New investment playbook in action

2023 Global Outlook - Q2 update

March 30, 2023 | The banking tumult on both sides of the Atlantic has made crystal clear how important it is to stay nimble and update investment views in real time. This is the new playbook in action amid the volatile economic and market regime. We prefer inflation-linked bonds and very short-term government paper for income.

Outlook in chart (PDF) Outlook in chart (PDF)

Investment themes

Pricing the damage

Financial cracks and economic damage are emerging from the fastest rate hiking cycle since the 1980s. What matters: how much damage is in the price and our assessment of market risk sentiment.

Rethinking bonds

We see higher yields, especially in short-term government paper, as a gift to investors after years of being starved of income.

Living with inflation

Central banks are likely to stop their rapid rate hikes when the economic and financial damage becomes clearer, with inflation likely settling above 2% policy targets.

Read details of our outlook update:

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Volatile regime in motion

Over the past 18 months or so we have been flagging that the new regime of higher macroeconomic and market volatility is playing out and that a new investment playbook is necessary. In this regime, central banks face a sharper trade-off than they have experienced in the past four decades, between crushing growth or living with higher inflation.

Central banks are deliberately causing recessions by hiking interest rates to try to rein in inflation. We see the banking tumult as a manifestation of the damage and financial cracks that we’ve said would appear from such rapid rate hikes.

More damage is emerging

Across a swath of different measures, we are seeing economic damage emerge. These include housing, industrial and consumer indicators. Credit conditions were already tightening before the bank turmoil, and we expect them to tighten further. Yet we don’t see a repeat of the 2008 financial crisis but instead this all reinforces our recession view.

Central banks have also made clear in recent weeks that curbing inflation is not at odds with acting to contain the fallout of the bank tumult. Yet markets have been quick to price in sharp rate cuts. That’s the old playbook.

A sharper growth-inflation trade-off

Source: BlackRock Investment Institute, Federal Reserve, March 2023. Notes: The chart shows the progression of the median Federal Open Market Committee projection for Q4 2023 U.S. real GDP growth and core PCE inflation year-over-year, from September 2021 to March 2023.

The chart above shows that the Fed is waking up to this sharper trade-off. The Fed has been repeatedly too optimistic on both growth and inflation. Its latest projections imply a recession in the months ahead, with growth stalling later in 2023 after a strong start to the year. The Fed still doesn’t plan to cut rates because inflation is persistently above its 2% target. So it is expecting to live with lingering inflation above its target through 2025, even with recession. We don’t expect central banks to come to the rescue with rate cuts this year.

Labor shortages = higher inflation

Even so, we think the Fed is underestimating how stubborn inflation is proving due to a tight labor market. In the U.S., this is primarily due to a labor shortage as more people reach retirement age and many retire early. Employers are having to raise wages to attract workers. Europe faces a similar challenge, but the cause of their labor shortage is different. The public sector has grown tremendously during the pandemic leaving a smaller pool of workers in the private sector. A tight labor market is not likely to ease by itself anytime soon. That means inflation could remain above central bank targets for even longer than they expect.

We estimate that inflation will settle above pre-pandemic levels and the 2% targets of central banks.

What does this mean for investing?

Developed market equities are not pricing in in the damage to come. That’s clear in corporate earnings expectations. Cost pressures due to elevated inflation are likely to crimp profit margins.

We like very short-term government paper for income and inflation-linked bonds. We also like emerging market assets that can better withstand the troubles in major economies. We have downgraded investment grade credit to neutral and higher yield to underweight as we see the banking tumult leading to tighter credit conditions.

Yield is back

Market expectations for rate cuts this year seems overdone to us. Two-year Treasuries could take a hit as any repricing happens. That’s why we prefer inflation-linked bonds and very short-term government paper for income. Treasury bills with maturities of a year or under are more attractive for their income and lack of interest rate risk.

Our investment views

Our new investment playbook – both strategic and tactical – calls for greater granularity to capture opportunities arising from greater dispersion and volatility we anticipate in coming years.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, March 2023

Asset	Tactical view	Commentary
Equities		We are overweight equities in our strategic views as we estimate the overall return of stocks will be greater than fixed-income assets over the coming decade. Valuations on a long horizon do not appear stretched to us. Tactically, we’re underweight DM stocks as central banks’ rate hikes cause financial cracks and economic damage. Corporate earnings expectations have yet to fully reflect even a modest recession. We are overweight EM stocks and have a relative preference due to China’s restart, peaking EM rate cycles and a broadly weaker U.S. dollar.
Credit		Strategically, we are overweight global investment grade but have reduced it given the tightening of spreads in recent months. We are neutral high yield as we see the asset class as more vulnerable to recession risks. Tactically, we’re neutral investment grade due to tightening credit and financial conditions. We’re underweight high yield as we see a recession coming and prefer to be up in quality. We’re overweight local-currency EM debt – we see it as more resilient with monetary policy tightening further along than in DMs.
Government bonds		We are neutral in our strategic view on government bonds. This reflects an overweight to short-term government bonds and max overweight to inflation-linked bonds. We remain underweight nominal long-term bonds: We think markets are underappreciating the persistence of high inflation and investors likely demanding a higher term premium. Tactically, we are underweight long-dated DM government bonds for the same reason. We favor short-dated government bonds – higher yields now offer attractive income with limited risk from interest rate swings.
Private markets	-	We’re underweight private growth assets and neutral on private credit from a starting allocation that is much larger than what most qualified investors hold. Private assets are not immune to higher macro and market volatility or higher rates, and public market selloffs have reduced their relative appeal. Private allocations are long-term commitments, however, and we see opportunities as assets reprice over time. Private markets are a complex asset class not suitable for all investors.

