Jean Boivin, Head of the BlackRock Investment Institute together with Wei Li, Global Chief Investment Strategist, Alex Brazier, Deputy Head of the BlackRock Investment Institute and Nicholas Fawcett, 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.

Key Points:

Shocks to supply – Supply shocks have created scarcity inflation, making higher inflation more persistent and increasing the risk of a growth slowdown.

Market backdrop – Ten-year U.S. Treasury yields hit three-year highs after it became clear the Fed will start to reduce its balance sheet quickly. We see further yield rises ahead.

Week ahead – We could see European Central Bank officials trying to guide down market expectations for multiple rate hikes this year and next.

Scarcity inflation is here. Supply shocks have created shortages of goods, energy and food that are driving up prices. We see this making inflation more persistent. It’s also spurring central banks to normalize policies faster. This is needed, in our view, as the economy no longer requires stimulus. The problem: Scarcity inflation has raised the risk of a global growth slowdown, either via the direct impact of the supply shocks or through central banks slamming the brakes on the economy.

Scarcity shock and inflation

Higher inflation is still driven by the sudden restart of economic activity from the pandemic’s lockdowns. Supply has struggled to keep up with shifting bursts in demand across sectors. Russia’s horrific invasion of Ukraine added a classic supply shock that is driving inflation higher and hurting economic activity. First, the West’s drive to wean itself off Russian energy added to an existing energy crunch. The result: Rising energy prices today are contributing 4 percentage points more to euro area inflation than in the five years before COVID, as the chart shows. Second, reduced food and fertilizer exports from Russia and Ukraine have created food insecurity around the world. These new supply disruptions add to existing pressures: Farmers already faced sharply higher fertilizer and diesel costs. Food inflation (green bars in the chart) could become a larger driver of inflation in developed markets as a result. World food prices jumped 13% in March to a new high, Food and Agriculture Organization data show.

Compounding and varying impacts

What is the impact of the two supply shocks and resulting scarcity inflation? It differs greatly by region. For Europe, the second shock could result in outright stagflation as the region’s energy costs have surged to near-record levels, as we detail in A new supply shock. In the U.S., a net exporter of energy these days, the momentum of the economic restart is strong. The risks to growth there stem from the Federal Reserve’s response to headline inflation running at 40-year highs, in our view.

Indeed, scarcity inflation is compounding the dilemma for central banks around the world: Inflation is high, but economies are not overheating. The usual playbook of jacking up rates to cool the economy doesn’t really apply in a world shaped by supply. Central banks are normalizing policy rates back to neutral levels that neither stimulate nor restrain the economy. Minutes of the Fed’s March meeting released last week reinforced our view that the central bank is determined to normalize very quickly, with a large projected rate increase this year and a quick reduction of its balance sheet.

The key issue: Will central banks go beyond neutral and slam the brakes on the economy with higher rates that crush activity – and risk assets? We believe central banks will ultimately choose to live with higher inflation, rather than destroy growth and employment. As a result, we expect the sum total of rate hikes to be historically low given the level of inflation. Once the Fed gets closer to neutral levels of rates later this year, inflation will likely have peaked. Growth and spending on goods should be normalizing. We see two risks. First, central banks could slam the brakes anyway because they think they can lift rates higher without causing damage. Second, the sticker shock from higher day-to-day prices causes inflation expectations to become de-anchored from central bank targets.

What are the investment implications?

We prefer equities over credit because the inflationary environment favors stocks, in our view. Many developed market companies so far have been able to pass on rising costs and kept margins high. First-quarter results starting this week will provide a reality check. We are underweight government bonds. We see long-term bond yield rising further and yield curves steepening as investors demand extra compensation for the risk of holding long-term government bonds amid high inflation and debt loads. Short-term bonds could outperform as we believe market expectations for rate increases have become overly hawkish. Such a backdrop could still be positive for equities because it represents a relative investor preference for stocks over bonds. We favor U.S. and Japanese equities over European peers within developed markets because we see the impact of the energy and food shocks as greatest there.

