BlackRock’s Weekly Market Commentary: Don’t be surprised by surprising data

By BlackRock Investment Institute

Hotter inflation has materialized and market volatility is rising as the economic restart gathers pace. This is playing out in line with our view that the economy is in a “restart” – not a traditional recovery. We prefer to look through any volatility and see a later “lift-off” from zero rates than markets expect. This means higher-than-expected inflation in the medium term, and underpins our pro-risk stance.

Chart of the week

Outsize Covid-19 surprises in U.S. core CPI and nonfarm payrolls

Sources: BlackRock Investment Institute, with data from Bloomberg, May 2021. Notes: Each dot represents the size of forecast error in month-on-month changes in the core consumer price index (CPI) and in nonfarm payrolls, for each month. The forecast error is the gap between realized data and consensus forecasts, and expressed as the number of standard deviations away from the average forecast error. We calculate the mean and standard deviation of forecast errors using monthly data between February 1997 and February 2020 to exclude the volatile pandemic period from the analysis. We use data as they were first reported and do not include subsequent revisions. There is a +121 standard deviation forecast error in the payrolls data in May 2020, and that dot is not shown in the chart.

The ongoing restart features both supply bottlenecks and pent-up demand – different from a typical business cycle recovery where demand typically catches up slowly to supply. Economic forecasters have had a hard time plotting out how these unusual dynamics will play out month to month, causing unusually large surprises on the upside and downside. See the chart above. This is why we need to be humble about our ability to forecast month-by-month dynamics, and to steer away from extrapolating too much from any outsize data surprises as the restart plays out over coming months. We expect supply disruptions to resolve eventually, but uncertainty around the timing could lead to noisy inflation readings – underscored by much higher-than-expected April consumer price index (CPI) data. This is why we recently turned neutral on Treasury Inflation-Protected Securities on a tactical basis, even as we believe markets are still underpricing the potential for above-target inflation in the medium term.

We see inflation trending up over the next few years, but expect inflation and growth data to be erratic in the near term as a unique economic restart takes shape. A look under the hood of April’s CPI data showed airfares, lodging and car rental were key drivers of rising inflation, as prices reset to pre-Covid levels. On their own, broad-based inflation pressures from the restart should recede as supply eventually comes back, sector-specific bottlenecks are resolved and the economy fully reopens. How this plays out month to month is highly uncertain. But the current dynamics will not be enough to sustain inflation above target, in our view, which will come instead from a delayed monetary policy response compared to history.

Markets appear primed to seize on any upside surprises to growth and inflation data as implying a more rapid lift-off from zero rates than the Fed policy makers’ own projections indicate. We believe near-term data bears very little on the policy rate path. The Fed is operating under a fundamentally different framework, which makes the bar to divert from this policy path very high. Two key developments would likely need to take place before the Fed considers a liftoff. First, the realized core personal consumption expenditures (PCE) price index – the Fed’s preferred inflation gauge – stays at or around the central bank’s 2% target for a sustained period of more than just a few months. Second, the Fed’s inflation projection points to a prolonged period of moderately above-target inflation. Neither of these conditions is close to being met.

As a result, we believe the expectation of a faster lift-off is premature and inconsistent with the Fed’s new framework. This implies markets are underappreciating medium-term price pressures that we believe will result from both the Fed’s new policy framework as well as higher production costs and higher public debt levels. This keeps us pro-risk in the medium term. We see real, or inflation-adjusted, yields staying low amid rising inflation pressures – and underpinning equities.

On a tactical horizon, we prefer looking through any near-term volatility and staying invested as the restart broadens out. Our tactical pro-risk view is mainly expressed in overweighting equities and underweighting government bonds. We see two main risks to this stance: first, a market overreaction to the near-term growth rebound and inflation overshoot; and second, a Fed miscommunication of its intent to start tapering asset purchases – or a market misinterpretation of such an announcement. The recent sell-off in tech shares, despite strong first-quarter earnings, illustrates the potential for hitting air pockets as the economic restart unfolds. This may create opportunities in a sector benefiting from structural trends.