A powerful economic restart is underway and our new nominal theme has been playing out, with a hefty jump in inflation expectations but a more muted rise in nominal yields. Against this backdrop, we reiterate our pro-risk stance and refine our tactical asset views.
- 1The new nominal: We see a more muted response of government bond yields to stronger growth and higher inflation than in the past, as central banks lean against any sharp yield rises. Strategic implication: We underweight government bonds amid inflationary pressures in the medium term.
- Globalization rewired: Covid-19 has accelerated geopolitical transformations such as a bipolar U.S.-China world order and a rewiring of global supply chains. Strategic implication: We favor deliberate country diversification and above-benchmark China exposures.
- Turbocharged transformations: The pandemic has added fuel to pre-existing structural trends such as an increased focus on sustainability, rising inequality within and across nations, and the dominance of e-commerce. Strategic implication: We prefer sustainable assets amid a growing societal preference for sustainability.
Pent-up demand powers restart
We are at an uncertain juncture in markets. Investors are grappling with how to interpret unusual growth dynamics and new central bank frameworks. On the first, U.S. activity looks set to restart strongly this year, powered by pent-up demand across income cohorts and sky-high excess savings. Growth outlooks have been catching up, as the chart below shows, but the magnitude of the restart may still be underappreciated.
Forward looking estimates may not come to pass.
Sources: BlackRock Investment Institute and Federal Reserve, with data from Haver Analytics, April 2021. The charts show the level of U.S. GDP and estimates of GDP over time for the global financial crisis and the Covid-19 shock. Both series are rebased to 100 for the year just prior to the shock – 2007 and 2019 respectively. Estimates are taken from the Fed’s Federal Open Markets Committee (FOMC)’s Summary of Economic Projections published through 2008 on the left and 2020-21 on the right, as indicated by the legends. The level of GDP is derived from the FOMC’s expectations of GDP growth from the fourth quarter of the preceding year to the fourth quarter of the current year.
This is in stark contrast to the repeat growth disappointments seen after the global financial crisis – and reflects the different nature of this shock. We see it as more akin to a natural disaster followed by a rapid “restart” – rather than a traditional business cycle recession followed by a “recovery.”
This is why a year ago we warned against extrapolating too much from the steep decline in activity. Now the same is true – but in reverse. U.S. growth will likely peak over the summer but the eye-popping data will be transient: the more activity is restarted now, the less there will be to restart later. We see the rest of the world following the U.S. and reopening as vaccine rollouts pick up pace.
New nominal plays out
The second dynamic investors are grappling with is new central bank frameworks. Our new nominal theme helps us navigate this environment. The Federal Reserve is building credibility in its new framework and has set a high bar to change its easy policy stance, even in face of higher realized inflation.
This has yet to be fully digested by markets, in our view. We see markets still underestimating the potential for the Fed to achieve above-target inflation in the medium term as it looks to make up for persistent undershoots in the past. This is why we think the direction of travel for yields is higher. But the overall adjustment will be much more muted than one would have expected in the past based on growth dynamics – and much adjustment has already taken place.
We expect inflation to build steadily over the medium-term as easy monetary policy allows the U.S. economy to run hot. Nominal long-term yields have risen but less than inflation expectations as reflected in breakeven inflation rates. That has kept real yields negative – a positive for risk assets.
Staying moderately pro-risk
The broadening restart – coupled with our belief that this will not translate into significantly higher rates – underpins our pro-risk stance. We remain overweight equities, neutral credit and underweight government bonds on a tactical basis. Yet we have tweaked some of our tactical views given significant moves in market pricing. See the “Asset views” tab above for more.
Originally Posted on April 26, 2021 – Powerful Restart
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