Market backdrop

U.S. 10-year Treasury yields jumped to three-year highs of around 2.7% even as short-term yields steadied, causing the yield curve to steepen sharply. The Fed’s plans to shrink its balance sheet – so-called quantitative tightening – was close to expectations but helped spark the back up in yields. We expect a further steepening of the yield curve as investors demand more term premium, or extra compensation for the risk of holding long-term bonds.

The European Central Bank’s rate decision is our focus this week, against a backdrop of hawkish market pricing that points to a lift-off in policy rates later this year. We think the ECB will be more cautious about lifting policy rates back near zero than markets currently expect. Our reasoning: The energy shock’s hit to growth will do some of the work for the ECB.

Assets in Review

Week ahead

• April 11-18: China total social financing
• April 12: Germany ZEW economic sentiment
• April 14: ECB policy meeting; University of Michigan sentiment

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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 28th, 2022 and may change. The information and opinions are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain ’forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

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The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

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Franklin Templeton’s Notes from the Trading Desk offers a weekly overview of what our professional traders and analysts are watching in the markets. The European desk is manned by eight professionals based in Edinburgh, Scotland, with an average of 15 years of experience whose job it is to monitor the markets around the world. Their views are theirs alone and are not intended to be construed as investment advice.

The Digest

Last week saw lacklustre performance for many equity markets as focus turned to hawkish rhetoric from the Federal Reserve (Fed), COVID-19 concerns in China and uncertainty around the outcome of the French presidential election. In addition, the war in Ukraine continues to grind on with little or no sign of progress in peace talks. Last week, the MSCI World Index declined 1.5%, the S&P 500 fell 1.3%, the STOXX Europe 600 Index rose 0.6% and the MSCI Asia Pacific Index fell 2.1%.

French Election

Up until last week, the French presidential election campaign had not really ruffled the market’s feathers, as the polls had shown a comfortable lead for President Emmanuel Macron.

However, this changed last week as the polls saw a late surge for right-wing candidate Marine Le Pen and a slump in support for Macron ahead of yesterday’s first-round vote. French equities had declined on this shift, with the French banks particularly weak. Le Pen has benefitted from campaigning on economic challenges such as the rising cost of living and energy inflation, and moving away from her traditional approach of focusing on immigration and other social issues.

The market’s nerves are due to the uncertainty a Marine Le Pen presidency would cause. Whilst she has backed away from policies such as France ditching the euro, or leaving the European Union (EU), she would likely be more confrontational with EU partners. In addition, her policies of rolling back pension reforms and increasing protectionism are not deemed “market-friendly”. Finally, her previous pro-Putin stance could disrupt the West’s united response to Russia’s aggression in Ukraine.

However, Macron did in fact win the first round (with 27.8% of the vote) while Marine Le Pen coming second (with 23.1%) and Jean-Luc Mélenchon third (at 21.9%). The two candidates will proceed to a second-round head-to-head on 24 April.

We are essentially seeing a rerun of the 2017 election result, which saw Macron win with 66% of the vote. Polls are far closer this time round though, with some even putting it as close at 51%/49% (Macron/Le Pen). Macron’s support in the first round held up better than some predictions, giving a small boost to France’s stock market. Furthermore, the left-wing candidate, Lean-Luc Mélenchon told his supporters “You must not give a single vote to Marine Le Pen”, although notably, he stopped short of backing Macron.

Looking ahead, the televised debate on 20 April will be key ahead of the vote on the 24 April. Expect a volatile few weeks for French markets, with French banks a good barometer for sentiment. It is also worth noting the yield on the French 10-year government bond has widened to 1.286%, trading at levels not seen for over five years. We would caveat that with the broader context of central banks moving away from easing and the inflationary impact, but the election will also likely be a market influence in France.

