Jean Boivin, Head of the BlackRock Investment Institute together with Wei Li, Global Chief Investment Strategist, Alex Brazier, Deputy Head and Elga Bartsch, head of Macro Research, 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.
Central banks are giving ever more hawkish signals to appear to be responsive to surging inflation. Normalizing policy rates to pre-pandemic levels makes sense to us, as the powerful economic restart does not need stimulus. Markets are betting they will raise rates well beyond that. We disagree, as such policies wouldn’t contain inflation without a heavy toll on growth. This is why we believe central banks will live with inflation for years to come as the world shifts to decarbonize.
Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, 4 Feb. 2022. Notes: The 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.
Inflation keeps surprising to the upside, and central banks are quickly pulling back emergency stimulus. The European Central Bank (ECB) last week suggested an early end to asset purchases that have underpinned European bond markets. The Bank of England (BoE) again raised rates, and nearly half of its policymakers wanted a bigger rise. Clearly, this is a big deal. Yet markets are ratcheting up expectations of future rate hikes ever higher, as the chart shows. Even the easing stalwart ECB is now expected to raise rates above zero this year (the yellow line). Market expectations may go higher yet, but we think they are already overdone: Fewer rate hikes will actually be delivered. We believe central banks are talking tough but ultimately will acknowledge that fighting inflation by aggressively hiking will come at too high a cost to growth. Why? Today’s inflation is driven by supply bottlenecks, energy mismatches and resources reallocation. This is why we see the eventual policy response as muted–but brace for bouts of volatility.
We trimmed risk heading into 2022 because we thought confusion over the macro backdrop could stress markets. The confusion now is stemming from central banks, in our view. Many are opportunistically framing policy normalization to pre-pandemic levels as “fighting inflation.” Normalization is prudent, in our view, but justifying it as fighting supply-driven inflation is not. This is not a typical recovery, with a surge in demand overheating the economy, but a world shaped by supply where growth is still below potential. Central banks already have accepted more inflation, and we see this continuing given the costs of pushing it down. The problem: The tough talk may open a Pandora’s box of risks. Central banks may undermine their credibility. Markets could keep pricing in ever more rate rises, increasing the risk of market stresses. Yield spreads between peripheral European bonds and German bunds already widened significantly last week. All this translates into more volatility for now – even as we believe the eventual policy response to inflation will be historically muted.
Tough policy choices and bouts of market volatility are here to stay, we believe. Why? We expect the transition to reach net-zero carbon emissions by 2050 to transform the macro environment. Will it hurt growth or be inflationary? Compared with the past, yes. But we believe the rear-view mirror is irrelevant for what’s ahead. Climate change is here. An orderly transition should boost growth and mitigate inflation versus no climate action or an eventual rush to decarbonize, in our view. Energy prices are a key part of the supply-driven inflation story. Overall production costs will likely rise as the world shifts away from carbon-intensive energy sources. We see this happening whether the shift is prompted by carbon taxes, regulations or consumers simply choosing to pay more to avoid climate damages. The transition’s resource re-allocation will add to inflation, in our view, as demand and supply shift across companies and sectors. Understanding how the net-zero journey will unfold has never been more important. See Managing the net-zero transition.
Our bottom line: Many central bankers want to be seen as doing something about inflation, if only for fear of being seen out of touch. Markets are egging them on by pricing in ever more hawkish policy moves. Our compass: It’s not about what central banks say; it’s about what they will have to do. Central banks eventually will be forced to live with inflation, we believe, given the macro backdrop. We are underweight developed market government bonds as we see investors increasingly demanding higher compensation for the risk of holding government bonds. We keep our modest overweight on equities because of the still-low sum total of expected policy rate hikes, but are bracing for bouts of volatility along the way. We see this creating opportunities for those with long investment horizons after a tough start for risk assets this year.
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 February 3, 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.
Market backdrop
Bond yields jumped around the globe amid hawkish policy signals and strong economic data. The ECB suggested it would wrap up its asset purchases earlier than expected and declined to rule out a rate increase this year after euro area inflation rose to a record 5.1%. The BoE raised rates again, and the latest U.S. jobs trends were much stronger than expected. What’s key: The cumulative pricing for rate hikes hasn’t changed and is a historically muted response to higher inflation.
Week Ahead
- Feb. 7 – China Caixin Services PMI
- Feb. 10 – U.S CPI inflation
- Feb. 10 – China total social financing
- Feb. 11 – U.S. University of Michigan sentiment: UK preliminary GDP
U.S. CPI data are in focus this week as markets are increasingly pricing in faster and more aggressive Fed rate hikes amid 40-year high inflation. The problem: This is a unique restart that will quickly slow down on its own. Inflation is driven by supply constraints following a huge shift to goods demand, not an overheating economy. So the old policy playbook of aggressively raising rates won’t work, in our view. We still see a historically low sum total of rate hikes supporting stocks.
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