BlackRock's Weekly Market Commentary: Keeping our modest equity overweight

By the BlackRock Investment Institute

Coming into 2022, we dialled down overall risk to have a modest overweight to equities on concerns about confusion over the macro environment. We don’t see a need to reduce risk further: the confusion has materialised. The roughly 10% drop in U.S. equities – against our unchanged view of fundamentals – makes them more attractive on the surface. Yet accounting for higher expected interest rates, we don’t think equities have dropped enough for a valuation-driven upgrade.

Chart of the week

Global equities rolling one-year price drawdown, 2010-2022

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, Jan. 28, 2022. Notes: The chart shows the price fall from the maximum level of the MSCI All-Country World Index over the previous one-year period.

Context is crucial. The equity retreat is far from magnitudes that warrant a wholescale reassessment of our views. The chart above shows the major drawdowns – calculated as the peak-to-trough moves over a rolling one-year period – for the MSCI All-Country World index. The takeaway: This pull-back is modest compared with some of the drops seen over the past decade. It also comes after a particularly strong run for risk assets. We believe the drawdown is consistent with our expectation for confusion and heightened volatility. The market has front-loaded pricing of Fed rate hikes over the next two years.

Yet importantly, the sum total of Fed rate hikes hasn’t changed – only the timing. That’s why we think the move in equities cannot be explained by this repricing alone. The U.S. equity risk premium – our preferred valuation gauge as it takes into account both earnings expectations and the interest rate environment – has moved up. It reflects confusion about whether the Fed will go further than priced and deliberately destroy demand to get inflation down, as well as worries on the geopolitical front.

We hold to our view that the unusual market regime we outlined in our 2022 Global Outlook will deliver a second successive year of equity gains and bond losses. The underlying drivers are unchanged. Yet we are also seeing the confusion we had flagged in action, the risk that central banks and markets might misinterpret the unusual restart and supply-driven inflation. The confusion is playing out via a swift market repricing of Fed policy expectations and surging short-term yields.

What might prompt us to change our modest overweight to equities? For an upgrade, we would need to see a deeper retreat or the Fed acknowledging that it will live with some inflation to keep the restart going in a trade-off of its objectives. For a downgrade, we would look to see if the Fed prioritizes fighting inflation over activity – with or without acknowledging a trade-off between its objectives. We got a hint of a tougher inflation stance last week but would need to see more evidence of a more forceful shift in tactics on inflation.

We see uncertainty lingering for a few reasons. First, we think policy confusion can persist. The Fed is rightly intent on normalising policy quickly. The restart does not need stimulus, so the Fed should take its foot off the accelerator. Our worry: The Fed likens the current normalisation to a previous episode in 2015. We think such logic could lead the Fed to over-tighten policy. This is a restart, not a typical recovery. The restart will quickly slow down on its own. Inflation is driven by supply constraints following a huge shift in demand during the pandemic, not an overheating economy – so the traditional policy playbook does not apply.

We think the Fed will eventually back off but are prepared for a bumpy ride in markets. Second, geopolitical risks – while typically not long-lasting market events – could weigh on investor sentiment, including the stand-off over Ukraine and the Iran nuclear deal. Third, equity valuations by our measure are only modestly cheaper and reflect some of the confusion we describe. With market attention on the Fed repricing, companies beating estimates have not yet been rewarded this earnings season. Yet we think fundamentals will prevail, and that’s one reason why we are not downgrading our modest equities overweight.

Our bottom line: We maintain our modest equities overweight, with a preference for developed markets and China. We prefer balanced exposures to beneficiaries of long-term trends such as tech and healthcare on the one hand and cyclicals on the other. We need to see a deeper equity selloff and more clarity on near-term uncertainties to add to our equities overweight.

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