US Fedspeak Remains Firmly Hawkish

Last week, Fed speakers stuck firmly with the hawkish narrative. Fed Governor Lael Brainard set the tone on Tuesday of last week, when he stated that curbing inflation is “paramount” so the Fed could start reducing its balance sheet as soon as May and would be doing so at “a rapid pace”. She also indicated that interest-rate hikes could come at a more aggressive pace than the typical increments of 0.25 percentage points. This garnered a lot of attention, as she is traditionally seen as a dove.

The Federal Open Market Committee minutes from the last meeting were released on Wednesday, which also had a hawkish tone. The minutes stated the Fed will look to reduce its bond holdings by as much as US$95 billion a month (US$60 billion in US Treasuries and US$35 billion in mortgage-backed securities) which was in line with market expectations, though nearly double the peak rate of US$50 billion a month the last time the Fed trimmed its balance sheet from 2017 to 2019. Somewhat unsurprisingly, the minutes noted many would have raised 50 basis points (bps) in March, but held off because of the Ukraine war. However, going forward, members viewed one or more 50 bps increases as possibly appropriate if price pressures fail to moderate.

Sentiment was not helped when a former Fed official, Bill Dudley, wrote an article stating “Investors should pay closer attention to what [Fed Chair] Powell has said: Financial conditions need to tighten. If this doesn’t happen on its own, the Fed will have to shock markets to achieve the desired response. This would mean hiking the federal funds rate considerably higher than currently anticipated”.

In this context, we saw a significant jump in Treasury yields, with the US 10-year note up 32 bps to 2.7%, and US real rates (inflation-adjusted interest rates) also jumping last week, up 25.1 bps to -0.18%. As these real rates move higher, some argue the TINA (There Is No Alternative) to equities argument is eroding.

The Week in Review

Europe

Markets did feel quieter as we approach the Easter holiday, but there were still some meaningful moves in European equities, with huge divergence between best/worst sectors. The STOXX Europe 600 index was essentially flat last week, but health care stocks surged as fears over aggressive central bank tightening (Brainard’s comments were a clear catalyst), recessionary fears in Europe and a stronger dollar saw a glut of buying in pharmaceutical stocks. In addition, nerves over the outcome of the French election added to the “risk-off” sentiment. In contrast, the “risk-on” sectors struggled last week, with technology, automotive, banks and travel stocks all weakening.

Looking at country indices, the Swiss Market Index unsurprisingly outperformed, up 2.2%, thanks to its pharmaceutical heavyweights. France’s CAC 40 Index had a miserable week, down 2.7%, as Le Pen saw a late surge in the presidential election polls, as noted.

It was quite a light data week, but inflationary pressures were evident in the February eurozone Producer Price Index (PPI), which rose 31.4% year-over-year (Y/Y).

Taking a quick look at European credit markets, the ITRAXX XOVER CDS Index widened, up 9% last week.

United States

As discussed, Fedspeak was the main talking point in the United States, and the hawkish narrative weighed on growth/tech stocks, with the Nasdaq 100 Index down 3.6% last week, lagging the S&P 500. This was reflected in sector performance, as the tech space lagged, whilst (as in Europe) the defensives saw significant outperformance, with health care stocks rising.

The S&P 500 Index is testing a key technical support level at its 200-day moving average—something to keep an eye in coming sessions.

Looking to the CNN Fear & Greed Index, it suggests investor sentiment is in “no-mans land”, with a neutral sentiment rating. This week, second-quarter earnings season kicks off in the United States, with JP Morgan reporting on Wednesday. Earnings season could give investor sentiment more direction in coming weeks.

ASIA-Pacific

Last week was poor in general for stocks across Asia, as the MSCI Asia Pacific closed down 2.1%. Japan was once again the underperformer, with its benchmark index down 2.4%. The main themes were COVID-19 restrictions, increased Russia sanctions, crude oil volatility, a weaker yen, weaker bonds, and concerns over a hawkish Fed continue.

Mainland Chinese equities closed the week mildly lower, having been closed Monday and Tuesday for the Ching Ming Festival. Interestingly, spending during this holiday plunged 30.9% from a year ago to CNY18.8 billion, about 39.2% of the level seen in 2019. The number of people who undertook trips fell 26.2% to 75 million from last year, or 68% of the level in 2019.

