BlackRock’s Weekly Market Commentary: A restart relay

By BlackRock Investment Institute

The restart of economic activity is real and broadening. This supports our pro-risk stance and our underweight in government bonds as we believe their low yields don’t reflect the restart’s momentum. We see the U.S. passing the baton to Europe and other DMs in leading the restart, whereas the delta variant may challenge some EMs lagging in vaccinations. This supports our tactical overweight in European equities and our recent downgrade of EM equities and debt to neutral.

Chart of the week

Purchasing managers’ index in the U.S., euro area and EM, 2019-2021

Sources: BlackRock Investment Institute, with data from Haver Analytics, August 2021. Notes: The chart shows the monthly Markit composite purchasing managers’ index (PMI) for the U.S., euro area and emerging markets. Emerging markets include Brazil, China, Czech Republic, Egypt, India, Indonesia, Kenya, Lebanon, Malaysia, Mexico, Nigeria, Philippines, Poland, Russia, Saudi Arabia, South Africa, Thailand, Turkey, United Arab Emirates and Vietnam, as defined by IHS Markit.

Global economies will be going through two distinct phases. Right now, the restart of economic activity causes a spurt in growth. Eventually, we see this settling into an expansion around trend growth. Beyond that point we see an unusually wide range of potential outcomes. The U.S. is still in the first phase. Growth likely peaked in the second quarter, but last week’s strong jobs report showed the restart is still in full swing. Growth momentum in the euro area appears to be catching up now, as indicated by purchasing managers’ index (PMI) data on the chart. In contrast, the EM PMI this year has trended lower toward 50 – a reading below which suggests stagnation – reflecting challenges in many EMs where renewed outbreaks threaten lockdowns and more dire public health outcomes. China’s potential slowdown, exacerbated by renewed outbreaks, may also spill over to EMs, in our view. Over the long term, we see a greater risk of permanent damages in some EMs due to slow vaccinations and more limited policy space.

China is the only major economy that has surpassed the pre-Covid projections of its growth trend. Consensus expectations see the U.S. returning to trend in the fourth quarter of 2021, and point to a return to pre-Covid trend by the end of 2022 for Europe – with growth rates similar to those over the last decade. Even though the pace toward a complete restart differs, we see some common drivers across DMs, such as pent-up consumer demand, especially in the hardest-hit services sectors.

The uneven pace of the restart is reflected in regional corporate earnings. Nearly 90% of S&P 500 companies have reported second-quarter results by August 6, and 87% of them had beat forecasts on both profit and sales – the highest since 2011. Yet stocks that have beaten expectations have on average not been rewarded, while those that undershot have been punished. We see this as consistent with the restart dynamics: very strong earnings – but just for the duration of the restart. About 90% of MSCI Europe companies have reported earnings, with just over half of them beating estimates. The earnings revision ratio – the share of earnings estimate upgrades vs. downgrades – has been rising in Europe and catching up with that in the U.S. This supports our overweight on European equities and neutral position in U.S. equities on a tactical basis.

The unprecedented restart has also led to unusual supply and demand dynamics – and volatility in growth and inflation data. This has manifested in recent market behavior, notably rising stocks and falling bond yields in the U.S. Record-high stocks may have priced in much of the powerful restart, and we believe the current yield levels are too low given the strength of the restart. The mixed market signals highlight a key question among investors: What lies beyond the restart? We see an unusually wide range of potential outcomes – and believe it’s all the more important to have an anchor. We stick to our new nominal investment theme: Major central banks are slower to respond to rising inflation than in the past, keeping nominal bond yields lower and real rates negative – a positive for risk assets.

The bottom line: The leadership of global restart looks set to pass on from the U.S. to Europe and other DMs, and we see a risk that the restart could stall in some EMs due to worsening virus dynamics and more limited policy room. This supports our tactical overweight on European equities and recent downgrade of EM assets to neutral. We also believe current government bond yield levels do not reflect the powerful momentum of the economic restart, and this supports our underweight in government bonds.