WEEKLY MARKET COMMENTARY


BlackRock Investment Institute 16/May/2022

Why we still prefer stocks over bonds

Market take

Weekly video_20220516

Vivek Paul

Opening frame: What’s driving markets? Market take

Camera frame

Equities have fallen hard this year on the prospect of rapid rate increases to rein in inflation, the tragic war in the Ukraine and a slowdown in China amid widespread Covid-19 lockdowns.

Title slide: Why we stick with equities

Both stocks and bonds have sold off in light of these challenges. Yet, we still prefer equities.

And here’s why:

1: Risks are more priced in now

Firstly, many of those risks are more priced in now to equity markets than they were, keeping valuations comparatively attractive given the sell-off.

2: Living with inflation

Secondly, we see the sum total of Fed rate hikes as being historically low and we think that recession fears are overblown.

Ultimately, we see the Fed choosing to live with inflation a little bit above its 2 percentage target, because going much beyond neutral risks damaging growth and jobs.

3: Reducing portfolio risk

However, we have reduced portfolio risk as a result of the worsening economic outlook. Back in March, we downgraded European equities on account of the energy shock. Just last week, we downgraded Asian assets and coupled that with a closing of the underweight back to neutral of investment grade credit and European government bonds.

So, despite our preference for equities at the whole portfolio level the big sell-off in bonds has created pockets of value in fixed income.

Video outro branding: Here’s our Market take

We see longer-dated yields rising as investors demand more compensation for holding government bonds amid high inflation and debt loads.

This keeps us overall underweight government bonds, giving us a preference for equities at the whole portfolio level, particularly in the U.S.

Closing frame: Learn more:

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Still stocks over bonds

We recently cut risk, but stick with stocks over bonds for now. Equity prices now reflect much of the worsening macro outlook and hawkish Fed, in our view.

Market backdrop

Markets came to grips last week with the trade-off central banks face: choke off growth or live with inflation. Yields fell and stocks bounced off new 2022 lows.

Week ahead

US retail sales and other activity data will give investors a read on growth momentum. We believe the restart from pandemic lockdowns has room to run.

Equities have fallen hard this year on the prospect of rapid rate increases to rein in inflation, the tragic Ukraine war and a slowdown in China. We recently reduced risk, yet keep our modest stocks overweight. Why? The selloff means more of these risks are now priced.  We also believe the Fed’s sum total of rate hikes will be historically low and see recession fears as overblown. We think equities remain more attractive than bonds, even as the historic sell-off in bonds has cut the gap between the two

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Chart of the week

Caution: steep rate path ahead

GMarket pricing of the fed funds rate, Dec. 2021 vs. current

The chart shows expectations for the path of U.S. short-term interest rates based on futures market prices compared to the market's December view of the rate path. The red line shows the series of steep rate rises that the market has quickly priced in a series of steep rate rises, while the yellow l

Sources: BlackRock Investment Institute, with data from Bloomberg, May 2022. Notes: The chart shows expectations for the path of US short-term interest rates based on futures market prices compared to the market’s December expectations of the rate path.

We started the year with an overweight in equities and underweight in bonds. The macro outlook has worsened since then. The Ukraine war added to already high inflation stemming from pandemic-related supply constraints. The Fed started to talk tough on inflation, and the market has quickly priced in a series of steep rate rises (the red line in the chart), whereas it was still expecting a shallow trajectory in December (the yellow line). And we now see a rising risk the Fed will raise policy rates to a level that slows the economy. The latest: Growth in China has slowed amid widespread Covid lockdowns. Both stocks and bonds have sold off in the face of these mounting challenges. We stick with our equities overweight for now. Why? First, much of the risks to growth are now reflected in stock prices, we believe, keeping valuations attractive. Second, we still think the cumulative total of Fed rate hikes will be historically low, given the level of inflation. We see the Fed ultimately choosing to live with core inflation that’s a bit higher than its 2% target, rather than fight it because of the costs to growth and jobs.

Reducing risk

The worsening economic outlook has prompted us to reduce portfolio risk this year. We downgraded European equities in March on the energy shock. We followed with a downgrade of Asian assets last week, coupled with an upgrade of investment grade credit and European government bonds. The sell-off in the bond market has narrowed the gap between the stocks and bonds, in our view, and created pockets of value. We still see longer-term yields rising further as investors demand a higher term premium, or compensation for the risk of holding government bonds amid high inflation and debt loads. As a result, we are not changing our overall bonds underweight and maintain our relative preference for equities.

