Wei Li, Global Chief Investment Strategist with the BlackRock Investment Institute, together with Alex Brazier, Deputy Head, Scott Thiel, Chief Fixed Income Strategist and Beata Harasim, Senior investment 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.

Key Points

Credit over stocks: We prefer investment grade credit over equities right now. Our reasoning: valuations, strong balance sheets, low supply and moderate refinancing risks.

Market backdrop: U.S. data last week showed strong job creation but still low labor participation. Stocks lost steam and bond yields spiked as markets priced in more Fed hikes. 

Week ahead: We expect U.S. CPI and PPI data this week to show that high inflation is persisting. China’s social financing and CPI inflation data are also in focus.

We prefer investment grade (IG) credit over equities on a tactical horizon as we see a new market regime with higher volatility taking shape. First, yields on IG credit have risen, making for improved valuations and a larger cushion against defaults. Second, balance sheets are strong, we think. Third, supply is low, and we see only moderate refinancing risks. Our conclusion: We believe IG credit can weather a significant growth slowdown whereas equities don’t look priced for this risk.

Attractive yields

U.S. Treasury yield and IG credit spread, July 2021–July 2022

Yields look more attractive than at the start of the year, in our view. That’s because of a surge in government bond yields (red area in chart) and a widening of spreads (yellow area), the risk premium investors pay to hold IG bonds over government peers. Since June, markets have been captivated by the prospect of lower rates in the face of a growth slowdown. This has resulted in a drop in yields, boosting IG performance and triggering a 10%-plus equities rally. We still like IG credit at these levels. Spreads have only marginally narrowed as investors lean back into equities. Plus, we think higher coupon income provides a cushion against another yield spike as markets price in the persistent inflation we expect. Equity valuations, meanwhile, don’t reflect the chance of a significant slowdown yet, so earnings estimates are still optimistic, in our view.

IG companies are in good shape, in our view. First, debt servicing remains low by historical standards and leverage has been coming down. U.S. non-financial IG companies lowered leverage, as measured by debt-to-equity, for the seventh straight quarter at the end of last year, according to ratings agency S&P Global. Second, the number of defaults in 2022 is the lowest since 2014, S&P data show. Lastly, we think credit quality is still solid. S&P’s tally shows that rising stars in credit, or those that gain into investment grade status from high yield, have outpaced those going the other way, so-called fallen angels. We are neutral high yield as we prefer up-in-quality credit amid a worsening macro backdrop. We think parts of high yield offer attractive income, but concern over widening spreads in any slowdown steers us toward IG.

Trends in the corporate bond market also support our overweight on credit, in our view. First, supply is relatively low. Corporate bond issuance is down almost 20% this year versus 2021, according to S&P. Many issuers could be waiting to see if financing conditions improve before issuing more debt. Second, refinancing needs don’t look pressing after a surge in issuance last year. For example, typical U.S. IG bond issuance of around $1 trillion a year easily exceeds upcoming maturities of less than $600 billion a year through 2029, S&P data show.

Our take on inflation 

How do inflation and the Fed’s next moves play into our credit view? Markets currently appear to expect that a mild contraction will result in falling rates and lower inflation. We don’t think such a “soft landing” is likely in a volatile macro regime shaped by production constraints. Central banks will have to plunge the economy into a deep recession if they really want to squash today’s inflation – or live with more inflation. We think they’ll ultimately do the latter – but they are not ready to pivot yet. As a result, we see lower growth and elevated inflation ahead. We see bond yields going up and equities at risk of swooning again. IG credit, in our view, benefits from relatively high all-in yields that reflect moderate default probabilities.

Our bottom line

We overweight IG credit versus equities on a tactical horizon. This is a move up in quality in a whole portfolio approach after we reduced risk throughout this year in response to higher macro volatility. IG valuations still look attractive, balance sheets appear strong, refinancing risks seem moderate. As a result, we see IG credit weathering a slowdown better than stocks. We see activity stalling, underpinning our underweight to most developed market equities. Rising input costs also pose a risk to elevated corporate profit margins. When would we turn positive on equities again? Our signpost is a dovish pivot by central banks when faced with a big growth slowdown, a definite sign they will live with inflation.

Market backdrop

The U.S. economy added some 528,000 new jobs in July, double the average of analyst expectations. The labor market has not yet normalized, with labor force participation ticking down, while wages ticked up. This caused the rally in U.S. stocks to lose steam and bond yields to spike as markets priced in higher odds of a 0.75%-hike by the Federal Reserve in September. This aligns with our view that markets had prematurely priced in a dovish pivot by central banks amid signs of a slowdown.

