Wei Li, Global Chief Investment Strategist with the BlackRock Investment Institute, together with Alex Brazier, Deputy Head, Beata Harasim, Senior investment strategist and Tara Sharma, Investment Strategist, all forming part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.

Key Points

Earnings Pressure: We see company earnings deteriorating amid a rotation in consumer spending and a sputtering restart. This is partly why we remain cautious on stocks.

Market backdrop: Stocks jumped on hopes of the Fed pausing hikes soon as inflation edges lower. We think that’s premature and see inflation settling above pre-Covid levels.

Week ahead: U.S. activity data could show how much the economic restart is slowing. UK CPI is likely to continue its march up amid high energy costs.

Stocks are rallying as markets believe inflation is waning and the Fed will slow hikes soon. We don’t think the rally is sustainable. Why? We see the Fed hiking rates to levels that will stall the economic restart. Corporate earnings may weaken more as consumer spending shifts and profit margins contract. This is not a typical business cycle, so we expect differentiated regional and sectoral effects. The risk of disappointing earnings is one reason we’re tactically underweight stocks.

Good for Whom?

Goods and services split for U.S. economy and S&P 500 earnings

The pandemic and unique restart of economic activity brought about a massive re-allocation of resources. During the pandemic, consumer spending shifted to goods and away from services. That propped up goods producers’ earnings. That’s changing, in our view. Goods demand is weakening. Overstocked inventories, from retailers to semiconductor firms, are evidence of that. Meanwhile, spending is returning to services. This shift could hit stocks. Why? Earnings tied to goods are expected to make up 62% of S&P 500 profits this year, versus 38% tied to services. See the top bar of the chart. In addition, the stock market isn’t the economy. Goods accounted for less than a third of the U.S. economy in the first half of this year. See the bottom bar. This means a boom in services doesn’t power S&P 500 earnings as much as it does the economy.

Today’s labor market also shows we’re not in a typical business cycle. The labor shortage has been a key production constraint after many people left the workforce during the pandemic. We think higher wages would help normalize the labor market by encouraging workers to return and incentivizing employees to stop hopping jobs for more pay. On the flip side, higher wages also ratchet up companies’ costs and pressure margins. These spending and labor dynamics are unfolding as the restart itself sputters. In Europe, the energy shock amid Russia’s invasion of Ukraine will likely trigger a recession later this year, as we said in Taking stock of the energy shock. The restart is stalling in the U.S. as it bumps into production and labor supply constraints, and we believe U.S. activity is now set to contract.

Earnings View 

What does all this mean for earnings? S&P 500 earnings growth has essentially ground to a halt, we calculate, if you exclude the energy and financial sectors. That’s down from 4% annualized growth last quarter, Bloomberg data show. What’s more, we believe analyst earnings expectations are still too optimistic. There are huge differences between sectors. High oil and gas prices have led to record profits for energy companies. We see these trends persisting for now. The reason: The West is aiming to wean itself off Russian energy and needs other suppliers. In the long run, high prices and profits could be eroded by the march toward decarbonization. The U.S. Senate passed a bill, called the Inflation Reduction Act, that is likely to shake up the sector. It calls for green energy infrastructure investments and tax benefits to incentivize the transition to net zero emissions.

Investment implications

What are the investment implications of a weaker earnings outlook? Stocks have rallied as markets price in hopes the Fed will pivot soon. But we’re not chasing the rally. Why? First, market expectations for a dovish pivot are premature, in our view. We think a pivot will come later as the Fed is for now responding to pressure to tame inflation. Second, we see the market’s views on earnings as overly optimistic. Spending returning to services, slowing growth and looming margin pressures pose risks.

Our bottom line: We are cautious in the short run but are staying invested. We tactically prefer investment grade credit over equities because we think it can weather a slowdown that equities haven’t priced in yet. We remain underweight most DM equities on a tactical basis until we see clear signs of a dovish central bank pivot. We like selected healthcare and energy stocks. We are cautious on tech stocks for now due to their sensitivity to higher rates. We do see strategic opportunities in tech and in healthcare as they’re set to outpace carbon-intensive sectors in the energy transition. Within sectors, we prefer quality firms with the ability to pass on higher costs, stable cash flows and strong balance sheets.

