GLOBAL WEEKLY COMMENTARY

Rate hikes: Sum total is key, not timing

Key points

Fed rate hikes
Markets have been pricing in faster Fed rate rises, resulting in a rocky start this year. We believe the historically low sum total of rate hikes is key, not the timing.
Market backdrop
The stream of fourth-quarter corporate results picks up pace this week, with a key question whether companies can keep passing on input price increases.
Week ahead
The U.S. CPI hit a 40-year high of 7% with little market reaction. The report gives more evidence that unusual supply factors are shaping the macro backdrop.

The year is off to a rocky start, with a jump in 10-year Treasury yields and a swoon in tech shares pulling down stocks. The culprit? Markets believe the Fed will raise rates sooner and more aggressively than expected. That’s not the story, in our view. The sum total of expected rate hikes remains low, thanks to a historically muted Fed response to inflation. Instead, the yield spike tells us that investors are less willing to pay a safety premium for bonds – and isn’t bad news for stocks per se.

What’s driving the yield spike

U.S. 10-year Treasury yield drivers, 2020-21

This chart shows that expectations for the future Fed funds rate have risen only modestly in recent weeks while 10-year Treasury yields have shot up. The main driver of this change has been an increase in the term premium.

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, January 2022. Notes: The left chart shows the U.S. 10-year Treasury yield along with New York Federal Reserve estimates of two components of that yield, expected interest rates and the term premium (the premium investors typically demand to hold riskier long-term government bonds). The right chart shows the cumulative breakdown of the change in the 10-year yield since its low point on Dec. 3, 2021.

The plunge in global government bond prices at the start of this year underscores the new market regime highlighted in our 2022 Global Outlook. The trigger was the Fed indicating a faster-than-expected policy normalization, including speeding up the timeline for letting its bond portfolio shrink. Markets quickly priced in faster and more rate hikes this year against a backdrop of 40-year high inflation and a tight labor market. Equities have come under pressure as growth stocks lost some of their luster with the apparent prospect of higher interest rates making future earnings less attractive. Is all of this bad for equities? We don’t think so. What really matters for stocks, in our view, is that the Fed has kept signaling a low sum total of rate hikes. That hasn’t changed. Indeed, expectations for the future fed funds rate (the yellow line in the chart) have risen only modestly in the last six weeks, whereas 10-year Treasury yields have shot up (the green line). The driver instead is an increase in the term premium (the red line), the extra compensation investors demand for the risk of holding government bonds at historically low yield levels.

Understanding the drivers behind both the Fed’s muted response and the yield spike are key to navigating this environment. The Fed has adopted new policies that let inflation run a little hot to make up for below-target inflation in the past – and has now met its target. We believe the Fed and other central banks will want to keep living with inflation. Why? Today’s inflation is triggered by pandemic-induced supply constraints, a sea change from decades of demand-driven price pressures. Our upcoming Macro and market perspectives will explain why this matters: Tightening would only serve to hurt growth and employment at a time when the economy has not yet reached full capacity. Central banks are merely lifting their foot from the gas pedal by starting to remove emergency stimulus released when the pandemic hit in 2020, in our view. This muted response should only modestly increase historically low real, or inflation-adjusted, yields and underpin equity valuations.

The recent yield spike ostensibly has echoes of 2013’s “taper tantrum” when the Fed then flagged a reduction of bond purchases. Yet we see key differences: It’s not driven by fears of a sharp increase in the policy rate;  growth is strong; and the Fed has honed its signaling. The Fed’s planned reduction of its balance could result in investors demanding a higher term premium for holding long-term bonds – but this need not be negative for equities in contrast to the taper tantrum, in our view. So far the Fed’s pivot on policy matters less for medium-term investors focused on the cumulative policy response.

We see three main risks. First and foremost: Central banks actually hit the brakes or markets think they might - a bad outcome for both stocks and bonds and one of the alternative scenarios to our base case laid out in our 2022 Global Outlook . We also considered the possibility of a sharper rise in the term premium relative to our base case for a more gradual increase depending on how the Fed handles the shrinking of its balance sheet. Second, we believe the Omicron strain presents downside risks to China’s growth outlook, especially given the influx of visitors for the Winter Olympics. We expect the country to maintain its zero-COVID policy – at least optically – in this politically important year. This heralds more restrictions on activity, even as Beijing appears bent on achieving its growth target this year by loosening policy. Third, we see potential conflict risks surrounding Iran’s nuclear ambitions, Russia’s massing of troops near Ukraine and, to a much lesser extent, Taiwan. These could rattle investors at a time the market’s attention to geopolitics is low. See our geopolitical risk dashboard. Our bottom line: We prefer equities in the inflationary backdrop of the strong restart of economic activity. We favor developed market stocks as we dial down risk slightly and are underweight government bonds.