Note: Views are from a U.S. dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, March 2023

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Asset	Tactical view	Commentary
Equities
Developed markets		We are underweight. Earnings expectations and valuations don’t fully reflect recession risk. We prefer a sectoral approach: energy and healthcare.
United States		We are underweight. Financial cracks are emerging from Fed rate hikes. We don’t think earnings expectations reflect the recession we see ahead.
Europe		We are underweight. The impact of higher interest rates and elevated inflation pose a challenge for earnings, even as the energy shock fades.
U.K.		We are underweight. Earnings expectations don’t fully reflect the economic damage we see ahead.
Japan		We are underweight. The Bank of Japan looks set to wind down its ultra-loose policy. Japan is exposed to the weaker activity we see in other DM economies.
Emerging markets		We are overweight and have a relative preference over DM stocks due to China’s powerful restart, peaking EM rate cycles and a broadly weaker U.S. dollar.
China		We see short-term opportunities from China’s restart. But geopolitical risks have risen, and we still see long-term, structural challenges and risks.
Asia ex-Japan		We are neutral. China’s near-term cyclical rebound is a positive, yet we don’t see valuations compelling enough to turn overweight.
Fixed income
Long U.S. Treasuries		We are underweight. We see long-term yields moving up further as investors demand a greater term premium.
Short U.S. Treasuries		We are overweight. We prefer very short-term government paper for income given the potential for a sharp jump in Fed rate expectations.
Global inflation-linked bonds		We are overweight. We see market pricing underestimating the risk of persistently higher inflation.
European government bonds		We are underweight. We see investors demanding greater term premium, with peripheral bonds at risk from tighter financial conditions.
UK Gilts		We are underweight. Gilts won’t be immune to the factors we see driving DM bond yields higher. We prefer short-dated gilts for income.
China government bonds		We are neutral. Yields are less attractive relative to those on short-term DM government bonds.
Global investment grade credit		We are neutral. We see tighter credit and financial conditions. We prefer European investment grade over the U.S. given more attractive valuations.
U.S. agency MBS		We’re neutral. We see agency MBS as a high-quality exposure within diversified bond allocations. But spreads near long-term averages look less compelling.
Global high yield		We are underweight. We think spreads are still too tight, given our expectation for tighter credit and financial conditions – and an eventual recession.
Emerging market - hard currency		We are neutral. We see support from higher commodities prices yet it is vulnerable to rising U.S. yields.
Emerging market - local currency		We are overweight due to China’s restart, and we see EM debt as more resilient to tightening financial conditions than DM as EM hiking cycles near peaks.
Asia fixed income		We are neutral. We don’t find valuations compelling enough yet to turn more positive.

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a U.S. dollar perspective. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.

Euro-denominated tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, March 2023

