BlackRock Commentary: Confusion yields opportunity

Jean Boivin, Head at the BlackRock Investment Institute together with Alex Brazier, Deputy Head, Wei Li, Global Chief Investment Strategist and Natalie Gill, Senior Portfolio Strategist 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.

The situation on the Russia-Ukraine border keeps escalating as President Vladimir Putin ordered troops into eastern Ukraine after recognizing breakaway regions as independent, adding to confusion about the macro and policy outlook. Heightened geopolitical risks keep us from adding risk tactically, even as we see central bank hawkish repricing as overdone. Yet we see an opportunity for long-term investors to raise equity allocations to position for the regime shift we see unfolding.

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Sources: BlackRock Investment Institute, with data from Bloomberg, February 2022. The chart shows the pricing of expected central bank policy rates via 1-year forward overnight index swaps. For example the last point on each chart shows the one-year OIS rate four years ahead.


Strategically, our asset views – a broad preference for equities over nominal government bonds and credit – have been positioned for the new market regime that we flagged in our 2022 Global Outlook. We see this regime being driven by investors demanding greater compensation, or term premium, for the risk of holding government bonds and our expectation for higher inflation in the medium term. It reinforces a significant reallocation to equities and away from government bonds that has only just begun, in our view. We push back against the notion that the recent pulling forward of rate hike timing and higher bond yields imply lower equity valuations. The cumulative path of rate hikes matters more for valuations than the speed of repricing over the next few years and that path hasn’t materially changed. See the chart. Accounting for the low path of expected rates, equity valuations are not as stretched as traditional metrics suggest, such as price-to-earnings ratios. The equity risk premium – our preferred valuation gauge that considers the outlook for rates and earnings – is in line with its historical average.

Markets have also been on tenterhooks due to the Russian military threat to Ukraine. It reflects the most serious security challenge in Europe since the end of the Cold War. We believe some form of Russian military action and an extended stand-off are increasingly likely. Such action could trigger Western sanctions, military aid to Ukraine and an increased NATO presence in eastern Europe. This evolving situation warrants near-term caution. Yet we are also mindful that geopolitical tensions tend to cause short-term gyrations like the ones we’re seeing rather than become ongoing market drivers.

Beyond these tensions, we believe the risk asset pullback is due to markets adjusting to a regime shift and the confusion stemming from the unusual economic restart, a supply-driven surge in inflation and new central bank frameworks. Central banks will likely only return policy to pre-Covid settings rather than aggressively fight inflation. Why? Because this is not your usual inflation. Supply factors are the main drivers rather than the more typical scenario of high demand in an overheating economy. DM economies still have room to grow. So aggressive rate hikes to stamp out supply-driven inflation would only torpedo economic activity that has not yet fully recovered. That’s why we think they will choose instead to live with inflation and only raise rates to remove stimulus that is no longer needed. This should keep real, or inflation-adjusted, yields low and is why we are looking to lean into tactical opportunities. The market may sometimes itch for a bigger policy response to inflation, but this matters more from a trading than a long-term investment perspective.

With that in mind, we believe equity markets are not making the distinction between the repricing in the near-term path of policy rates, which has been sharp yet has a limited impact on long-term expected returns, and the muted change in long-run rate expectations – far more important for equity valuations and returns. The sum total of expected rate hikes over the cycle – key for asset valuations – has not moved materially, particularly in the U.S. That means equities have become more attractively valued than they were prior to the selloff. Over the long-term, we also see the net-zero transition driving a relative return advantage for “greener” sectors, such as tech and healthcare, over “browner” sectors, such as energy and utilities.

Strategically, we remain underweight DM government bonds. First, we expect yields to move higher as investors demand a greater term premium. Second, yields are close enough to effective lower bounds to limit their role as portfolio ballast in risk-off environments. Tactically, we also see yields moving higher – but also see the hawkish repricing as overdone.

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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 February 17, 2022. 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: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.

Market backdrop

Equity markets were mildly weaker as the threat of a Russian invasion of Ukraine dominated headlines, with the U.S. government warning of potential imminent action. We see a range of possible actions that Russia could take, including cyber-attacks or other destabilizing actions, military incursions into Ukraine territory, all the way up to a full-scale invasion. U.S. Treasury yields pulled back from recent highs, and crude oil prices fell after reaching an eight-year peak.

Week Ahead

  • Feb. 21  – Global flash PMIs for February
  • Feb. 22 – U.S. flash PMI for February
  • Feb. 25 – U.S. January PCE inflation and spending

Developments on Russia’s military buildup around Ukraine will likely remain a market focus. Global flash purchasing managers’ indexes will give some color on whether supply chain bottlenecks are getting resolved. The key data point will be the U.S. January PCE inflation index to see how the higher-than-expected jump in the January U.S. CPI to a fresh 40-year peak translates into the inflation gauge targeted by the Fed – and what it means for rate hikes expected to start in March.

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