BlackRock’s Weekly Market Commentary: Confusion yields opportunity

By the BlackRock Investment Institute

The situation on the Russia-Ukraine border keeps escalating as President Vladimir Putin ordered troops into eastern Ukraine after recognizing breakaway regions as independent, adding to confusion about the macro and policy outlook. Heightened geopolitical risks keep us from adding risk tactically, even as we see central bank hawkish repricing as overdone. Yet we see an opportunity for long-term investors to raise equity allocations to position for the regime shift we see unfolding.

Chart of the week

Market pricing of future Fed policy rates, current vs. March 2021

Strategically, our asset views – a broad preference for equities over nominal government bonds and credit – have been positioned for the new market regime that we flagged in our 2022 Global Outlook. We see this regime being driven by investors demanding greater compensation, or term premium, for the risk of holding government bonds and our expectation for higher inflation in the medium term. It reinforces a significant reallocation to equities and away from government bonds that has only just begun, in our view. We push back against the notion that the recent pulling forward of rate hike timing and higher bond yields imply lower equity valuations. The cumulative path of rate hikes matters more for valuations than the speed of repricing over the next few years and that path hasn’t materially changed. See the chart. Accounting for the low path of expected rates, equity valuations are not as stretched as traditional metrics suggest, such as price-to-earnings ratios. The equity risk premium – our preferred valuation gauge that considers the outlook for rates and earnings – is in line with its historical average.

Markets have also been on tenterhooks due to the Russian military threat to Ukraine. It reflects the most serious security challenge in Europe since the end of the Cold War. We believe some form of Russian military action and an extended standoff are increasingly likely. Such action could trigger Western sanctions, military aid to Ukraine and an increased NATO presence in eastern Europe. This evolving situation warrants near-term caution. Yet we are also mindful that geopolitical tensions tend to cause short-term gyrations like the ones we’re seeing rather than become ongoing market drivers.

Beyond these tensions, we believe the risk asset pullback is due to markets adjusting to a regime shift and the confusion stemming from the unusual economic restart, a supply-driven surge in inflation and new central bank frameworks. Central banks will likely only return policy to pre-Covid settings rather than aggressively fight inflation. Why? Because this is not your usual inflation. Supply factors are the main drivers rather than the more typical scenario of high demand in an overheating economy. DM economies still have room to grow. So aggressive rate hikes to stamp out supply-driven inflation would only torpedo economic activity that has not yet fully recovered. That’s why we think they will choose instead to live with inflation and only raise rates to remove stimulus that is no longer needed. This should keep real, or inflation-adjusted, yields low and is why we are looking to lean into tactical opportunities. The market may sometimes itch for a bigger policy response to inflation, but this matters more from a trading than a long-term investment perspective.

With that in mind, we believe equity markets are not making the distinction between the repricing in the near-term path of policy rates, which has been sharp yet has a limited impact on long-term expected returns, and the muted change in long-run rate expectations – far more important for equity valuations and returns. The sum total of expected rate hikes over the cycle – key for asset valuations – has not moved materially, particularly in the U.S. That means equities have become more attractively valued than they were prior to the selloff. See more on page 4. Over the long-term, we also see the net-zero transition driving a relative return advantage for “greener” sectors, such as tech and healthcare, over “browner” sectors, such as energy and utilities.

Strategically, we remain underweight DM government bonds. First, we expect yields to move higher as investors demand a greater term premium. Second, yields are close enough to effective lower bounds to limit their role as portfolio ballast in risk-off environments. Tactically, we also see yields moving higher – but also see the hawkish repricing as overdone.