Jean Boivin, Head of BlackRock Investment Institute together with Wei Li – Global Chief Investment Strategist, Natalie Gill – Portfolio Strategist and Carolina Martinez Arevalo – 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.
Key Points
The stock story: U.S. stocks could run with hopes for inflation to fall to target and sharp rate cuts into 2024. We stay selective as we expect resurgent inflation to come into view.
Market backdrop: U.S. stocks climbed and the 10-year U.S. Treasury yield fell last week. The December U.S. CPI confirmed inflation is falling but set to rollercoaster back up.
Week ahead: We look to U.S. data this week for more signs policy rates are cooling business activity and consumer spending. We expect growth to slow further this year.
Equity markets – and even the Federal Reserve – have largely embraced the soft landing narrative that inflation will fall to the Fed’s 2% target without a recession. We agree that inflation will near 2% this year, likely supporting that narrative for now. The problem: Inflation won’t remain at that target, in our view, and this risk becoming clearer could challenge upbeat sentiment. So we monitor earnings season for any signs of cracks given pricey valuations.
Even after the market-wide rally in December, market concentration in a handful of mega caps – firms with ultra-large market capitalizations – remains high. Favored by markets for their ability to leverage artificial intelligence (AI), these technology companies drove U.S. stock market gains last year. Price-to-earnings ratios divide a company’s share price by its earnings per share. Their expected price-to-earning valuations for the next 12 months (orange line in the chart) are about a third higher than for the S&P 500 and when excluding them (green and pink lines). Stronger earnings expectations have supported the mega cap rally, with valuations falling in the second half of 2023. Will pricey valuations halt the rally? We find valuations tend to matter more for long-term rather than near-term stock returns, and that’s why they usually aren’t enough to spoil market sentiment without a catalyst.
Earnings could be a catalyst. We expect greater focus on earnings this year after consensus expectations rose through last year, with up to 11% growth now expected in the next 12 months, LSEG data show. The 2023 Q4 earnings season should shed more light on how such expectations will evolve. Profit margins in the U.S. and euro area have held up as companies have passed on higher costs to consumers and cut costs. We think they will normalize over time due to pressure from higher interest rates, ongoing wage gains and lower if still above-target inflation.
All eyes on inflation
Inflation is another catalyst that could challenge the positive market sentiment, in our view. Stocks are currently priced for a near-perfect outcome: a soft economic landing, where inflation falls, central banks sharply cut rates and more cuts come if growth risks emerge. Appetite for investing in risk assets seems much stronger now as markets have confidence inflation is normalizing back to 2% and that rates cuts are on the way. Inflation falling closer to target will likely dominate market news in the near term and buoy stocks for some time. Yet market jitters in early January suggest there is some anxiety about macro risks further out. Our portfolio managers generally see 2024 as another year of flip-flopping market narratives – and volatility.
The December CPI confirmed our view that U.S. inflation is on track to fall back near 2% this year due to falling goods prices. Yet data also reinforced that inflation will likely jump back near 3% in 2025 due to structural forces such as ongoing wage pressures in a tight labor market and geopolitical fragmentation. The risk of resurgent inflation coming into view – which we think will happen later this year – is one development that could spoil upbeat market sentiment. In Europe, banks have driven fatter profit margins for the broader market. But the European Central Bank cutting rates this year could dent their income.
Our bottom line
We think stocks can run with the soft-landing narrative into 2024, until other possible outcomes – like an inflation rollercoaster – come into view. We stay selective in developed market stocks. We still favor Japan, tech, AI and quality overall as they have outperformed – and will likely be more resilient to any shift in market narrative. Bond yields have fallen on market pricing of sharp rate cuts. We expect ongoing yield volatility as we don’t see central banks delivering such cuts.
Market backdrop
U.S. stocks rose nearly 2% last week, now flat for the year, while the 10-year Treasury yield ticked down to 3.95%. We think long-term yields are likely to drift higher. That’s because the Fed will not be able cut rates as deep or as quickly as markets are pricing due to the resurgent inflation we expect – a risk the December CPI confirmed. We also see investors demanding more compensation for the risk of holding long-term bonds given interest rate volatility and massive Treasury bond issuance.
We look to U.S. data out this week for more signs that higher policy rates are cooling business activity and consumer spending. CPI data in the UK will likely follow other developed markets and show inflation falling as the mismatch between goods and services unwinds. Yet we see inflation rising again in early 2025 as an aging population keeps the labor market tight, driving wage pressures. That means central banks will likely keep interest rates high for longer.
Assets in review
Week Ahead
Jan. 17: U.S. retail sales; UK CPI; China Q4 GDP
Jan. 18: U.S. Philly Fed business index
Jan. 19: University of Michigan consumer sentiment survey
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