All eyes will be on this week’s U.S. CPI and PPI data to gauge whether high inflation is persisting. We see inflation staying above the Fed’s 2% target through next year. We think the Fed will keep responding to calls to tame inflation until it acknowledges how that would stall growth. We’re also watching China’s social financing and CPI inflation data releases.

Week ahead

Aug. 10: U.S. and China CPI inflation data

Aug. 11: U.S. PPI data

Aug. 12: UK GDP; U.S. University of Michigan sentiment survey

Aug. 10-17: China total social financing

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BlackRock’s Key risks & Disclaimers:

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 8th August, 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.

Issued by BlackRock Investment Management (UK) Limited, authorized and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL.

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This information has been accurately reproduced, as received from  BlackRock Investment Management (UK) Limited. 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.

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

Global equities finished relatively flat last week following the release of the US July employment report. The MSCI World Index closed the week up 0.21%, the S&P 500 Index closed the week up 0.4%, the  STOXX Europe 600 Index was down 0.6%, whilst the MSCI Asia Pacific Index was up 0.3%. The US reported very firm job gains in July, with nonfarm payrolls coming in at 528,000, which was higher than expected. However, average weekly earnings have slowed from the highs and are in deeply negative territory in real terms.

After the release of the jobs report, investor attention quickly turned to the Federal Reserve (Fed), with a 75 basis point (bp) interest-rate hike now expected for September. Two more Consumer Price Index (CPI) reports are expected before that announcement, the first of which is on Wednesday this week.

The other key focus last week was the Bank of England’s (BoE) policy meeting. The central bank hiked rates by 50 bps, which was largely as expected, but it was the bank’s estimates for a five-quarter recession starting in the fourth quarter of 2022 which garnered the most attention.

Energy prices were a focus once again last week, with oil prices at their lowest level since Russia’s invasion of Ukraine. Yet, geopolitical tensions between Russia and Europe remain heightened, with gas supplies restricted by Russia’s political posturing. Meanwhile, US Speaker of the House of Representatives Nancy Pelosi’s visit to Taiwan has caused some shockwaves and signalled a deterioration in US-China relations.

US jobs report—good news bad news for equities?

As stated, July’s employment report came in at an impressive increase of 528,000 jobs, well ahead of expectations. The report is a good sign for the US labour market and the broader US economy in general. The risk for equity markets is that the Fed is likely to have to do more to cool inflation. The Fed raised rates by 75 bps at the end of July, which followed a 75 bp hike in June. The market is now pricing in an 80% chance of another 75 bp hike by the Fed in September. The jobs report seemed to end hopes of an imminent dovish pivot as it throws cold water on the idea of a significant cooling in labour demand. Comments from various Fed speakers last week were notably hawkish even before the data was released, noting high inflation.

BoE challenges for the UK economy

Last Thursday’s BoE policy meeting provided a stark reminder of the challenges facing the UK economy. As expected, the Monetary Policy Committee raised interest rates by 50 bps, taking the base rate to 1.75%, and detailed plans for Quantitative Tightening (QT). The bank has now raised rates  for six meetings in a row. However, what drew the most attention was its bleak outlook for the UK economy. The fourth-quarter inflation target was raised to 13.2%, and the central bank predicted the UK economy would enter a recession in the fourth quarter that would last through all of 2023.

The central bank decided to hike quite aggressively in the face of an economic downturn, meaning it is preparing for a hard landing to bring inflation back to target.

Key takeaways from the BoE meeting:

• Interest rates were raised by 50 bps (to 1.75%) for the first time since 1995. Vote was 8 to 1, a convincing majority.
• QT for after the September policy meeting at a pace of £10 billion a quarter, £80 billion total cut to gilt holdings in the year from September, including redemptions.
• UK inflation is seen peaking at 13.2% in the fourth quarter as average energy bills will likely increase by 75% to around £3,500 ($4,240) in October.
• Inflationary pressures have “intensified significantly,” the BoE said. “The latest rise in gas prices has led to another significant deterioration in the outlook for activity in the United Kingdom.”
• The BoE sees UK economy entering recession from the fourth quarter. Predicting a recession that lasts for five quarters, so all the way through 2023, with a gross domestic product (GDP) decline of 2.1%.
• Guidance of forceful action if inflationary pressures persist was kept. That may put further 50 bps moves on the table at upcoming meetings.
• BoE Governor Andrew Bailey said “all options” are on the table for future meetings.

