• The Fed is talking tough on inflation, predicting a large and rapid rise in inflation
rates, but we think it won’t be entirely up to scratch and will have to live with inflation.
• The S&P 500 posted its biggest weekly gain since 2020 and bond yields rose.
Chinese stocks rebounded strongly after authorities reassured a panicked market.
• This week’s economic data is expected to show a deterioration in economic activity and
consumer sentiment due to the war in Ukraine and high inflation.
The Fed last week signaled a large and rapid increase in its key rate over the next few months.
two years and took a surprisingly hawkish tone, indicating that he is ready to go beyond
normalize in an attempt to control inflation. It’s easy to talk tough, and we think the Fed is
it is unlikely to fully respect its projected rate path. The reason? it would come too
a high cost for growth and jobs. We now see higher Fed risk
slamming the brakes on the economy as he was able to talk to himself in a corner.
The Federal Reserve has kicked off its hiking cycle with a quarter-point increase – the first since 2018. The decision was expected. What surprised was the Fed’s stated goal to get the fed funds rate to 2.8% by the end of 2023 (see the pink dots on the chart). This level is in the territory of destroying growth and employment, in our view. At the same time, the Fed’s latest economic projections pencil in persistently high inflation but low unemployment – even as it has called current labor conditions tight. We believe this means the Fed either doesn’t realize its rate path’s cost to employment or – more likely – that it shows its true intention: to live with inflation. We think this is necessary to keep unemployment low because inflation is primarily driven by supply constraints and high commodities prices.
The Bank of England (BoE), the first major developed market (DM) bank to kick off the current hiking cycle, increased its policy rate for the third time to 0.75%. Like the Fed, the BoE recognized additional inflation pressures from high energy and commodity prices. It also signaled that it may pause further rate increases, with rates back at pre-pandemic levels. We believe this means the BoE is willing to live with energy-driven inflation, recognizing that it’s very costly to bring it down. The BoE provides a glimpse of what other DM central banks may do once they get back to pre-pandemic rate levels and the effect of rate rises on growth become apparent. The Fed’s tone may change as the consequences for growth become more apparent after aggressively hiking this year. The Fed last week perhaps wanted to appear tough by implying even more rate increases in future years to keep inflation expectations anchored, in our view, without expecting to deliver those hikes. To be sure: The Fed will normalize policy because the economy no longer needs pandemic-induced stimulus. It has also signaled it will start reducing its balance sheet, marking the start of quantitative tightening. Finally, we expect the Fed to raise the fed funds rate to around 2% this year – close to pre-pandemic neutral levels – and then pause to evaluate the effects. What are the risks? Central banks are in a tough spot. First, they may start to believe some of their own rhetoric – and think they can raise rates well above neutral levels without damaging growth. They could hike too much, too fast as a result – and plunge economies into recession. We think this risk has risen since last week’s Fed meeting. Second, inflation expectations could de-anchor and spiral upward as markets and consumers lose faith that central banks can keep a lid on prices. This could force them to act aggressively amid persistently high inflation. Our bottom line: Last week’s central bank actions reinforce our views. We see more pain ahead for long-term government bonds even with the yield jump since the start of the year. We expect investors will demand more compensation for the risk of holding government bonds amid higher inflation. We stick with our underweight to nominal government bonds on both tactical and strategic horizons. We think the hawkish repricing in short-term rates is overdone and prefer short-maturity bonds over long-term ones. We prefer to take risk in equities over credit in the inflationary backdrop because we expect real – or inflation-adjusted – yields to stay historically low. We added to the DM equity overweight two weeks ago. We still like the overweight in this environment but see a differentiated regional impact from higher energy prices.
Market backdrop Stocks rallied and government bond yields climbed last week after the Fed raised rates and Chinese policymakers soothed beaten-down Chinese markets. Chinese equities rebounded after officials suggested an end to the crackdown on tech companies and announced a relaxation of Covid restrictions to hit growth targets. We believe China’s ties to Russia have created a risk of geopolitical stigma, including potential sanctions.
Investment themes
Living with inflation
• We expect central banks to carry on with normalizing policy. We see a higher risk of the Federal Reserve slamming on the brakes to deal with supply-driven inflation after it raised rates for the first time since the pandemic. It projected higher-than-expected policy rates over the next two years and struck an unrealistically hawkish tone.
• It’s easy to talk tough, and we believe the Fed is unlikely to deliver on the rate hikes. Markets for now agree, with U.S. two-year Treasury yields well below the Fed’s projection for policy rates by the end of 2023.
• Normalization means that central banks are unlikely to come to the rescue to halt a growth slowdown by cutting rates. The risk of inflation expectations becoming unanchored has increased as inflation becomes more persistent. • We believe the cumulative response to rising inflation will be historically muted. DM central banks have already demonstrated they are more tolerant of inflation.
• The Bank of England hiked rates for a third time but signaled that it may pause policy normalization on concerns about the growth outlook from spiraling energy costs. This is the bind other central banks will likely face this year.
• The European Central Bank struck a hawkish tone earlier this month, planning to wind down asset purchases and leaving the door open for a rate increase later this year. We expect it to adopt a flexible stance in practice given the material hit to growth we see from higher energy prices.
• Investment implication: We prefer equities over fixed income and remain overweight inflation-linked bonds.
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.
• We saw the confusion play out with the aggressively hawkish repricing in markets this year – and central banks have sometimes been inconsistent in their messages and economic projections, in our view.
• The Russia-Ukraine conflict has aggravated inflation pressures and has put central banks in a bind.Trying to contain inflation will be more costly to growth and employment, and they can’t cushion the growth shock. • The sum total of expected rate hikes hasn’t changed much even with the Fed’s hawkish shift. • Investment implication: We have tweaked our risk exposure to favor equities at the expense of credit.
Navigating net zero
• Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story, it’s a now story.
• The West’s decision to reduce reliance on Russian fossil fuels will encourage fossil fuel producers elsewhere to increase output, but we don’t expect an overall increase in global supply and demand. We see the drive for greater energy security accelerating the transition in the medium term, especially in Europe.
• The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher inflation, in our view. Risks around a disorderly transition are high – particularly if execution fails to match governments’ ambitions to cut emissions.
• We favor sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from the transition, such as tech and healthcare, because of their relatively low carbon emissions.
• Investment implication: We favor DM equities over EM as we see them as better positioned in the green transition.
By Jean Boivin Head – BlackRock Investment Institute
