its narrative – paving the way for us to lean even more tactically pro-risk.
    • The European Central Bank has set its inflation target at 2% in the medium term but rejected an average inflation targeting framework. We see this as part of an ongoing policy evolution, and see near-term policy changes as unlikely. The ECB also said it would include climate change considerations in monetary policy operations.
    • Tactical implication: We go overweight European equities and inflation-linked bonds. We cut U.S. equities to neutral.
    • Strategic implication: We remain underweight DM government bonds and prefer equities over credit.
Globalization

 

China is already a distinct pole of global growth. We believe it is time to also treat it as an investment destination separate from EM and DM. Growth in China is starting to slow at the same time the policy stance is relatively tight. The regulatory crackdown on dominant companies is ongoing. We see these as key aspects of China’s efforts to improve the quality of growth.

    • China’s central bank unexpectedly announced a decision to cut the reserve requirement ratio, or the amount of cash banks must hold as reserves, to support economic growth that appears to be losing steam. We still believe the government will maintain its broadly hawkish policy preference to stay focused on the quality of growth.
    • We could see times when markets become concerned that China’s policy setting might be excessively tight. That points to downside risks in the short term. China is pushing through reforms that could weigh on the quantity of growth in the near term but potentially improve the quality in the long run.
    • Tactical implication: We break out China from EM with a neutral stance on equities and an overweight to debt.
    • Strategic implication: Our neutral allocation to Chinese assets is multiples larger than typical benchmark weights.
Turbocharged transformations

 

There is no roadmap for getting to net zero, and we believe markets underappreciate the profound changes coming. The path is unlikely to be a smooth one – and we see this creating opportunities across investment horizons.

    • Certain commodities, such as copper and lithium, will likely see increased demand from the drive to net zero. Yet we think it’s important to distinguish between near-term price drivers of prices of some commodities – notably the economic restart – and the long-term transition that will matter to prices.
    • Climate risk is investment risk, and we also see it as a historic investment opportunity. Our long-run return assumptions now reflect the impact of climate change and use sectors as the relevant unit of investment analysis.
    • Tactical implication: We are overweight the tech sector as we believe it is better positioned for the green transition.
    • Strategic implication: We like DM equities and the tech sector as a way to play the climate transition.

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Read our past weekly commentaries here.

Jean Boivin
Jean Boivin
Head of BlackRock Investment Institute
Jean Boivin, PhD, Managing Director, is the Head of the BlackRock Investment Institute (BII). The institute leverages BlackRock’s expertise and produces proprietary ...
Wei Li
Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Wei Li, Managing Director, is Global Chief Investment Strategist at the BlackRock Investment Institute (BII).
Scott Thiel
Scott Thiel
Chief Fixed Income Strategist, BlackRock Investment Institute
Scott Thiel, Managing Director, is Chief Fixed Income Strategist for BlackRock and a member of the BlackRock Investment Institute (BII). He is responsible for developing ...
Natalie Gill
Portfolio Strategist — BlackRock Investment Institute
Natalie Gill, CFA, Vice President, is a member of the Portfolio Research team within the BlackRock Investment Institute.