Market backdrop

Stocks marched higher after markets priced in a slowing Fed hiking cycle on softer-than-expected U.S. CPI inflation. We don’t think the equity bounce is worth chasing. We see inflation persisting and settling above pre-Covid levels. We believe the Fed will remain susceptible to “the politics of inflation,” a chorus of voices demanding it tame inflation. Our bottom line: The latest inflation reading isn’t enough to spur the Fed pivot we’ve been waiting for to lean back into stocks.

We’re watching U.S. industrial production and retail sales to see how quickly activity might be slowing. Consensus forecasts see U.S. industrial production improving in July but retail sales cooling for the same month. UK CPI inflation is likely to show a continued increase after the Bank of England revised up its expected peak to above a 13% annual rate earlier this month. Persistently high natural gas prices are likely to keep fuel and power costs elevated.

Week ahead

Aug. 15: Japan Q2 GDP

Aug. 16: U.S. industrial production

Aug. 17: U.S. retail sales, UK CPI

Aug. 18: U.S. Philadelphia Fed business survey

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BlackRock’s Key risks & Disclaimers:

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 8th August, 2022 and may change. The information and opinions are derived from proprietary and non-proprietary 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 material 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 forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

Issued by BlackRock Investment Management (UK) Limited, authorized and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL.

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This information has been accurately reproduced, as received from  BlackRock Investment Management (UK) Limited. No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

Franklin Templeton’s Notes from the Trading Desk offers a weekly overview of what our professional traders and analysts are watching in the markets. The European desk is manned by eight professionals based in Edinburgh, Scotland, with an average of 15 years of experience whose job it is to monitor the markets around the world. Their views are theirs alone and are not intended to be construed as investment advice.

The Digest

Global equities finished higher last week, helped by a weaker-than-expected Consumer Price Index (CPI) in the United States on Wednesday. The MSCI World Index closed the week up 3.0%, the S&P 500 Index closed up 3.3%, the STOXX Europe 600 Index closed up 1.2%, and the MSCI Asia Pacific Index closed up 1.5%.

The inflation print seemed like the sole focus for markets last week, with volumes particularly poor and investors seemingly in a wait-and-see mode through the first part of the week. The CPI report showed that 12-month inflation dropped from 9.1% in June to 8.5% through July, with investors hoping that this does signal a turning point in the trajectory of inflation prints. Outside of that, focus was on Zantac litigation fears in the health care sector, strength in the US technology sector, as well as drought concerns in central Europe. Fund flows were fairly risk-on last week, with large flows into bonds. US equities saw inflows, while European equity funds saw their 26^th consecutive week of outflows US$4.8 billion.

CPI print raises hopes for US “soft-landing”

The US CPI report last Wednesday was the big focus for the markets, and it came in at 8.5% for the year to July, lower than anticipated and down notably from 9.1% in June, which was a 40-year high. Core inflation remained unchanged at 5.9% amidst drops in gasoline prices, as well as airfares and lodgings away from home. However, there were increases in prices for food, core goods and rent.

Again, attention quickly turned to the Federal Reserve (Fed) and the central bank’s possible policy response after the CPI data. The US dollar sold off 1% on the CPI headline, whilst global equity markets rallied. The softer data, combined with last week’s strong July employment report, raised hopes that the Fed could achieve a soft landing for the US economy. One more CPI report is due out before the next Federal Open Market Committee (FOMC) meeting in September, so there is an argument that August’s CPI print will be even more important to the interest-rate decision.

Retail gasoline prices continued to decline at the start of August, and further declines over the next couple of weeks would likely result in a negative headline CPI. Data is suggesting that airfares are also continuing to decline, helped by drops in oil prices. In addition, core goods prices should slow as import prices fall and with higher motor vehicle production in recent months.

Fed speakers were quick to try and calm the market excitement; however, they appeared keen to stress that there was no formal dovish pivot. All agreed that rate rises should continue through next year as inflation remains unacceptably high, but their comments failed to quell any market excitement and the US dollar sold off again through Thursday to reclaim the lows. The market is now pricing in a 55% chance of a 75 basis-point (bp) rate hike in September, down from an 80% probability this time last week. All eyes will be on the release of last month’s Fed meeting minutes, which are due to be released this Wednesday.