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Asset	Tactical view	Commentary
Equities
Europe ex UK		We are underweight. The ECB looks intent on squeezing out inflation via policy overtightening, making a recession likely. The impact of higher interest rates and sticky inflation pose a challenge for earnings and in our view is set to offset the positive impact from the fading energy shock and boost to export-oriented sectors in the near term from China’s reopening.
Germany		We are underweight. Valuations are moderately supportive relative to peers, but we see earnings under pressure from higher interest rates, slower global growth and medium-term uncertainty on energy supply. Longer term, we think the transition to net zero may bring opportunities.
France		We are underweight. Relatively richer valuations and a potential drag to earnings from weaker consumption amid higher interest rates offset the positive impact from productivity enhancing reforms, favorable energy mix and boost to the luxury sector from China's near-term reopening.
Italy		We are underweight. The economy’s relatively weak credit fundamentals amid a global tightening financial conditions keep us cautious even though valuations and earnings revision trends look attractive versus peer.
Spain		We are underweight. Valuations are moderately supportive relative to peers, but the market’s greater tilt towards financials cloud the earnings outlook amid banking sector woes.
Netherlands		We are underweight. The Dutch stock market is trading at a comparable valuation versus the European market but offer a relatively low dividend yield.
Switzerland		We are neutral. The index’s high weights to defensive sectors like health care and consumer goods provide a cushion amid heightened global macro uncertainty. Valuations remain high versus peers and a strong currency is a drag on export competitiveness.
UK		We are underweight. Earnings expectations don’t fully reflect the economic damage from higher rates we see ahead.
Fixed income
Euro area government bonds		We are underweight. We see investors demanding greater term premium, with peripheral bonds at risk from tighter financial conditions.
German bunds		We maintain our underweight of the long end as we expect a return of term premium to push long-term yields up amid elevated inflation persisting, higher for longer rates, and the ECB's balance sheet unwind. We prefer short-term government paper for income.
French OATs		We are underweight. Elevated French public debt and a slower pace of structural reforms remain headwinds even as French spreads to German bonds are above historical averages.
Italian BTPs		We are underweight. The BTP-Bund spread is too tight amid a deteriorating macro backdrop we think. Recent data revisions have shown a higher deficit/GDP than originally reported for the period 2020-2022. Yet this is offset to some extent by the new government’s relatively prudent fiscal stance and relatively attractive yields.
Swiss government bonds		We are neutral. We don’t see the SNB hiking rates as much as the ECB given relatively subdued inflation and a strong currency. Further upward pressure on yields appears limited given global macro uncertainty.
UK gilts		We are underweight. Gilts won’t be immune to the factors we see driving DM bond yields higher. We prefer short-dated gilts for income.
European inflation-linked bonds		We are neutral. We see euro area inflation falling to the ECB target over a multi-year period, supporting breakeven pricing.
European investment grade credit		We are modestly overweight European investment-grade credit for decent income. We prefer European investment grade over the U.S. given more attractive valuations. We monitor tighter credit and financial conditions.
European high yield		We are neutral. We find the income potential attractive yet prefer up-in-quality credit exposures amid a worsening macro backdrop.

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Note: Views are from a euro perspective, March 2023. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.

Not a repeat of 2008, yet recession is reinforced

The effects of higher interest rates and tightening financial conditions are hitting the economy with several indicators flashing red. We don’t see a repeat of 2008’s financial crisis, yet the bank tumult has reinforced our recession view.

This chart shows that economic damage and financial cracks are emerging across a swath of different measures. These include housing, industrial and consumer indicators.

Source: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2023. Notes: The chart shows a heatmap of key economic indicators from 2006-2023. Series are scored based on the number of standard deviations from average over the period. The squares turning more red represents the indicator worsening. The series used are the following. Mortgage rate: the conventional 30-year mortgage rate, Mortgage Bankers Association; Homebuilder confidence: U.S. National Association of Home Builders Housing Market Index; Residential investment growth: the annual change in U.S. residential private domestic investment, U.S. Bureau of Economic Analysis; Pending home sales: U.S. pending home sales, National Association of Realtors; CEO confidence: U.S. Conference Board CEO Confidence Survey; Small business credit conditions: U.S. NFIB Survey percentage of respondents positive on credit conditions less negative.; Corporate lending conditions: U.S. C&I loan survey – large and medium firms, tightening credit.; Business investment growth: U.S. non-residential private fixed investment; U.S. personal savings rate and U.S. retail sales (the annual change in sales excluding motor vehicle dealers and gas stations, Commerce Department).

We don’t expect central banks to come to the rescue

Bond markets are pricing in rate cuts in 2023 reflecting the old recession playbook where central banks cut rates on signs of economic and financial damages. Yet persistent inflation means we expect rates to stay higher for longer.

These chart shows that markets are pricing in policy rate cuts by major central banks this year.

Source: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2023. Notes: The charts show the forward fed funds rate and the European Central Bank deposit rate through December 2024 as implied by futures prices. Forward looking estimates may not come to pass.

We favor inflation-linked bonds as higher inflation persists

Markets are expecting inflation to fall back near 2%. We think the market is underappreciating the persistence of inflation in a world shaped by supply. We stay overweight inflation-linked bonds as a result.

This chart shows that markets are expecting inflation to fall back to near 2% from currently elevated levels near 6%.

Source: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2023. Notes: The chart shows U.S. CPI and core CPI inflation and market pricing of what inflation will average over the five-year period that begins five years from today – also known as the 5-year/5-year inflation swap. Forward looking estimates may not come to pass.

We’re overweight very short-term bonds for income

Higher short-term rates and the inverted U.S. yield curve make Treasury bills – with maturities of a year or under – more attractive for their income and lower duration risk. Money market funds have seen record inflows as a result.

The chart to the left shows that 3-month Treasury bill yields have spiked since 2021 to near 5%. The chart on the right shows that U.S. money market fund slows continue to increase in flows and total assets since the pandemic.

Source: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2023. Notes: The chart on the left shows the interest rate on the 3-month U.S. Treasury bill. The chart on the right shows the weekly net flow and total assets of U.S. money market funds.