Jean Boivin together with Wei Li, Global Chief Investment Strategist, Alex Brazier, Deputy Head, Elga Bartsch, Head of Macro Research and, Scott Thiel, Chief Fixed Income 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.
The year is off to a rocky start, with a jump in 10-year Treasury yields and a swoon in tech shares pulling down stocks. The culprit? Markets believe the Fed will raise rates sooner and more aggressively than expected. That’s not the story, in our view. The sum total of expected rate hikes remains low, thanks to a historically muted Fed response to inflation. Instead, the yield spike tells us that investors are less willing to pay a safety premium for bonds – and isn’t bad news for stocks per se.
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, January 2022. Notes: The left chart shows the U.S. 10-year Treasury yield along with New York Federal Reserve estimates of two components of that yield, expected interest rates and the term premium (the premium investors typically demand to hold riskier long-term government bonds). The right chart shows the cumulative breakdown of the change in the 10-year yield since its low point on Dec. 3, 2021.
The plunge in global government bond prices at the start of this year underscores the new market regime highlighted in our 2022 Global Outlook. The trigger was the Fed indicating a faster-than-expected policy normalization, including speeding up the timeline for letting its bond portfolio shrink. Markets quickly priced in faster and more rate hikes this year against a backdrop of 40-year high inflation and a tight labor market. Equities have come under pressure as growth stocks lost some of their luster with the apparent prospect of higher interest rates making future earnings less attractive. Is all of this bad for equities? We don’t think so. What really matters for stocks, in our view, is that the Fed has kept signaling a low sum total of rate hikes. That hasn’t changed. Indeed, expectations for the future fed funds rate (the yellow line in the chart) have risen only modestly in the last six weeks, whereas 10-year Treasury yields have shot up (the green line). The driver instead is an increase in the term premium (the red line), the extra compensation investors demand for the risk of holding government bonds at historically low yield levels.
Understanding the drivers behind both the Fed’s muted response and the yield spike are key to navigating this environment. The Fed has adopted new policies that let inflation run a little hot to make up for below-target inflation in the past – and has now met its target. We believe the Fed and other central banks will want to keep living with inflation. Why? Today’s inflation is triggered by pandemic-induced supply constraints, a sea change from decades of demand-driven price pressures. Our upcoming Macro and market perspectives will explain why this matters: Tightening would only serve to hurt growth and employment at a time when the economy has not yet reached full capacity. Central banks are merely lifting their foot from the gas pedal by starting to remove emergency stimulus released when the pandemic hit in 2020, in our view. This muted response should only modestly increase historically low real, or inflation-adjusted, yields and underpin equity valuations.
The recent yield spike ostensibly has echoes of 2013’s “taper tantrum” when the Fed then flagged a reduction of bond purchases. Yet we see key differences: It’s not driven by fears of a sharp increase in the policy rate; growth is strong; and the Fed has honed its signaling. The Fed’s planned reduction of its balance could result in investors demanding a higher term premium for holding long-term bonds – but this need not be negative for equities in contrast to the taper tantrum, in our view. So far the Fed’s pivot on policy matters less for medium-term investors focused on the cumulative policy response.
We see three main risks. First and foremost: Central banks actually hit the brakes or markets think they might – a bad outcome for both stocks and bonds and one of the alternative scenarios to our base case laid out in our 2022 Global Outlook. We also considered the possibility of a sharper rise in the term premium relative to our base case for a more gradual increase depending on how the Fed handles the shrinking of its balance sheet. Second, we believe the Omicron strain presents downside risks to China’s growth outlook, especially given the influx of visitors for the Winter Olympics. We expect the country to maintain its zero-COVID policy – at least optically – in this politically important year. This heralds more restrictions on activity, even as Beijing appears bent on achieving its growth target this year by loosening policy. Third, we see potential conflict risks surrounding Iran’s nuclear ambitions, Russia’s massing of troops near Ukraine and, to a much lesser extent, Taiwan. These could rattle investors at a time the market’s attention to geopolitics is low. See our geopolitical risk dashboard. Our bottom line: We prefer equities in the inflationary backdrop of the strong restart of economic activity. We favor developed market stocks as we dial down risk slightly and are underweight government bonds.
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 14, 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 USA Index, MSCI Europe Index, ICE U.S. Dollar Index (DXY), MSCI Emerging Markets Index, Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, spot gold, Refinitiv Datastream Italy 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index, Refinitiv Datastream Germany 10-year benchmark government bond index and Refinitiv Datastream U.S. 10-year benchmark government bond index.
Market backdrop
U.S. CPI hit a 40-year high of 7% with little market reaction. We see the report as more evidence that supply factors are shaping the macro backdrop. The fundamental culprits are the sputtering restart of supply and reallocation of resources spurred by the pandemic. The problem: policymakers can’t stabilize inflation without destroying activity. It’s a key reason why central banks have flagged a muted response to inflation. We see inflation settling at a level higher than pre-COVID.
Week Ahead
- Jan.17 – China urban investment, industrial output, retail sales and Q4 GDP
- Jan. 18 – UK unemployment data Bank of Japan policy decision
- Jan. 19 – UK CPI
- Jan. 20 – U.S. Philly Fed Business Index
The stream of fourth-quarter corporate results picks up pace this week, with a key question whether companies can keep up their profit margins by passing on input price increases. Investors may also get an early read on the impact of Omicron on future results. Some 8% of S&P 500 companies are set to report this week, dominated by financials, healthcare and real estate. UK inflation and employment could guide the Bank of England in the timing and magnitude of further rate rises.
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