What are the risks? Today’s inflation is very different from the past 30 years, and central banks need a new playbook. Inflation is always caused by excess demand over a certain amount of supply. That doesn’t mean excessive demand is driving inflation, as has been mostly the case since the 1990s. The real question: Is demand unusually high or is supply abnormally low? We think it’s the latter. The economy is working its way through two major shocks: the pandemic and the war in Ukraine. This has created supply constraints such as a tight labor market (caused by the “Great resignation”) that will take time to resolve. Why does all of this matter? If inflation is caused by supply factors, the Fed faces a stark choice: choke off growth with higher rates – the old playbook - or live with more persistent inflation. The risk is that the Fed fails to recognize the trade-off and pushes rates to such levels they destroy growth and jobs.

Markets are waking up to the risks surrounding this trade-off, and now look to be pricing in a fed funds rate of close to 3.5% in the very long run. If that’s true, equities may have more room to fall: Higher discount rates make future cash flows less attractive. We think the Fed ultimately won’t go this high for fear of hurting growth, but recognize hawkish policy pronouncements can lead markets to believe differently. This is why we brace for more volatility in the short run – and why we are not adding to our equities overweight despite improved valuations.

The bottom line

We stay overweight equities and underweight bonds, but have reduced risk to reflect the worsening macro outlook. The momentum of the restart of economic activity is still strong, especially in the US, so we don’t see a recession ahead.  We prefer developed market stocks, especially US and Japanese equities. We particularly like the US market’s quality bent featuring companies with strong cashflows and balance sheets. We would turn more negative on equities should the risk of the Fed slamming the brakes on the economy materialise and trigger a material slowdown.

Market backdrop

Markets are coming to grips with the stark growth-inflation trade-off central banks are facing to rein in supply-driven inflation: choke off growth or live with higher inflation. Last week, markets started to price in the risk that the Fed will push ahead with the first option. Yields on 10-year US Treasuries fell, and stocks bounced off new 2022 lows. We believe the sharp trade-off will ultimately give the Fed pause before taking rates up to levels that trigger a material slowdown.

US activity data and surveys will shed light on the ongoing restart of economic activity and the shift in consumer spending back to services, from goods. Market concerns around a pronounced slowdown in the US miss the key point that the restart has further room to play out, in our view.

Week ahead

The chart shows that Brent crude oil is the best performing asset this year to date among a selected group of assets, while emerging market equities are the worst.

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  May 12, 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 US dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE US Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (US, 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.

May 17

US retail sales and industrial production; Japan GDP

May 18

UK CPI; Japan trade data

May 19

US Philly Fed Business Index; Japan CPI; UK retail sales

Read our past weekly commentaries here.

Investment themes

01

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.

02

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.

03

Navigating net zero

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.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, May 2022

Legend Granular

Asset Strategic view Tactical view
Equities Equities: strategic Overweight +1 Tactical view - neutral
We increased our strategic equities overweight in the early 2022 selloff. We saw an opportunity for long-term investors in equities because of the combination of low real rates, strong growth and a change in valuations. Incorporating climate change in our expected returns brightens the appeal of developed market equities given the large weights of sectors such as tech and healthcare in benchmark indices. Tactically, we favor developed market equities over emerging market stocks, with a preference for the US and Japan over Europe.
Credit Strategic equities - neutral Tactical view - neutral
We are underweight credit on a strategic basis against a backdrop of rising interest rates. We prefer to take risk in equities instead. Tactically, we have upgraded credit to neutral as the dramatic sell-off this year has restored value in areas such as investment grade. We overweight local-currency EM debt on attractive valuations and potential income. A large risk premium compensates investors for inflation risk, in our view.
Govt Bonds Strategic equities - neutral Tactical view - neutral
We are strategically underweight nominal government bonds given their diminished ability to act as portfolio diversifiers with yields near lower bounds. We see investors demanding higher compensation for holding government bonds amid rising inflation and debt levels. We prefer inflation-linked bonds instead. Tactically, we also underweight government bonds as we see the direction of travel for long-term yields as higher – even as yields have surged in 2022. We prefer inflation-linked bonds as portfolio diversifiers in the higher inflation regime.
Private markets Strategic equities - neutral Tactical view - neutral
We believe non-traditional return streams, including private credit, have the potential to add value and diversification. Our neutral view is based on a starting allocation that is much larger than what most qualified investors hold. Many institutional investors remain underinvested in private markets as they overestimate liquidity risks, in our view. Private markets are a complex asset class and not suitable for all investors.