China’s COVID-19 outbreak continues to grow, with all of Shanghai now in some form of lockdown. This, together with continued concerns about a hawkish Fed, curbed risk appetite in general. On a more positive note, regulators altered a rule that will provide US regulators fuller access to auditing reports, reducing risk of Chinese stocks being delisted from the United States, which had been blamed for recent volatility.

Last week, China’s March Purchasing Management Index (PMI) reading was weaker than expected, with the Composite PMI at 43.9 (the prior reading was 50.1) and the Services PMI at 42 (the prior reading was 50.2). Additionally, the Caixin services purchasing managers’ index came in at 42.0 vs. 50.2 prior. A steep decline in new work drove the decline (contracting at the sharpest pace in two years), with widespread movement restrictions across China, while business confidence was hit by the war in Ukraine, Caixin said in its report. We saw some downgrading of China growth forecasts amid the headwinds from its COVID-19 outbreak, weak property market and commodity-driven cost pressures, reinforcing expectations the government could undershoot its 2022 gross domestic product (GDP) growth target.

In response, the State Council signalled looser monetary policy and measures to boost consumption; the People’s Bank of China stated that will also establish financial stability protection fund to bolster ability to prevent systemic risks.

Hong Kong’s equity market was closed on Tuesday for the Ching Ming Festival. Early in the week, Chief Executive of Hong Kong, Carrie Lam, said she won’t seek second term. The tech space traded higher early last week as delisting concerns eased, only to give the gains back as COVID-19 headlines worsened on Wednesday (partial or full lockdown in 23 Chinese cities, which account for 13.6% of the country’s population and 22% of China’s GDP).

In Japan, we saw continuing focus on higher bond yields and weaker yen. The yield on the 10-year JGB rose to 0.23% from 0.21% at the end of the previous week. The yen depreciated to around 124.05 vs. the US dollar, its weakest level in nearly seven years. A further easing of border restrictions failed to offset the adverse impact on sentiment of a hawkish Fed and the negative repercussions, particularly inflationary pressures, of the Russia-Ukraine war.

On the recent yen weakness, Bank of Japan Governor Haruhiko Kuroda said that recent moves had been “somewhat rapid”, emphasising the importance of currency rates moving stably, reflecting economic and financial fundamentals.

Elsewhere, in Australia, the Reserve Bank of Australia announced that it has abandoned its language of patience and signaled that it could begin raising interest rates within months if wages and inflation data produce strong results.

Also, South Korea’s 2022 inflation is likely to be “much higher” than the central bank’s February forecast of 3.1%, according to a Bank of Korea statement. Inflation is likely to remain in the 4% level for some time due to rising oil and grain prices in the wake of the Ukraine war.

The Week Ahead

Although we have several market holidays over the Easter weekend, there is still plenty to focus on in terms of geopolitics and macroeconomic data. Fallout from the French election will be closely watched, and the Ukraine crisis remains front and centre. In terms of macro data, we have inflation readings in the United States and Europe which will be important, given current inflationary pressures. Elsewhere, US earnings season kicks off this week.

Monday 11 April

• UK Manufacturing & Industrial Production & Trade Balance
• Norway CPI
• Sweden PES weekly unemployment data

Tuesday 12 April

• UK ILO Unemployment Rate & Claimant Count
• Germany CPI
• France Trade Balance
• US CPI
• US Federal budget

Wednesday 13 April

• UK CPI & RPI
• Spain CPI
• Italy Industrial Production
• Eurozone Industrial Production
• US Core PPI

Thursday 14 April

• European Central Bank Interest-Rate Decision
• Sweden CPI
• US Jobless claims

Friday 15 April

• France CPI
• Italy CPI EU Harmonized
• US Manufacturing & Industrial production

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This information has been accurately reproduced, as received from Franklin Templeton Investment Management Limited (FTIML). No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.