By BlackRock Investment Institute
Investors are contemplating very different potential outcomes beyond the economic restart – leaving markets prone to overreacting to news flow, as we witnessed just last week. We see holding on to a clear medium-term anchor as crucial. The new nominal – a more muted monetary policy response to inflation than in the past – is for us such an anchor, and supports our pro-risk stance.
Chart of the week
Estimated GDP path for key economies, July 2021
Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute, U.S. Bureau of Economic Analysis, Eurostat, Cabinet Office of Japan, China National Bureau of Statistics, with data from Refinitiv Datastream and Reuters News, July 2021. Notes: The chart shows actual GDP, and projections of GDP levels in different economies according to latest consensus estimates compiled by Reuters, with data rebased to 100 in Q4 2019. Solid lines represent published GDP data, and dotted lines show median consensus expectations.
The powerful restart is broadening, as we detailed in our 2021 midyear outlook. China’s activity levels already surpassed pre-Covid trend estimates within 2020. We see U.S. activity now back above pre-Covid levels, and restart momentum is now picking up in the euro area and Japan. See the chart above. We see the post-pandemic world as very different from the recovery after the global financial crisis that featured deleveraging, sluggish growth, low inflation and constant policy support. That support helped herald a decade-long bull market in both risk assets and bonds. By contrast, historic fiscal stimulus and innovative monetary policy in response to the Covid-19 shock make a repeat of the 10-year bull market in stocks and bonds unlikely, in our view. Our base case is the new nominal: We expect a higher inflation regime in the medium term – with a more muted monetary response than in the past. This should be positive for equities and neutral for bonds, in our view. Yet we also see the potential for other macro outcomes. In such a noisy and unprecedented economic restart, volatile data and market over-reactions are to some extent expected, in our view.
The new nominal is one of our three themes, along with China stands out and the journey to net zero. It is key to our tactical pro-risk stance and supports our strategic preference for equities over credit and bonds. Tactically we see potential for cyclical shares and regions to benefit from the broadening restart. We are turning positive on European equities – after having upgraded it to neutral earlier in the year when sentiment on this market was negative – and upgrading Japanese equities to neutral. Strategically we see the equity risk premium – our preferred gauge of equity valuations that accounts for interest rate changes – as in line with historical averages. This suggests equities are not overvalued, while credit spreads are near historically tight levels. We also see private market valuations supported in such an environment.
Our second theme – China stands out – stems from our belief it is time to treat China as an investment destination separate from emerging markets (EM) and developed markets (DM) as it is already a distinct pole of global growth. China’s central bank last week announced a decision to cut the reserve requirement ratio, or the amount of cash banks must hold as reserves, to support economic growth that appears to be losing steam. This came sooner than we had expected, yet we still believe the government will maintain its broadly hawkish policy preference to stay focused on the quality of growth. Together with the ongoing anti-monopoly clampdown, this supports our tactically neutral view on China equities and overweight on China bonds. We are positive on Chinese equities and government bonds on a strategic basis.
The journey to net zero is our third theme. We believe markets are underappreciating the profound changes coming, and the transition to net zero carbon emissions will create opportunities across investment horizons. Certain commodities, such as copper and lithium, will likely see increased demand along the journey, in our view. Yet we think it’s important to distinguish between the near-term drivers of commodity prices – such as the powerful restart – and the net-zero transition that will have implications on prices over the long term. Our climate-aware return assumptions sees a green transition to a low-carbon economy improving the outlook for growth and risk assets relative to a no-action scenario.
The bottom line: Investors shouldn’t be surprised by any near-term market whipsaw as volatility is expected to some extent under the unprecedented restart dynamics. We favor equities over credit and government bonds on both a strategic and tactical horizon, informed by our three investment themes. Read details in our 2021 midyear outlook.