The British pound finished the week down 82 bps vs the US dollar. In the gilt market, the two and 10-year yield curve inverted for first time since 2019, a relatively reliable lead indicator of a recession.

Europe

European stocks traded down last week following a late sell-off after the US employment report release. Sentiment appeared relatively supportive throughout the week in equity markets, despite a series of headwinds lingering. The BoE announcement was the clear focus for the region. European industrials remain a focus for investors, with power prices surging to new highs again last week. In addition, the Rhine water level is at its lowest in 25 years. This could have significant impact on industrial production in the region; supply chains have become disrupted once again as goods cannot be shipped to end markets. There are reports of France having to run nuclear on lower output levels as there is not enough water to cool the reactors.

Last week was the 24^th consecutive week of outflows from Europe-focused funds.

In terms of sector moves, banks outperformed given the expected higher-rate environment, and the  BoE announcement and hawkish Fed in mind. For the same reason, real estate stocks struggled, finishing down last week. Crude oil prices saw their biggest weekly drop last week since March 2020, putting oil stocks under pressure. Despite the headwinds, the latest corporate earnings season has surprised to the upside. Energy has been the winning sector so far, whilst real estate has been the losing sector.

United States

US equities recorded small gains last week as the July employment  report alleviated recession fears a little. The S&P 500 Index closed up 0.4%, recording its third straight week of gains. Geopolitics was a focus for US markets as House Speaker Nancy Pelosi visited Taiwan, renewing tensions with China. Prior to the visit, China threatened “serious consequences” if Pelosi went ahead with her visit. The extent of China’s intended response is unknown, with investors fearing that global trade could be impacted.

There was a clear rotation in the US equity markets last week, with energy stocks selling off and technology stocks rallying. Energy has been the standout performer year-to-date, so with West Texas Intermediate crude oil prices down nearly 10% last week, investors decided to take some profits. Low market volumes likely exacerbated the selloff in the sector. Technology stocks outperformed amid solid earnings in the space. The outlook remains constructive, and value stocks have been delivering stronger revenue and earnings-per-share than growth stocks.

Asia-Pacific

Asian equities traded higher overall last week, with the MSCI Asia Pacific Index closing the week up 0.25%. The escalation in US/China tensions is a focus for the region. Chinese equities were in risk-off mode last week as foreign investors reduced their exposure amid a ramping up of geopolitical risks. July’s Purchasing Management Index (PMI) report also weighed on sentiment. It missed expectations, indicating that the recovery may be short-lived, especially as COVID-19 control remains a key focus for the government.

However, trade data reported over the weekend showed China’s exports are expected to maintain a high rate of growth in the third quarter, while Chinese imports are expected to experience a further recovery. The significant increase in exports to the European Union influenced by tight energy supply, provided a key boost to exports in July.

The week ahead

Monday 8 August

• Eurozone investor confidence

Tuesday 9 August

• US NFIB Small Business Optimism; Non-Farm Productivity; Unit Labour Costs

Wednesday 10 August

• Italy CPI
• Germany CPI
• China CPI, Producer Price Index (PPI)
• Japan PPI
• US CPI, real average earnings

Thursday 11 August

• US PPI, jobless claims

Friday 12 August

• UK GDP, imports/exports; Industrial Production (IP); Manufacturing Production; construction output; total business investment
• France CPI
• Spain CPI
• Italy trade balance
• Eurozone IP
• US import/export price Index; University of Michigan Sentiment, current conditions, expectations

Franklin Templeton Key risks & Disclaimers:

What Are the Risks?

All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.  Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

Past performance is not an indicator or guarantee of future performance. There is no assurance that any estimate, forecast or projection will be realised.

This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of 8 August 2022, and may vary from the analysis and opinions of other investment teams, platforms, portfolio managers or strategies at Franklin Templeton. Because market and economic conditions are often subject to rapid change, the analysis and opinions provided may change without notice. An assessment of a particular country, market, region, security, investment or strategy is not intended as an investment recommendation, nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. This article does not provide a complete analysis of every material fact regarding any country, region, market, industry or security. Nothing in this document may be relied upon as investment advice or an investment recommendation. The companies named herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. Data from third-party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FT affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

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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.