• We cut developed market (DM) equities to neutral on a risk of the Fed talking itself into overtightening policy and China adding to a weaker global outlook.
• Stocks plumbed new 2022 lows on fears steep rate rises will trigger a growth slowdown. We see a brighter picture, but this may not become clear for months.
• U.S. PCE inflation data this week are expected to show pressures are slowing. We think inflation will settle higher than pre-Covid levels.
The Federal Reserve signaled its focus is on taming inflation without flagging the big economic costs this will entail. As long as this is the case and markets believe it, we don’t see the basis for a sustained rebound in risk assets. We think the Fed will consider the costs to growth at some point, especially if inflation cools, and expect a dovish pivot later this year. China’s slowdown is a large shock that will be felt over time. We further trim risk and downgrade DM equities to neutral.
China slowdown to ripple across globe
Composite PMIs 2008-2022
The Fed stepped up its rhetoric last week by vowing to bring inflation down at any cost. We think reality will be more complex. First, supply-driven inflation implies the sharpest policy trade-off in decades: between choking off growth via sharply higher rates or living with supply-driven inflation. Second, this trade-off is even more stark amid a weaker global macro outlook. The hit to Chinese growth is starting to rival its 2020 shock and already surpasses the one from the global financial crisis. See the chart. We think this will reduce growth in major economies and nudge up DM inflation at a very inopportune time when higher inflation is already proving more persistent. We had already seen Europe at risk of recession, which prompted us to reduce risk a few weeks ago. As a result, we further downgrade DM equities to neutral from overweight.
The Fed’s hawkish pivot this year has been stunning, and pronouncements on reining in inflation have become regular fare. Chair Jerome Powell just last week said the Fed would keep hiking rates until inflation is “tamed” – a comment that dismisses any trade-off or the lagged effect of monetary policy on the economy. The Fed now appears to be constraining itself to the hawkish side of policy options with such language, just as talking about the jump in inflation being “transitory” last year boxed it in when inflation proved more persistent and forced a sharp pivot. We think the Fed could be forced into another sharp pivot later this year, which we expect rather than a recession. These Fed pivots are driving market volatility, in our view.
Market expectations are now calling for the Fed funds rate to zoom up to a peak of 3.1% over the next year, more than doubling since the start of the year. For the European Central Bank, market pricing reflects four hikes this year and getting to nearly 1.4% next year, well above our estimate of neutral and for an economy at real risk of stagflation this year. The equity selloff this year makes sense from this perspective – if you believe that the market’s view of the Fed and ECB rate paths are right.
The growth reality will be more complex – both from the policy trade-off it faces amid a deteriorating macro backdrop, especially China’s slowdown and Europe facing stagflation. That’s why we expect a dovish pivot later in the year. We stick to our view of the Fed raising rates to around 2.5% by the end of this year – and then stopping to evaluate the effects. We still see the U.S. economy’s momentum as strong – we expect growth of around 2.5% this year, slightly below consensus and far from recession. Equities may have short-term, technical rebounds. Yet until the Fed starts to pivot, we don’t see a catalyst for a sustained rebound in risk assets.
The upshot? We further reduce portfolio risk after having trimmed it to a benchmark level a few weeks ago with the downgrade of European equities. We are now neutral DM equities, including U.S. stocks. But a dovish pivot by the Fed would spur us to consider leaning back into equities. Our change in view prompts us to keep an overweight to inflation -linked bonds from a whole-portfolio perspective. We prefer short-term government bonds for carry, and see scope for long-term yields to rise further as investors demand greater term premium for the risk of holding such debt in this inflationary environment.Overall we remain underweight U.S. Treasuries.
Stocks plumbed new 2022 lows and bond yields edged down last week on concerns that higher rates are causing a growth slowdown. Earnings updates from large U.S. retailers underscored inflation is pinching demand – and eroding profit margins through higher costs. We see this year’s equity pullback in line with the hawkish repricing of the policy rate path. We believe the market will ultimately ease its expectations for policy tightening – but this won’t be clear for months.
U.S. financial conditions have tightened a lot in the last six months – in other words, financing is becoming more costly for individuals and companies. That tightening can be seen across multiple market gauges captured in our indicator: higher bond yields, falling equity prices and soaring mortgage rates. Tighter financial conditions typically slow economic growth. We think they could knock around 40 basis points off GDP over coming months. See the chart.
Why is this happening? The Fed is raising policy rates to achieve precisely that. The goal is to bring down inflation by curbing what it considers to be excessive demand. It’s true that the economy doesn’t need ultra-loose financial conditions like it did at the start of the pandemic: the economic restart is self-sustaining. But there’s a risk that they become too tight and slow the economy too much. We think pushing policy rates past neutral would be too much. Especially since it’s not only tighter financial conditions that could slow growth: the slowdown in China could ripple out and hit the U.S. So the Fed is treading a tricky path, in our view.
BlackRock U.S. financial conditions indicator, 2017-2022
1)Living with inflation
• Central banks are facing a growth-inflation trade-off. If they hike interest rates too much, they risk triggering a recession. If they tighten not enough, the risk becomes runaway inflation. It’s tough to see a perfect outcome.
• The Fed has made clear it is ready to dampen growth. It has projected a large and rapid increase in rates over the next two years, and raised rates by 0.5% in May – the largest increase since 2000. We see the Fed delivering on its projected rate path this year but then pausing to evaluate the effects on growth.
• Normalization means that central banks are unlikely to come to the rescue to halt a growth slowdown by cutting rates. The risk of inflation expectations becoming unanchored has increased as inflation becomes more persistent.
• The Bank of England warned of the poisonous combination of recession and high inflation as it raised interest rates to their highest level since 2009.
• The European Central Bank has also struck a hawkish tone and looks poised to raise rates in July, but we expect it to adopt a flexible stance in practice given the material hit to growth we see from higher energy prices.
• We believe the eventual sum total of rate hikes will be historically low, given the level of inflation.
• Investment implication: We are neutral DM equities after having further trimmed risk.
2)Cutting through confusion
• We had thought the unique mix of events – the restart of economic activity, virus strains, supply-driven inflation and new central bank frameworks – could cause markets and policymakers to misread the current surge in inflation.
• We saw the confusion play out with the hawkish repricing in markets this year – and central banks have sometimes been inconsistent in their messages and economic projections, in our view.
• The Russia-Ukraine conflict has aggravated inflation pressures and has put central banks in a bind. Trying to contain inflation will be more costly to growth and employment, and they can’t cushion the growth shock.
• We see a worsening macro outlook because of the Fed’s determination to slow growth, the commodities price shock and the spillovers from a growth slowdown in China.
• Investment implication: We remain underweight U.S. Treasuries and overweight inflation-linked bonds.
3) Navigating net zero
• Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story; it’s a now story.
• The West’s decision to reduce reliance on Russian energy will encourage fossil fuel producers elsewhere to increase output, but we don’t expect an overall increase in global supply and demand. We see the drive for greater energy security accelerating the transition in the medium term, especially in Europe.
• The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher inflation, in our view. Risks around a disorderly transition are high – particularly if execution fails to match governments’ ambitions to cut emissions.
• We favor sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from the transition, such as tech and healthcare, because of their relatively low carbon emissions.
• Investment implication: We favor equity sectors better positioned for the green transition.