Notes: Views are from a US dollar perspective,  March 2022. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction,  May 2022

Legend Granular
Equities

Asset Tactical view
Developed markets Developed markets
We overweight DM stocks amid supportive fundamentals, robust earnings and low real yields. We see many DM companies well positioned in the inflationary backdrop thanks to pricing power. We prefer the US and Japan over Europe.
United States
United States
We overweight US equities due to still strong earnings momentum. We see the Fed not fully delivering on its hawkish rate projections. We like the market’s quality factor for its resiliency to a broad range of economic scenarios.
US small caps
US small caps
We are overweight US small-caps. We see potential in this segment of the US equity market to benefit from the cyclical rebound in domestic activity.
Europe
Europe
We reduce our overweight in European equities as we expect the energy shock to hit European growth hard. We like the market’s cyclical bend in the inflationary backdrop and expect the ECB to only slowly normalise policy.
UK
UK
We are neutral UK equities. We see the market as fairly valued and prefer other DM equities such as US and Japanese stocks.
Japan
We increase our overweight to Japan equities on supportive monetary and fiscal policies - and the prospect of higher dividends and share buybacks.
China Emerging markets
We cut our modest overweight to Chinese equities to neutral on a worsening macro outlook. China’s ties to Russia also have created a new geopolitical concern that requires more compensation for holding Chinese assets, we think.
Emerging markets Emerging markets
We are neutral EM equities and prefer DM equities, given more challenged restart dynamics, higher inflation pressures and tighter policies in EM.
Asia ex-Japan Asia ex-Japan
We are neutral Asia ex-Japan equities. We prefer more targeted exposure to China because of easing monetary and regulatory policy.

Fixed income

Asset Tactical view
US Treasuries US Treasuries
We underweight US Treasuries even as yields have surged this year. We see long-term yields move up further as investors demand a higher premium for holding governments bonds. We prefer short-maturity bonds instead.
Treasury Inflation-Protected Securities Treasury Inflation-Protected Securities
We overweight US TIPS as we see inflation as persistent and settling above pre-Covid levels. We prefer TIPS as diversifiers in the inflationary backdrop.
European government bonds
We upgrade European government bonds to neutral. Market pricing of euro area rate hikes is too hawkish, we think, given the energy shock’s hit to growth.
UK Gilts UK Gilts
We are neutral UK Gilts. We see market expectations of rate hikes as overdone amid constrained supply and weakening growth.
China government bonds
We cut Chinese government bonds to neutral. Policymakers have yet to take easing actions to avoid a slowdown, and yields have fallen below US. Treasuries
Global investment grade
We upgrade investment grade credit to neutral as this year’s sell-off has made valuations more attractive. Coupon income is the highest in about a decade.
Global high yield
We are neutral high yield. We do not expect credit spreads to tighten but find the income potential attractive. We prefer to take risk in equities.
Emerging market - hard currency
We are neutral hard-currency EM debt. We expect it to gain support from higher commodities prices but remain vulnerable to rising US yields.
Emerging market - local currency
We are modestly overweight local-currency EM debt on attractive valuations and potential income. Higher yields already reflect EM monetary policy tightening, in our view, and offer compensation for interest rate risk.
Asia fixed income
We downgrade Asia fixed income to neutral. A worsening macro outlook and geopolitical concern about China’s Russia ties make Chinese assets riskier, in our view. Outside China, we like Asian sovereigns and credit for income.

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Source: BlackRock Investment Institute Notes: Views are from a US dollar perspective as of May 2022. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.

Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Vivek Paul
Senior Portfolio Strategist – BlackRock Investment Institute
Natalie Gill
Portfolio Strategist – BlackRock Investment Institute

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Sources: Bloomberg unless otherwise specified.

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