Jean Boivin, Head of the BlackRock Investment Institute together with Elga Bartsch, Head of Macro Research, Wei Li, Global Chief Investment Strategist, and Vivek Paul, Senior Portfolio Strategist, all part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
Inflation looks set to overshoot the Fed’s target as we have expected. Yet we see uncertainties around the near-term persistence of the overshoot as the restart leads to unusual supply and demand dynamics. We have closed our tactical overweight in inflation-linked bonds as inflation expectations have risen sharply, but favor them strategically as we see medium-term inflation still underpriced.
Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute, U.S. National Federation of Independent Business, Bureau of Labor Statistics, Reuters News, with data from Haver Analytics, April 2021. Notes: The orange line shows the net balance of firms in the NFIB survey of small and medium-sized businesses reporting that they are currently raising their prices. A value of 0 indicates that the number of firms raising and reducing their prices is the same. The solid yellow line shows the annual change in the U.S. core CPI inflation rate. The dotted line indicates estimates for core CPI. Expected values for 2021-22 are based on the Reuters consensus as of March 2021. The core CPI estimates from 2022 onwards are based on our expectations of the likely path of GDP growth, spare capacity in the economy and the outlook for monetary policy.
The Covid shock is more akin to a natural disaster followed by a rapid “restart” – rather than a traditional business cycle recession followed by a “recovery”, in our view. We see this distinct nature of the shock as having profound implications for inflation: The pandemic didn’t cause a shortfall in demand as in typical recessions; it has instead led to shortfalls in both supply and demand. As the economy restarts, both supply bottlenecks and pent-up demand are coming into sharp focus. Small U.S. businesses slashed prices at the onset of the pandemic, coinciding with a dip in the core consumer price index (CPI), or prices excluding those of volatile energy and food. See the chart above. The trend has since turned, with many small businesses raising prices. Consensus forecasts point to a peak of inflation in May, yet we believe inflation could be volatile in the near term and see risks to the upside given the unusual interplay between supply bottlenecks and pent-up demand as the restart plays out.
Right now we are witnessing supply constraints being pitted against surging demand as the economy reopens. Global supply chains have come under pressure during the pandemic, as companies are faced with challenges including component shortages, rising raw material prices and longer delivery times. Meanwhile we expect the pent-up demand to unleash as virus restrictions ease and activity reopens. This unusual dynamic could lead to volatile inflation in the near term, in our view. In addition, it could allow many companies more power to pass on higher input prices to consumers with cash to spare, preventing compression in profit margins.
We have closed our tactical overweight in Treasury Inflation-Protected Securities (TIPS) after sharp increases in both inflation expectations and nominal bond yields. The 10-year breakeven inflation rate – a market-based measure of inflation expectations – has risen from 0.5% last March to about 2.4%. It has also become less responsive to recent inflation data surprises. We don’t see it moving significantly above 2.5% in coming months. Net inflows to TIPS exchanged-traded products (ETPs), on a rolling six-month basis, have hovered near record levels hit last December, according to Bloomberg.
We see U.S.CPI inflation averaging just under 3% between 2025-2030, and we believe this is still underpriced by markets. First, we expect higher production costs as the pandemic accelerates the rewiring of global supply chains. Second, major central banks are evolving their policy frameworks and explicitly intend to let inflation overshoot their targets. Third, the higher debt levels will make it harder for central banks to lean against inflation – and make the decision to start tightening more politicized, in our view. When looking at the concrete impact of higher debt servicing costs due to tightening monetary policy, the less tangible – but no less real – risk of loosening the grip on inflation expectations will likely pale in comparison.
The bottom line: We will likely see peak growth data and volatile inflation data in coming months – different from typical business cycle recoveries where better growth data typically have led to higher inflation. This may trigger some knee-jerk reactions and market volatility. We believe markets are still underestimating the potential for above-target inflation over the medium term. As a result we prefer inflation-linked bonds and are underweight nominal government bonds over the strategic horizon.
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 April 29, 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, Bank of America Merrill Lynch Global High Yield Index, ICE U.S. Dollar Index (DXY), Refinitiv Datastream Italy 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index, J.P. Morgan EMBI index, Refinitiv Datastream Germany 10-year benchmark government bond index, Refinitiv Datastream U.S. 10-year benchmark government bond index and spot gold.
A decline in U.S. Treasury yields and strong corporate earnings are providing some support to equities. The S&P 500 Index hit a record high last week and posted gains for the third straight month. Among the just over 40% of S&P 500 companies that have reported first-quarter earnings, 85% have beaten estimates, Refinitiv data showed. Mega-cap tech companies reported strong results. President Joe Biden outlined his $4 trillion spending plan to enhance infrastructure and social services, and the Fed reinforced its emphasis on policy patience.
- May 3 – U.S., euro zone manufacturing purchasing managers’ index (PMI)
- May 5 – U.S. ISM non-manufacturing PMI; euro zone composite PMI
- May 6 – Bank of England policy meeting
- May 7 – Caixin China services PMI; U.S. nonfarm payrolls
U.S. nonfarm payrolls data will be in focus. Economists expect an increase of 978,000 jobs in April, after a rise of 916,000 jobs in the previous month, according to Reuters. Investors will look for clues on the rebound of sectors that have been most affected by the pandemic as well as a further increase in construction jobs. They will also try to gauge the pace of the economic restart from PMI data from key economies.
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