Global Weekly Commentary: Sticking with reduced risk taking
Reaffirming tactical views
The new regime of macro volatility is playing out with weaker growth, persistent inflation and volatile markets. We stick with our dialed-down risk stance.
U.S. stocks slumped and yields surged on a renewed rise in core inflation. We’ve argued inflation will be persistent and see the Fed hiking through year-end.
Central banks are the main attraction this week. The Fed and the Bank of England are set to hike rates again. We see the Fed hiking 0.75% a third time.
The new regime of macro volatility is playing out. Business activity is slumping and higher inflation persists. Central banks are responding with aggressive rate hikes without fully acknowledging the growth damage required. Expected policy rates have jumped further since we downgraded developed market (DM) stocks in July – and recession risks still aren’t factored in. We reaffirm our reduced risk taking stance in our tactical views and favor credit over stocks.
Weak growth, higher rates: a tough combo
Manufacturing PMIs and policy rate pricing, 2022
Sources: BlackRock Investment Institute, with data from S&P and Refinitiv Datastream, September 2022. Notes: the left chart shows S&P Manufacturing Purchasing Managers’ Indexes - a value below 50 indicates contracting activity. The right chart shows the pricing of expected central bank policy rates via forward overnight index swaps. The rate shown is the one-year OIS rate expected starting one year from now.
Business activity is already stalling in the U.S. and Europe, as business surveys show (left chart). Yet the Federal Reserve and the European Central Bank (ECB) are expected to hike rates aggressively with a singular focus on fighting inflation (right chart). Last week’s U.S. CPI report confirmed why we don’t see a soft landing for the economy: inflation is proving sticky as we expected, and central banks are following a whatever-it-takes approach to inflation. This suggests they will overreact to upside inflation surprises but not necessarily respond to downside surprises. The upshot? We expect a policy overtightening that causes recessions. Our whole portfolio approach prompts us to reaffirm our tactical views taking reduced risk. We favor credit given our view that a major default cycle is unlikely and are underweight DM equities given the recession hit we see ahead.
Our investment views had already been based on a mild recession in the U.S. and a deeper one in Europe given the energy crunch – but we don’t think risk assets have come to terms with the combination of deteriorating activity and central banks pushing up rates more quickly. These developments prompt us to stick with our tactical positioning.
Reaffirming tactical views
Our relative preference for high quality credit over equities still holds because of one big aspect: valuation. Higher spreads and government bond yields push up expected returns. And strong balance sheets imply investment grade credit could weather a recession better than stocks. We like investment grade credit, especially with short maturities, over high yield. This reflects our preference to be up in quality amid a worsening macro backdrop.
We’re underweight most DM equities for now. We haven’t bought the dips all year. The combination of an imminent recession and higher rates is still not fully reflected in equity valuations, in our view. If and when both of these are factored in – we would tilt back to neutral on stocks and start to consider signposts to turn more positive.
We are underweight U.S. Treasuries. Overall, we see long-term yields moving higher as investors demand greater term premium – the extra return that investors demand to compensate them for the risk of holding long-term bonds amid persistent inflation and high debt loads. That’s partly why we favor inflation-linked bonds - we expect inflation to persist and this isn’t reflected in current pricing. We’ve also started to prefer short-term over long-term government bonds. We’re neutral European government bonds, but we think the market pricing of the ECB is unrealistically hawkish given the deteriorating growth outlook on the back of the energy crisis.
Our bottom line
The new regime of macro volatility is taking root with weaker growth, persistent inflation and volatile markets. Our whole portfolio approach prompts us to stick with our tactical views especially with the macro deterioration since our last update. We like credit over equities on valuations. High quality credit can also weather a recession better than stocks, we think. Persistent inflation keeps us away from longer-term nominal government bonds and makes inflation-linked bonds more attractive. Shorter-term government bonds are looking better because market pricing of policy rates looks too hawkish to us and recession risks are underappreciated. We think economic damage from rate hikes, and the energy crunch in Europe, will eventually lead central banks to stop hiking, but not anytime soon given persistently high core inflation.
U.S. equities slumped and Treasury yields pushed near this year’s highs after data showing a renewed rise in U.S. core inflation in August, suggesting core higher inflation will persist. That prompted the market to price in a third-straight 0.75% rate hike by the Fed next week and more big hikes for the rest of this year. We see the Fed hiking rates through year-end. Yet we doubt the Fed will acknowledge the recession needed to bring inflation back to its 2% target in its projections next week.
The Fed seems determined to get inflation down to 2% without recognizing the extent of the contraction needed to do so, in our view. The upside surprise in the August U.S. CPI confirms why we expect the Fed to hike rates by 0.75% for a third straight time. The BoE has recognized the inflation-growth trade-off it faces and still seems determined to trigger a recession to fight inflation – especially after the UK fiscal response to the energy shock.
Fed policy decision
Bank of England and Bank of Japan policy decisions
Global flash PMIs
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 Sept. 16, 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.
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