Wei Li, Global Chief Investment Strategist together with Alex Brazier, Deputy Head, Beata Harasim, Senior Investment Strategist and, Natalie Gill, 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.
Coming into 2022, we dialed down overall risk to have a modest overweight to equities on concerns about confusion over the macro environment. We don’t see a need to reduce risk further: the confusion has materialized. The roughly 10% drop in U.S. equities – against our unchanged view of fundamentals – makes them more attractive on the surface. Yet accounting for higher expected interest rates, we don’t think equities have dropped enough for a valuation-driven upgrade.
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 Refinitiv Datastream, Jan. 28, 2022. Notes: The chart shows the price fall from the maximum level of the MSCI All-Country World Index over the previous one-year period.
Context is crucial. The equity retreat is far from magnitudes that warrant a wholescale reassessment of our views. The chart above shows the major drawdowns – calculated as the peak-to-trough moves over a rolling one-year period – for the MSCI All-Country World index. The takeaway: This pull-back is modest compared with some of the drops seen over the past decade. It also comes after a particularly strong run for risk assets. We believe the drawdown is consistent with our expectation for confusion and heightened volatility. The market has front-loaded pricing of Fed rate hikes over the next two years. Yet importantly, the sum total of Fed rate hikes hasn’t changed – only the timing. That’s why we think the move in equities cannot be explained by this repricing alone. The U.S. equity risk premium – our preferred valuation gauge as it takes into account both earnings expectations and the interest rate environment – has moved up. It reflects confusion about whether the Fed will go further than priced and deliberately destroy demand to get inflation down, as well as worries on the geopolitical front.
We hold to our view that the unusual market regime we outlined in our 2022 Global Outlook will deliver a second successive year of equity gains and bond losses. The underlying drivers are unchanged. Yet we are also seeing the confusion we had flagged in action, the risk that central banks and markets might misinterpret the unusual restart and supply-driven inflation. The confusion is playing out via a swift market repricing of Fed policy expectations and surging short-term yields.
What might prompt us to change our modest overweight to equities? For an upgrade, we would need to see a deeper retreat or the Fed acknowledging that it will live with some inflation to keep the restart going in a trade-off of its objectives. For a downgrade, we would look to see if the Fed prioritizes fighting inflation over activity – with or without acknowledging a trade-off between its objectives. We got a hint of a tougher inflation stance last week but would need to see more evidence of a more forceful shift in tactics on inflation.
We see uncertainty lingering for a few reasons. First, we think policy confusion can persist. The Fed is rightly intent on normalizing policy quickly. The restart does not need stimulus, so the Fed should take its foot off the accelerator. Our worry: The Fed likens the current normalization to a previous episode in 2015. We think such logic could lead the Fed to overtighten policy. This is a restart, not a typical recovery. The restart will quickly slow down on its own. Inflation is driven by supply constraints following a huge shift in demand during the pandemic, not an overheating economy – so the traditional policy playbook does not apply. We think the Fed will eventually back off but are prepared for a bumpy ride in markets. Second, geopolitical risks – while typically not long-lasting market events – could weigh on investor sentiment, including the stand-off over Ukraine and the Iran nuclear deal. Third, equity valuations by our measure are only modestly cheaper and reflect some of the confusion we describe. With market attention on the Fed repricing, companies beating estimates have not yet been rewarded this earnings season. Yet we think fundamentals will prevail, and that’s one reason why we are not downgrading our modest equities overweight.
Our bottom line: We maintain our modest equities overweight, with a preference for developed markets and China. We prefer balanced exposures to beneficiaries of long-term trends such as tech and healthcare on the one hand and cyclicals on the other. We need to see a deeper equity selloff and more clarity on near-term uncertainties to add to our equities overweight.
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 January 28, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point over the last 12-months and the dots represent current 12-month 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 Europe Index, MSCI USA Index, ICE U.S. Dollar Index (DXY), Bank of America Merrill Lynch Global High Yield Index, spot gold, J.P. Morgan EMBI Index, Refinitiv Datastream Germany 10-year benchmark government bond index, Refinitiv Datastream Italy 10-year benchmark government bond index, Refinitiv Datastream U.S. 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI Emerging Markets Index.
Fed Chair Jerome Powell flagged a likely rate hike in March and suggested the Fed could front-load rate hikes even more than previously indicated. Stocks extended their volatile run into the last week of the month, with U.S. tech leading losses. U.S. Treasury yields are also sharply higher across the board this month. The short-end has surged because of a sharp pulling forward of policy rate hikes, while we see the 10-year yield driven more by a resurgence of the term premium.
- Feb. 1 – Euro area unemployment rate
- Feb. 2 – Euro area flash inflation
- Feb. 3 – ECB, BoE monetary policy meetings
- Feb. 4 – U.S. employment report
U.S. jobs data this week will shed some light on the impact of Omicron on the restart but is unlikely to dissuade the Fed from kicking off rate hikes at its March meeting. We are also focused on the Bank of England. The BoE may follow its December rate hike with another one and could start to unwind its balance sheet. Markets do not expect any change in policy from the European Central Bank, but the media briefing could shed light on future moves.
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