(BlackRock) The Russian invasion of Ukraine is a human tragedy. We now know what we are dealing with: a protracted stand off between Russia and the West. We also think it has reduced the risk of central banks slamming the brakes to contain inflation. We are tactically upgrading developed market (DM) stocks as a result. We believe market expectations of rate hikes have become excessive and have created opportunities in equities. We downgrade credit, preferring to take risk in equities.
Market pricing of future policy rates, current vs. March 2021
Past performance is no guarantee of current or future results. Forward looking estimates may not come to pass.
Sources: BlackRock Investment Institute, with data from Bloomberg, February 2022. The chart shows the pricing of expected central bank policy rates via 1 year forward overnight index swaps. For example the last point on each chart shows the one year OIS rate four years ahead.
Markets have been hit by a double whammy this year: ever-more hawkish expectations of interest rate hikes and the escalating conflict in Ukraine. In the U.S., markets have pulled forward expected policy tightening. Yet the cumulative total of hikes is little changed (left chart), making for a historically muted response to inflation that is running at four-decade highs. This is why we remain underweight government bonds both tactically and strategically. In the euro area, markets are not only pricing faster hikes by the European Central Bank (ECB) but also see a significantly higher policy end point (right chart). All this is happening while economic fundamentals have not changed materially, and we believe the repricing is now overdone. Central banks are returning to a neutral policy stance by removing emergency stimulus put in place when the pandemic first hit. They won’t go much beyond that to rein in inflation, in our view, because of high costs to growth and employment in an economy that still has not reached potential.
How does the invasion of Ukraine affect the policy landscape? We see fast-rising energy prices exacerbating supply-driven inflation, both delaying and raising its peak. We think central banks will need to normalize policy to pre-Covid settings, and that they will find it tough to respond to any slowdown in growth. In other words, policy rates are headed higher. Yet central banks may face less political pressure to contain inflation as the conflict becomes an easy culprit for higher prices. We believe this will allow them to move more cautiously as they raise rates, especially the ECB. Our conclusion: The invasion has reduced the biggest risk to our investment thesis – policymakers slamming on the brakes or markets thinking they will.
We dialed down risk-taking coming into this year, because we saw a risk of confusion amid a confluence of unique events: a powerful restart of economic activity, spiking energy prices and new central bank frameworks that allow for higher inflation. The confusion we flagged in our 2022 outlook has indeed played out, hitting developed market equities hard amid excessive hawkishness over rate hikes. We believe this has created tactical opportunities as markets will start to realize that central banks have little choice but to live with inflation. We prefer equities in the inflationary backdrop of the strong restart and low real, or inflation-adjusted, yields. Also, valuations are not stretched relative to history when viewed through equity risk premiums – our preferred metric that takes into account the prevailing interest rate backdrop.
We prefer to take risk in equities and downgrade credit in a whole portfolio context, especially given how well credit spreads have held up as rates moved higher. We stay underweight government bonds because we expect long-dated yields to resume their march higher. We see investors demanding greater compensation for holding them amid higher inflation and larger debt loads. Government bonds are also losing their diversification benefits, as shown by their muted response to this year’s equity selloffs. We generally prefer short-dated government bonds as we see the market’s hawkish repricing as particularly overdone at the short end of the curve.
On a strategic horizon, we recently added to overweight in equities to take advantage of this year’s selloff. We remain deeply underweight nominal government bonds and prefer Treasury Inflation Protected Securities instead. Bond markets are not yet pricing in higher medium-term inflation, in our view. We now see faster rate hikes, but believe the historically low sum total is what will really matter for equities. Our bottom line: The new market regime favors equities over bonds.
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