Europe

European equities finished higher overall last week, continuing to pull back from recent lows. The STOXX Europe 600 Index closed the week up 1.2%, with the US CPI print the key catalyst. Some 81% of the STOXX 600 companies have now reported earnings, and so far, we are seeing them beat expectations across the main metrics. In regards to earnings, consumer staples has been the winning sector so far, whilst real estate stocks have struggled.

Last week, travel and leisure stocks advanced amid better-than-expected earnings in the gambling space. Real estate stocks also rose amid the pullback in rate-hike expectations. The health care sector garnered the most attention last week, finishing lower amid nervousness over the ongoing Zantac litigation. Low summer market volumes likely exacerbated the selloff in the pharmaceutical sector.

Despite the strength in the market overall, a number of headwinds persist for European corporates, and one area of focus is the Rhine river water level, which continues to drop. This could have the potential to restrict the transportation of goods through central Europe, at a time when the continent is already suffering the worst energy crisis in decades. The Rhine is used to ship everything from fuels, chemicals and grains. Bloomberg reported last Friday that the water level had already fell below the critical 40-centimetre mark, a level where it becomes uneconomical for heavy ships to pass the chokepoint.

The United Kingdom has also experienced a drought, recording the driest summer in 50 years, and the lack of rain has meant that crops have started to show signs of stress.

Power prices in Europe have continued to surge to new highs as the heatwave puts upward pressure on the energy network. We noted last week that French utility company EDF had reported that it is now running nuclear on lower output levels as there is not enough water to cool the reactors. The one-year forward power prices were up 13.2% in Germany last week, whilst in France they were up 14.6%.

Germany’s top network regulator said last week that the country must cut gas use by 20% or face rationing gas, which will have an impact upon output. This is another reminder of how dependent the region is on Russian energy; Russia halted oil flows through a key pipeline amid overdue transit fees. These fees were paid on 12 August and the flows resumed, but the issues have highlighted how disruptive this could still become as we head into autumn/winter.

UK real gross domestic product (GDP) contracted by 0.1% in the second quarter, which followed a 0.8% gain in the first quarter. The second-quarter performance was a little ahead of market expectations for a contraction. UK GDP is likely to come into focus over the next few months after last week’s Bank of England prediction of a five-quarter recession starting in the fourth quarter of this year.

There has been a lot of chatter in the last week on whether European equities can continue to rally, as the MSCI Europe Index is trading at a new 20+ year low versus the MSCI US Index. However, the European economy still faces some strong headwinds.

United States

Last week’s softer-than-expected US CPI inflation data boosted hopes that the country could be past peak inflation, and US equities put in a strong performance amid improved sentiment. The S&P 500 Index closed above 4,200 for the first time since May, with the index up 3.3% last week. Other major indices also performed well, with the small-cap Russell 2000 index up 4.9% last week. It was also notable the CBOE VIX—known as the “fear gauge”—was down 7.5% last week, closing below 20 for first time since April.

Remarkably, with last week’s moves, the S&P 500 Index and Nasdaq are up 18% and 24% respectively from their mid-June lows, which has demonstrated their strong performance over the summer.

There has been a clear improvement in US investor sentiment and the CNN Fear & Greed Index is now on the cusp of a “Greed” reading, something that seemed a long way off less than two months ago when the gauge languished in “Extreme Fear.” In this context, US stocks saw inflows of US$11 billion last week, the biggest in eight weeks.

Looking at sector performance last week, energy stocks surged on the back of a rise in West Texas Intermediate (WTI) oil after the US Energy Information Administration (EIA) lowered its forecast for US supply in 2023. In a “risk-on” environment, defensives lagged.

In terms of other US macro data last week, the July Producer Price Index (PPI) was down 0.5%, which added to the idea that inflation may have peaked. On Friday, the University of Michigan Confidence report saw a surprise uptick to 55.1, showing increased confidence, versus 51.5. and the near-term inflation expectations faded.

Asia

Last week was generally better in Asia, with the softer US CPI number helping stocks close the week higher overall.

