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Over the past 18 months or so we have been flagging that the new regime of higher macroeconomic and market volatility is playing out and that a new investment playbook is necessary. In this regime, central banks face a sharper trade-off than they have experienced in the past four decades, between crushing growth or living with higher inflation. The banking tumult on both sides of the Atlantic has made crystal clear how important it is to stay nimble and update investment views in real time. This is the new playbook in action amid the volatile economic and market regime. We prefer inflation-linked bonds and very short-term government paper for income. Here’s a summary of our 2023 Global Outlook – Q2 Update: “New investment playbook in action.”
Central banks are deliberately causing recessions by hiking interest rates to try to rein in inflation. We see the banking tumult as a manifestation of the damage and financial cracks that we’ve said would appear from such rapid rate hikes.
Across a swath of different measures, we are seeing economic damage emerge. These include housing, industrial, and consumer indicators. Credit conditions were already tightening before the bank turmoil, and we expect them to tighten further. Yet we don’t see a repeat of the 2008 financial crisis but instead this all reinforces our recession view.
Central banks have also made clear in recent weeks that curbing inflation is not at odds with acting to contain the fallout of the bank tumult. Yet markets have been quick to price in sharp rate cuts. That’s the old playbook.
The chart above shows that the Fed is waking up to this sharper tradeoff. The Fed has been repeatedly too optimistic on both growth and inflation. Its latest projections imply a recession in the months ahead, with growth stalling later in 2023 after a strong start to the year. The Fed still doesn’t plan to cut rates because inflation is persistently above its 2% target. So it is expecting to live with lingering inflation above its target through 2025, even with recession. We don’t expect central banks to come to the rescue with rate cuts this year.
Even so, we think the Fed is underestimating how stubborn inflation is proving due to a tight labor market. In the U.S., this is primarily due to a labor shortage as more people reach retirement age and many retire early. Employers are having to raise wages to attract workers. Europe faces a similar challenge, but the cause of their labor shortage is different. The public sector has grown tremendously during the pandemic, leaving a smaller pool of workers in the private sector. A tight labor market is not likely to ease by itself anytime soon. That means inflation could remain above central bank targets for even longer than they expect.
We estimate that inflation will settle above pre-pandemic levels and the 2% targets of central banks.
Developed market equities are not pricing in in the damage to come. That’s clear in corporate earnings expectations. Cost pressures due to elevated inflation are likely to crimp profit margins.
We like very short-term government paper for income and inflation-linked bonds. We also like emerging market assets that can better withstand the troubles in major economies. We have downgraded investment-grade credit to neutral, and higher-yield to underweight, as we see the banking tumult leading to tighter credit conditions.
Market expectations for rate cuts this year seems overdone to us. Two-year Treasuries could take a hit as any repricing happens. That’s why we prefer inflation-linked bonds and very short-term government paper for income. Treasury bills with maturities of a year or under are more attractive for their income and lack of interest rate risk.
View the full report from the BlackRock Investment Institute, “New investment playbook in action,” by Philipp Hildebrand, Vice Chairman, BlackRock, Jean Boivin, Head, BlackRock Investment Institute, Wei Li, Global Chief Investment Strategist, BlackRock Investment Institute, Alex Brazier, and Vivek Paul, Head of Portfolio Research, BlackRock Investment Institute.
Alex Brazier is Managing Director, Deputy Head of the Blackrock Investment Institute at BlackRock Inc.
Disclaimer
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
© 2023 BlackRock Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. This article first appeared March 30, 2023, on the BlackRock website. Used with permission.
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