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Major spending shift
Prices in the U.S. are rising at their fastest rate in about four decades. Learn why 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 over the past 12 months among a selected group of assets, while EM equities 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 January 14, 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, in descending order: spot Brent crude, MSCI USA Index, MSCI Europe Index, ICE U.S. Dollar Index (DXY), MSCI Emerging Markets Index, Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, spot gold, Refinitiv Datastream Italy 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index, Refinitiv Datastream Germany 10-year benchmark government bond index and Refinitiv Datastream U.S. 10-year benchmark government bond index.

Market backdrop

U.S. CPI hit a 40-year high of 7% with little market reaction. We see the report as more evidence that supply factors are shaping the macro backdrop. The fundamental culprits are the sputtering restart of supply and reallocation of resources spurred by the pandemic. The problem: policymakers can’t stabilize inflation without destroying activity. It’s a key reason why central banks have flagged a muted response to inflation. We see inflation settling at a level higher than pre-COVID.

Week ahead

Jan.17  – China urban investment, industrial output, retail sales and Q4 GDP
Jan. 18 UK unemployment data Bank of Japan policy decision
Jan. 19 UK CPI
Jan. 20 U.S. Philly Fed Business Index

The stream of fourth-quarter corporate results picks up pace this week, with a key question whether companies can keep up their profit margins by passing on input price increases. Investors may also get an early read on the impact of Omicron on future results. Some 8% of S&P 500 companies are set to report this week, dominated by financials, healthcare and real estate. UK inflation and employment could guide the Bank of England in the timing and magnitude of further rate rises.

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Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, September 2020

Asset Strategic view Tactical view
Equities Strategic equities - neutral Tactical view - neutral
We have turned neutral on equities on a strategic horizon given increased valuations and a challenging backdrop for earnings and dividend payouts. We move to a modest underweight in DM equities and tilt toward EM equities. Tactically, we are also neutral on equities overall . We like the quality factor for its resilience and favor Europe among cyclical exposures.
Credit Strategic equities - neutral Tactical view - neutral
We have turned neutral on credit on a strategic basis because we see investment grade (IG) spreads offering less compensation for any increase in default risks. We still like high yield for income. On a tactical horizon, we strongly prefer high yield for its income and more room for spread tightening. We are neutral on IG and underweight emerging market debt.
Govt Bonds Strategic equities - neutral Tactical view - neutral
The strategic case for holding nominal government bonds has materially diminished with yields closer to perceived lower bounds. Such low rates reduce the asset class’s ability to act as ballast against equity market selloffs. We prefer inflation-linked bonds as we see risks of higher inflation in the medium term. On a tactical basis, we keep duration at neutral as unprecedented policy accommodation suppresses yields.
Cash Tactical view - neutral Tactical view - neutral
We are neutral on cash. Holding some cash makes sense as a buffer against supply shocks that could drive both stocks and bonds lower.
Private markets Strategic equities - neutral Tactical view - neutral
Non-traditional return streams, including private credit, have the potential to add value and diversification. Many institutional investors remain underinvested in private markets as they overestimate liquidity risks, in our view. Private assets reflect a diverse array of exposures but valuations and inherent uncertainties of some private assets keep us neutral overall.

Note: Views are from a U.S. dollar perspective, September 2020. 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, September 2020

Legend Granular
Equities

Asset Tactical view
United States United States
We are neutral on U.S. equities. Risks of fading fiscal stimulus and an extended epidemic are threatening to derail the market’s strong run. Renewed U.S.-China tensions and a divisive election also weigh.
Europe
Europe
We are overweight European equities. The region is exposed to a cyclical upside as the economy restarts, against a backdrop of solid public health measures and a galvanizing policy response.
Japan
Japan
We keep Japanese equities at neutral. We see strong fiscal policy and public health measures allowing for rapid normalization.
Emerging markets Emerging markets
We are underweight emerging market equities. We are concerned about the pandemic’s spread and see less room or willingness for policy measures to cushion the impact in many – but not all – countries.
Asia ex-Japan Asia ex-Japan
We hold Asia ex-Japan equities at neutral. Renewed U.S.-China tension is a risk. China’s goal to balance growth with financial stability has led to relatively muted policy measures to cushion the virus fallout.
Momentum Momentum
We keep momentum at neutral. The sectoral composition of the factor provides exposure to both growth (tech) and defensive stocks (pharma). Yet momentum’s high concentration poses risks as recovery takes hold.
Value
Value
We are neutral on value. We see the ongoing restart of economies likely benefiting cyclical assets and potentially helping value stage a rebound after a long stretch of underperformance.
Minimum volatility Minimum volatility
We hold min vol at neutral. The restart of economies is likely to benefit cyclical assets and reduce the need for defensive exposures.
Quality
Quality
We keep our strong overweight on quality. We see it as the most resilient exposure against a range of outcomes in terms of developments in the pandemic and economy.