Japan’s equity benchmark closed the week up 1.32%, as we saw Prime Minister Fumio Kishida reshuffle his cabinet following the Conservative LDP’s convincing win with its coalition partner Komeito in the parliamentary upper house election last Wednesday. Continuity has been retained, as he appointed many of his top colleagues in key positions. So, the “Abenomics” philosophy looks intact. Kishida also stated that fiscal spending would be used without hesitation to respond to inflation and rising coronavirus infections, as well as signalling that the government are looking to bring back their nuclear energy power plants online to help secure stable energy supplies.

Chinese equities rose overall last week amid news of a record trade surplus last month and a central bank report signalling support for growth. However, COVID-19 cases continued to climb to a three-month high, roughly half of them recorded in the island of Hainan, a popular holiday destination, which was widely locked down last week and caused many tourists to become stranded.

There was some economic news just out from the People’s Bank of China (PBoC) and the government:

• The PBoC interest rates (after a slew of bad July economic data) by 10 basis points (bps) to 2.75%, the first reduction since January. It’s a sign that the central bank is  looking to inject cash into the economy to help cope with the continuing COVID-19 lockdowns.
• More worryingly, July year-on-year Industrial Production (IP) missed estimates, coming in at 3.8% vs estimate 4.3%. Year-on-year July retail sales also missed by quite some margin as they came in at 2.7% vs estimate 4.9%.

Looking ahead to this week, the focus will be on corporate earnings. There are growing fears that China may be falling into a liquidity trap, with falling interest rates failing to stimulate demand. Earnings reports from major companies including Tencent, China Life and the major banks are ahead, and expectations are fairly bleak.

Stocks in Hong Kong closed the week down 0.13%, with technology/semiconductors under notable pressure in the wake of Micron’s warning of weaker chip demand. On Tuesday of last week, there was some  positive excitement as it was rumoured that the government may consider waiving extra stamp duty on homes for mainland Chinese buyers. However, this was subsequently disregarded by state officials.

The other big news was that Hong Kong had eased COVID-19 entry rules for international arrivals from last Friday, requiring them to remain in a hotel for three days before undergoing four days of “home medical surveillance” that will allow limited movement into areas where vaccine pass checks are not mandatory.

Finally, this coming week could see more tension between the United States and China as a US congressional delegation arrives in Taiwan. The visit comes 12 days after House Speaker Nancy Pelosi’s trip triggered some of the highest US-China tension  over the past 25 years. Beijing has asked countries, including India, to reiterate their commitment to the “One China” policy.

Week ahead

Monday 15 August

• China IP, retail sales
• Eurozone Bloomberg economic survey
• US empire manufacturing
• Japan GDP, IP

Tuesday 16 August

• UK job data
• Germany ZEW survey
• Eurozone trade balance
• US building permits, housing starts; IP

Wednesday 17 August

• UK CPI, Retail Price Index, PPI
• Eurozone employment, GDP
• US retail sales, FOMC meeting minutes

Thursday 18 August

• Eurozone construction output, CPI
• US jobless claims, existing home sales

Friday 19 August

• UK consumer confidence, retail sales
• Germany PPI
• European Central Bank current account

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This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of 15 August 2022, and may vary from the analysis and opinions of other investment teams, platforms, portfolio managers or strategies at Franklin Templeton. Because market and economic conditions are often subject to rapid change, the analysis and opinions provided may change without notice. An assessment of a particular country, market, region, security, investment or strategy is not intended as an investment recommendation, nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. This article does not provide a complete analysis of every material fact regarding any country, region, market, industry or security. Nothing in this document may be relied upon as investment advice or an investment recommendation. The companies named herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. Data from third-party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FT affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

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This information has been accurately reproduced, as received from Franklin Templeton Investment Management Limited (FTIML). No information has been omitted which would render the reproduced information inaccurate or misleading. This information is being distributed by MeDirect Bank (Malta) plc to its customers. The information contained in this document is for general information purposes only and is not intended to provide legal or other professional advice nor does it commit MeDirect Bank (Malta) plc to any obligation whatsoever. The information available in this document is not intended to be a suggestion, recommendation or solicitation to buy, hold or sell, any securities and is not guaranteed as to accuracy or completeness.

The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest in a mutual fund should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.