Wei Li, Global Chief Investment Strategist and the BlackRock Investment Institute together with Ben Powell, Chief Investment Strategist for APAC, Yu Song, Chief China Economist and Vivek Paul, Senior Portfolio Strategist, all 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.
Market volatility is on the rise, as worries about new virus strains have been exacerbated by stretched positioning and light summer trading. Recent swings in market sentiment reflect the unusually wide range of potential outcomes beyond the current economic restart, in our view. Market overreactions may create opportunities to readjust portfolios to a pro-risk stance as we maintain high conviction in our new nominal investment theme that implies low real yields.
Market sentiment has been swinging between extremes: One week the concern is runaway inflation; the next it’s the prospect of a deflationary spiral. Most recently, bond markets appear to have ignored the latest strong U.S. employment and inflation data, and are focusing more on virus fears. Real, or inflation-adjusted, yields have dropped back toward historic lows, as the chart shows. The drop in nominal yields was likely exacerbated by foreign buying and short covering – or investors force to close out bets that yields would head higher. Shifting sentiment drove equity market volatility too - with large sectoral moves that quickly reversed.
The big picture: We believe these swings are to be expected, given the wide range of potential outcomes beyond the current restart of economic activity. In a noisy and unprecedented economic restart, having an anchor is all the more important. We stick to our new nominal investment theme: Major central banks are slower to respond to rising inflation than in the past, keeping nominal bond yields lower and real rates negative – a positive for risk assets.
We believe the powerful restart of economic activity remains the key story for markets, and it’s too early to make the determination that new virus strains will derail this. The evidence on vaccines is still consistent with their expected effectiveness, in our view, as reflected in hospitalizations significantly lagging the recent rise in cases due to the delta variant. Rising cases in the U.S. are to be expected – given the swift reopening and the emergence of the delta variant. The increase in cases in Europe has come quicker than many foresaw, yet pressure on hospitals is limited so far. The UK remains a test case to monitor -- and we are watching for a decline in the rate of growth of new cases after a recent spike. Asian and emerging market economies struggling with vaccination rollouts are suffering most in terms of health outcomes and mobility restrictions. Yet vaccines remain the way out, barring vaccine-resistant variants or new evidence on vaccine effectiveness, in our view.
While virus dynamics are uncertain, we remain confident that the policy paradigm has changed: many central banks are now attempting in different ways to overshoot inflation targets to make up for past misses. Our analysis suggests the drop in yields since May was primarily due to a decline in the term premium – the additional compensation that investors demand for moving further out the yield curve in duration. This represents a partial unwinding of a spike in the term premium seen since mid last year. We have also seen a reversal in market expectations of the U.S. “terminal” rate – or the neutral rate consistent with the Fed’s objectives. Markets are pricing in around four quarter percentage point rate hikes by 2025, roughly half what they priced in April – moving back toward our new nominal theme.
The bottom line? We believe the economic restart is real – but it is a restart, and will eventually taper back to the pre-covid trend. We see nominal yields rising far less in response to inflation than during similar episodes in the past. Yet still believe the direction of travel should be higher for nominal yields – and this is why we remain underweight Treasuries and government bonds overall, both on a tactical and strategic basis. Negative real interest rates provide a positive backdrop for equities, in our view. Markets may overreact to economic data and other news flow with thin liquidity in the summer, amid an unusually wide range of macro outcomes, in our view. Yet for now we see the restart intact and the new nominal holding – and would consider any temporary sell-offs as opportunities to readjust portfolios into a pro-risk stance.
Risk assets have rebounded from their swoon earlier in the month, with bond yields bouncing off lows. Such sharp price swings are the latest example of markets overreacting while grappling with the unusually wide range of potential outcomes that lie beyond the restart of economic activity. The ECB tweaked its forward guidance by making a lift-off in rates conditional on inflation durably reaching 2%, well within its forecast horizon. This is consistent with our new nominal theme, which holds that central banks will be slower to raise rates in the face of rising inflation than in the past.
July 27 – U.S. consumer confidence
July 28 – FOMC policy decision
July 29 – U.S. second-quarter GDP
July 30 – Euro area second-quarter GDP and inflation
All eyes will be on the Fed this week. We see the central bank likely upholding its accommodative policy stance as the strong activity restart in the U.S has led to unusual supply and demand dynamics and volatile near-term growth and inflation data. We don’t see the Fed discussing a tapering of asset purchases imminently, and a discussion later this year doesn’t mean a lift-off from near zero policy rates is close, in our view.
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