Wei Li, Global Chief Investment Strategist at the BlackRock Institute together with Vivek Paul, Senior Portfolio Strategist, 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.
The Russian invasion of Ukraine is a human tragedy. We now know what we are
dealing with: a protracted stand off between Russia and the West. We also think it
has reduced the risk of central banks slamming the brakes to contain inflation. We
are tactically upgrading developed market (DM) stocks as a result. We believe
market expectations of rate hikes have become excessive and have created
opportunities in equities. We downgrade credit, preferring to take risk in equities.
Past performance is no guarantee of current or future results. Forward looking estimates may not come to pass.
Sources: BlackRock Investment Institute, with data from Bloomberg, February 2022. The chart shows the pricing of expected central bank policy rates via 1 year forward overnight index swaps. For example the last point on each chart shows the one year OIS rate four years ahead.
Markets have been hit by a double whammy this year: ever-more hawkish expectations of interest rate hikes and the escalating conflict in Ukraine. In the U.S., markets have pulled forward expected policy tightening. Yet the cumulative total of hikes is little changed (left chart), making for a historically muted response to inflation that is running at four-decade highs. This is why we remain underweight government bonds both tactically and strategically. In the euro area, markets are not only pricing faster hikes by the European Central Bank (ECB) but also see a significantly higher policy end point (right chart). All this is happening while economic fundamentals have not changed materially, and we believe the repricing is now overdone. Central banks are returning to a neutral policy stance by removing emergency stimulus put in place when the pandemic first hit. They won’t go much beyond that to rein in inflation, in our view, because of high costs to growth and employment in an economy that still has not reached potential.
How does the invasion of Ukraine affect the policy landscape? We see fast-rising energy prices exacerbating supply-driven inflation, both delaying and raising its peak. We think central banks will need to normalize policy to pre-Covid settings, and that they will find it tough to respond to any slowdown in growth. In other words, policy rates are headed higher. Yet central banks may face less political pressure to contain inflation as the conflict becomes an easy culprit for higher prices. We believe this will allow them to move more cautiously as they raise rates, especially the ECB. Our conclusion: The invasion has reduced the biggest risk to our investment thesis – policymakers slamming on the brakes or markets thinking they will.
We dialed down risk-taking coming into this year, because we saw a risk of confusion amid a confluence of unique events: a powerful restart of economic activity, spiking energy prices and new central bank frameworks that allow for higher inflation. The confusion we flagged in our 2022 outlook has indeed played out, hitting developed market equities hard amid excessive hawkishness over rate hikes. We believe this has created tactical opportunities as markets will start to realize that central banks have little choice but to live with inflation. We prefer equities in the inflationary backdrop of the strong restart and low real, or inflation-adjusted, yields. Also, valuations are not stretched relative to history when viewed through equity risk premiums – our preferred metric that takes into account the prevailing interest rate backdrop.
We prefer to take risk in equities and downgrade credit in a whole portfolio context, especially given how well credit spreads have held up as rates moved higher. We stay underweight government bonds because we expect long-dated yields to resume their march higher. We see investors demanding greater compensation for holding them amid higher inflation and larger debt loads. Government bonds are also losing their diversification benefits, as shown by their muted response to this year’s equity selloffs. We generally prefer short-dated government bonds as we see the market’s hawkish repricing as particularly overdone at the short end of the curve.
On a strategic horizon, we recently added to overweight in equities to take advantage of this year’s selloff. We remain deeply underweight nominal government bonds and prefer Treasury Inflation Protected Securities instead. Bond markets are not yet pricing in higher medium-term inflation, in our view. We now see faster rate hikes, but believe the historically low sum total is what will really matter for equities. Our bottom line: The new market regime favors equities over 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 February 24, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point this year to date, and the dots represent current year-to-date 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: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
The S&P 500 fell briefly into correction territory last week and then recovered after Russia invaded Ukraine. Russian assets nosedived on the fear of more Western financial sanctions. Government bond prices only rose slightly during the worst of the selloff, once again showing their declining diversification properties in equity pullbacks this year. We see long-term yields headed higher as investors demand more compensation for holding them amid higher inflation.
- March 1 – U.S. ISM manufacturing survey, Germany inflation
- March 2 – Euro area inflation
- March 3 – U.S. ISM non-manufacturing survey
- March 4 – U.S. employment report
We could see the market’s attention return to inflation, growth and central bank policy. The U.S. jobs data will feed into the Fed’s likely decision to raise rates in its meeting later in March, while the ECB will be focused on flash euro area inflation data. We see the market’s view of rate hikes as excessive, particularly for the euro zone. We believe the response of central banks to inflation will be historically muted for fear of hurting growth and employment.
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