Jean Boivin, Head of BlackRock Investment Institute together with Wei Li, Global Chief Investment Strategist, Alex Brazier, Deputy Head and Elga Bartsch, Head of Macro Research, all forming 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.
Last year saw central banks living with inflation. This higher tolerance for price pressures, and the powerful economic restart, kept risk assets buoyant and limited the rise in yields. How central banks – particularly the Fed – respond to inflation will be the key story for 2022, in our view. We expect the Fed to raise rates but see its cumulative response to inflation as more muted than ever before. Yet the possibility that policymakers or investors misread the situation prompts us to trim risk.
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 Bloomberg, December 2021. Notes:: The chart shows the U.S. nominal federal funds rate (orange line), the projected path implied by the dot plot in the U.S. Federal Reserve’s latest Summary of Economic projections (yellow diamonds) and the path implied by market pricing. The green dotted line shows the path that would have been implied by a monetary policy rule linking the choice of policy rate to the rate of inflation and the level of the output gap.
2021’s powerful restart of economic activity resulted in severe price pressures and supply bottlenecks. In a stark departure from past practice of pre-emptive tightening, most developed market (DM) central banks did not respond when inflation and growth surged. Nominal bond yields rose, but not as much as inflation. This kept real yields deeply negative and supported equities, the hallmarks of our 2021 new nominal investment theme. The next phase of this story is playing out now. Most central banks are poised to nudge up policy rates – but this is taking the foot off the monetary accelerator, not hitting the brakes. We don’t see them responding aggressively to persistent inflation. Case in point: the Fed. It signaled three rate increases this year at its December meeting, noting high inflation, strong growth and labor market improvements. This is more than we expected, but what matters is the sum total of rate hikes. The Fed’s indicated policy response (yellow dots in the chart) is very mild compared with how it would deal with inflation in the past: a series of rapid-fire rate hikes that would have already began and would hoist the fed funds rate to near 4% over time (dotted green line).
In developed economies, we see the European Central Bank (ECB) keeping its foot on the accelerator while others such as the Fed prepare to pull back slightly. Importantly, no one is contemplating hitting the brakes – a factor for our modestly pro-equities stance and upgrade to U.S. equities. What matters next is whether DM central banks think their respective labor markets have returned to pre-Covid trends. Why? They may have an explicit employment mandate, like the Fed, or they use labor market conditions as a gauge for future inflationary pressures. This will play into the timing, pace and end point of policy hikes.
As we note in our 2022 Global Outlook, a unique confluence of events – the restart, new virus strains, supply-driven inflation and new central bank frameworks – are creating confusion as there are no historical parallels. Cutting through this confusion is key which is why we assess alternative scenarios to our base outcome and trim risk.
What are the risks to our base case? One is a delayed activity restart due to a global resurgence in Covid-19 infections. This could be particularly acute in China if its zero-Covid approach results in repeated activity shutdowns. We expect the People’s Bank of China to keep policy looser as a result, a shift already underway after last year’s economic slowdown.
We see two other risks, both negative for risk assets and fixed income. Central banks could revert to previous policy responses in the face of persistent inflation pressures. The Bank of England (BoE) – which in December became the first major DM central bank to raise rates since the pandemic struck – has made the most noise about responding more aggressively to inflation, leading markets to expect repeated rate hikes. The BoE may serve as a test case of a DM central bank coming closer to hitting the brakes, prompting the market to price in a risk of a policy reversal on rates by 2024. And inflation expectations could become unanchored from policy targets in the post-Covid confusion, forcing central banks to react aggressively. This could lead to stagflation: higher inflation becoming sticky amid stagnating activity. Understanding these potential outcomes around inflation and the market implications is key to cutting through confusion outlook theme.
Our bottom line: We expect interest rates to end at a lower level than in the past given higher inflation. That matters more for markets than what rates are going to do next year, in our view. We see the higher inflation regime and solid growth as positive for risk assets but bad for bonds for a second consecutive year – the new regime highlighted in our 2022 outlook.
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 Dec. 31, 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, 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
Global stocks ended 2021 up 19% while global fixed income fell 5%. We expect a repeat of this unusual combination in 2022, albeit with more moderate equity returns. The reason is the historically muted policy and market response to inflation. The Fed confirmed this at its meeting last month. This should keep real yields negative and support equities. We see inflation settling at a level higher than pre-Covid even as pressures from supply bottlenecks ease.
Week Ahead
- Jan. 5 – Germany, euro area, U.S. PMIs
- Jan. 6 – Japan CPI and services PMI, Germany industrial orders, U.S. jobless claims
- Jan. 7 – U.S. non-farm payrolls; China trade data ; Euro area inflation
U.S. employment data will be the key indicator for assessing whether the Fed follows through with its planned rate increases in 2022. A series of Purchasing Managers’ Indexes should give investors a read on the momentum of the restart. China’s trade data will give an indication of whether supply bottlenecks that have pushed up inflation are resolving.
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