Global Weekly Commentary: Volatility a key feature of new regime
Volatile new regime
We see volatility as a constant in the new regime. We’re neutral long-term U.S. Treasuries because risks are more balanced after three years of rising yields.
Stocks and bonds rallied last week on milder-than-expected U.S. inflation data. We see the U.S. economy on a weak growth path, with policy rates staying high.
Global PMI data this week will likely confirm that higher interest rates are causing business activity to stagnate. We don’t expect rate cuts this year.
The plunge in long-term U.S. Treasury yields last week on news of slowing U.S. inflation shows volatility is persistent in the new regime of greater macro uncertainty. Compounding this is a disconnect between the latest cyclical market narrative of a strong expansion – and the reality we have just climbed out of a deep economic hole caused by the pandemic. This disconnect risks obscuring the new regime’s opportunities – a key conclusion of our 2024 Outlook Forum last week.
U.S. government bond volatility, 2015-2023
Source: BlackRock Investment Institute, with data from LSEG Datastream, November 2023. Notes: The chart shows volatility in U.S. Treasuries based on the MOVE index. The series is shown in standard deviations from average during the period shown.
Stocks rallied, and yields on 10-year U.S. Treasuries tumbled 19 basis points last week – the biggest one-day move since the March U.S. banking turmoil. The drop came after news of a slower-than-expected pace of inflation. This is keeping bond volatility at much higher levels than before the pandemic, as the chart shows. The current market narrative: Inflation is falling while growth is holding up. We agree with the first part – for now. We see core inflation hitting the Fed’s 2% target in the second half of 2024. The problem: Inflation is falling because rapid rate rises to combat it have pushed U.S. growth trend below pre-Covid levels. We think more of the same is needed to keep inflation down as price pressures resume amid slowing labor force growth and geopolitical shocks. Markets appear to miss this bigger picture, and we see more volatility ahead as they swing between hopes for a “soft landing” and fears about higher rates and recession.
We upgraded long-term Treasuries to neutral on a tactical, six-to-12-month horizon last month because we now see even odds of yields swinging in either direction in this volatile environment. That’s in part because the Fed seems to be at the end of its rate hike cycle. Yet looser fiscal policy and slowing labor force growth will likely force the Fed to keep rates high for longer. Long-term yields should eventually resume their march higher. Why? We expect the term premium, or the compensation investors demand for the risk of holding long-term bonds, to keep rising amid greater macro volatility, large fiscal deficits and high debt issuance.
Indeed, U.S. fiscal challenges have already contributed to volatility, and we see that playing out further. The U.S. government ramped up spending to restart the economy from pandemic lockdowns and launched other stimulus such as the Inflation Reduction Act. Bond issuance ballooned as a result. Higher interest rates are feeding into this cycle by raising government borrowing costs and adding to the debt burden. If borrowing costs stay near 5% as we expect, the U.S. government is poised to spend more on interest payments than on Medicare in a few years time. Investors are struggling to absorb the bond supply. Their indigestion spurred another surge in bond yields earlier this month after an auction for 30-year Treasuries saw historically weak demand.
Higher rates and volatility took center stage at our semi-annual Investment Outlook Forum held last week in New York. Some 100 BlackRock portfolio managers, executives and experts spent two days pinpointing investment opportunities and risks. Adapting portfolios to higher interest rates and mega forces – structural shifts such as geopolitical fragmentation and demographic divergence – were top of mind. Participants debated how to go beyond the obvious beneficiaries of mega forces, and highlighted granular opportunities within sectors and countries such as Japan. There was consensus that the new regime calls for selective and dynamic investment strategies, rather than static and broad exposures. And many saw wider dispersion of security returns – a feature of the new regime – and greater volatility opening opportunities to generate above-benchmark returns. Look for the details in our 2024 Global Outlook slated to come out in early December.
Volatility is a constant in the new regime, with markets quick to extrapolate single data releases. We believe the Fed is ending its hiking cycle – and is set to keep rates high for longer. This underpins why we have turned neutral long-term Treasuries and are overweight short-term Treasuries and European government bonds for income.
U.S. stocks jumped about 2% last week, and 10-year U.S. Treasury yields slid sharply after the U.S. CPI data showed inflation slowing more than expected. Long-term U.S. yields have swung sharply – a reflection of the volatile new regime – after reaching 16-year highs last month as markets hope for sharp Fed rate cuts next year. We don’t think that is likely and see the Fed only starting to trim rates in the second half of 2024.
Global manufacturing and services PMI data out this week will likely confirm that higher interest rates are causing global production and business activity to stagnate. We think most developed market central banks will keep policy rates high for longer to lean against inflationary pressures – even as activity slows.
Euro area, UK flash PMI
U.S. flash PMI; Japan flash PMI, CPI
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 LSEG Datastream as of Nov. 16, 2023. Notes: The two ends of the bars show the lowest and highest returns at any point in the last 12-months, 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, LSEG 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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