We expect central banks to keep hiking to fight higher inflation – not come to the rescue. We stay risk-off: underweight developed market (DM) stocks and trim credit to neutral. But we are ready to seize opportunities as macro damage gets priced in. We overweight very short-term government paper for income and prefer emerging markets.
Rethinking rates
Market pricing of fed funds rate, March 2023
Source: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2023. Notes: The chart shows the forward fed funds rate through December 2024 as implied by SOFR futures prices as of March 8 and March 17.
Banking troubles on both sides of the Atlantic were roiling markets last week. That’s the latest fallout from the most rapid rate hikes since the early 1980s. We have argued that bringing inflation down would be costly, creating economic damage and cracks in the financial system. This week’s events will crimp bank lending, reinforcing our recession view. As the cracks emerged, market expectations for peak rates plummeted, as the pink line in the chart shows. The reason: hopes that central banks will come to the rescue and cut rates, as they did in the past. That’s the old playbook – and it no longer works. Central banks are set to keep fighting stubbornly higher inflation, and use other tools to safeguard financial stability. Case in point: The European Central Bank raised rates by 0.5% last week. And we see the Fed raising rates this week. Our conclusion: Investors need a new investment playbook and to stay nimble in this new market regime.
The banking stresses that are roiling markets are very different – but what they have in common is that markets are now scrutinizing bank vulnerabilities through a lens of high interest rates. We don’t see a repeat of the 2008 global financial crisis. Some of the troubles that emerged recently were longstanding and well-known, and banking regulations are much stricter now. Instead, this is about a recession foretold. Why? The only way central banks could bring inflation down was to hike rates high enough to cause economic damage. The latest financial cracks are likely to tighten credit, dent confidence – and eventually hurt growth. What does this mean for investing? We see three clear takeaways:
Three takeaways
First, we stay underweight equities and downgrade credit to neutral. We believe risk assets are not pricing the coming recession. This is why we stay underweight DM equities on a tactical horizon of six- to 12-months. We expect reduced bank lending in the wake of the sector’s troubles. The recession is likely to see more credit tightening now. We downgrade our overall credit view to neutral as a result, trimming investment grade (IG) credit to neutral and high yield to underweight. We have a relative preference for European IG because of more attractive valuations versus U.S. peers.
Second, we overweight short-term government bonds. We think this recession will be different. Central banks will not try to resuscitate growth by cutting rates. The reason: persistent inflation. We think major central banks will distinguish their inflation fights from any actions taken to shore up the banking system. The ECB did so last week by hiking rates as it originally telegraphed – even as markets had started to doubt its resolve. We expect the Fed to take a similar approach when it hikes rates this week. The U.S. CPI last week confirmed core inflation is not on track to fall to the Fed’s target. That’s why we could see a reversal of the recent sharp drop in two-year and other short-term government bond yields. As a result, we now prefer even shorter maturities for income in this asset class. We stay underweight long-term government bonds and upgrade inflation-linked bonds given our view inflation is likely to stay well above current market pricing.
Third, we prefer emerging market (EM) assets. Markets have focused on the mayhem in the developed world. Under the radar has been confirmation that the economic restart in Asia from Covid restrictions is powerful. In addition, China’s monetary policy is supportive as the country has low inflation compared with DM. This should benefit EM assets, in our view. As a result, we keep our relative preference for EM stocks. We also go overweight on EM local-currency debt as EM central banks near the end of their hiking cycles and possibly cut rates.
Market backdrop
Short-term government bond yields plunged as the emergence of financial cracks spurred the market’s hopes for sharp rate cuts. Bank shares led losses in Europe and were a drag in the U.S. after the troubles at U.S. medium-sized banks and concerns over a large Swiss financial institution. We think central banks will keep hiking as they both seek to bolster banking systems but distinguish those efforts from the need to keep fighting inflation.
We expect the Fed to press ahead with another rate hike, as the ECB did last week. The Fed’s updated forecasts may prompt markets to price back in rate hikes after the February CPI data showed sticky core inflation. But the Bank of England could pause hikes next week. Global PMIs will help gauge how much rate hikes are denting economic activity.