Fixed income

Asset Tactical view
U.S. Treasuries  
   U.S. Treasuries
We still like U.S. Treasuries. Long-term yields are likely to fall further than other developed market peers, even as low rates reduce their ability to cushion against risk asset selloffs.
Treasury Inflation-Protected Securities Treasury Inflation-Protected Securities
We are neutral on TIPS. A huge decline in rates makes the entry point less attractive. We still see potential for higher inflation over time and like TIPS in strategic allocations.
German bunds 
    Europe
We remain underweight bunds as current yield levels provide little cushion against major risk events. Also, potential issuance related to the proposed EU recovery fund could compete with bunds for investment.
Euro area peripherals Japan
We are overweight euro area peripheral government bonds despite recent outperformance. We see further rate compression due to stepped-up quantitative easing by the European Central Bank and other policy actions.
Global investment grade Global investment grade
We downgrade investment grade credit to neutral. We see little room for further yield spread compression, as we see deeper rate cuts and more asset purchases as unlikely as policy response. Central bank asset purchases and a broadly stable rates backdrop still are supportive.
Global high yield 
Global high yield
We increase our overweight on high yield. We see the very high implied default rates as overly pessimistic, and high yield remains an attractive source of income in a yield-starved world.
Emerging market - hard currency Emerging market - hard currency
We are underweight hard-currency EM debt due to the pandemic’s spread, heavy exposure to energy exporters and limited policy space in some emerging economies. Default risks may be underpriced.
Emerging market - local currency Value
We have downgraded local-currency EM debt to underweight. We see many EM countries as having insufficient capacity to rein in the virus spread and limited policy space to cushion the shock from the pandemic.
Asia fixed income  
Asia fixed income
We are neutral on Asia fixed income. The pandemic’s containment in many countries and low energy exposure are positives. Renewed U.S.-China tensions and China’s relatively muted policy fallout are risks.

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 2022 Global outlook.

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.

    • Inflation is being driven by the unusual restart dynamics of extraordinary demand bumping up against supply bottlenecks. We expect many supply-demand imbalances to resolve over the year.
    • The policy response to rising inflation isn’t uniform. The Fed and the ECB are more tolerant of inflation, even as the Fed has started to warn of inflation risks.
    • Other developed market (DM) central banks have signaled policy rate paths with steeper initial increases, and many of their emerging market (EM) counterparts have already lifted off.
    • The Fed has achieved its new inflation goal to make up for past misses and sees full employment being reached this year. This is the justification for the three rate hikes it has suggested for 2022. This is more than we expected, but we believe the total sum of hikes is unchanged and historically muted – and more important to markets.
    • The Fed has sped up its tapering of bond purchases and has indicated it may start to trim its balance sheet earlier than expected by letting bonds run off when they mature.
    • Investment implication: We prefer equities over fixed income and remain overweight inflation-linked bonds.
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.

    • We keep the big picture in mind: We see the restart rolling on, inflation meeting a muted central bank response, and real rates remaining historically low.
    • We do see increasing risks around this base case: Central banks could revert to their old policy response, and growth could surprise on the upside or disappoint.
    • There’s also a risk markets misread China’s policy. The country has emphasized social objectives and quality growth over quantity in regulatory crackdowns that have spooked some investors. Yet policymakers can no longer ignore the growth slowdown, and we expect incremental loosening across three pillars - monetary, fiscal and regulatory.
    • Investment implication: We have trimmed risk-taking amid an unusually wide range of outcomes.
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.

    • Sustainability cuts across multiple dimensions: the outlook for inflation, geopolitics and policy. The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher inflation, in our view.
    • Risks around a disorderly transition are high – particularly if execution fails to match governments’ ambitions to cut emissions.
    • We favor sectors with clear transition plans. Over a strategic horizon, we like the sectors that stand to benefit more from the transition, such as tech and healthcare, because of their relatively low carbon emissions.
    • Investment implication: We favor DM equities over EM as we see them as better positioned in the green transition.

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Jean Boivin
Head – BlackRock Investment Institute
Wei Li
Wei Li
Global Chief Investment Strategist - BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Elga Bartsch
Head of Macro Research — BlackRock Investment Institute
Scott Thiel
Chief Fixed Income Strategist – BlackRock Investment Institute