By the BlackRock Investment Institute
Historically low rates ahead
Bond yields have sprinted higher on ballooning inflation and hawkish comments by central banks. Yield spikes have often spelled trouble for stocks, but we believe the past is an imperfect guide in a world shaped by supply shocks. We see central banks normalising quickly – but not slamming the brakes on the economy. This should keep real yields low and underpin equity valuations. The inflationary backdrop and growth momentum led by the U.S. also favours stocks, we believe.
Chart of the week
Fed funds rate and U.S. inflation, 1992-2027
Yields on benchmark 10-year U.S. Treasuries hit three-year highs last week after data showed inflation was still running at levels not seen since the early 1980s. This understandably created angst about equities, especially about stocks of fast growing tech companies. Higher discount rates make future cash flows less attractive. We believe fears about a further downdraft in equities are overblown. The rate hikes we expected are happening faster, but we don’t see central banks raising policy rates beyond neutral levels that neither stimulate or restrain the economy.
Markets have priced in a rapid rise of the fed fund rate to 3% in the next year, followed by a levelling out to 2.5% in five years’ time (the green dotted line in the chart). That’s markedly higher than a month ago (dotted pink line), just before the Fed raised rates and started to talk tough on inflation. We don’t see the Fed going this high. Even if it did, the level would still be historically low compared with previous hiking cycles (red line) and the level of inflation (yellow line).
The big picture
Markets have swiftly brought forward a rise in policy rates in the past year and now are pricing in a steep liftoff. Yet it’s the sum total of rate hikes that matters for equities, in our view, not the timing and speed. Why? We use the cumulative rate for determining future corporate cash flows, not the current rate or bond yields. And the higher the peak rate in this cycle, the bigger the impact because of the compounding effect over time. As a result, we believe equities can thrive when the end destination of policy rates is historically low. Central banks will be forced to live with inflation, in our view, to avoid destroying growth and employment.
We see inflation settling higher than pre-Covid levels because of the supply shocks triggered by the restart of economic activity and the horrific Ukraine war. This means real yields, or inflation adjusted yields, should remain low and underpin equity valuations. We could see long-term yields rising further as investors demand higher compensation for holding them in the inflationary backdrop. This is not necessarily bad news for equities as it could trigger a re-allocation away from bonds into equities.
How about equity fundamentals?
Three things jump out at us as first-quarter results get underway this week. First, the powerful restart is providing a growth cushion for developed markets (DM economies), especially in the U.S. Second, record high profit margins bear close watching. DM companies have been able to pass on increased input costs to consumers and kept labor costs in check – so far. Third, we see the economic fallout of the Ukraine war cutting into earnings even as analysts have been revising up estimates across the board.
We expect estimates for European companies to come down in particular as analysts start factoring in the war’s effects. Companies in the MSCI Europe index are export-oriented and derive just half of their revenues domestically, we calculate, softening the impact a bit. A weaker euro helps, too. All in all, this led us to reduce our overweight in European equities earlier this month. We prefer U.S. and Japanese equities instead.
What are the risks?
First, central banks could trigger a recession by raising rates too high in an effort to contain inflation. Second, inflation expectations could become de-anchored from central bank targets and cause them to slam the brakes. Third, companies could see margins shrink amid escalating input costs and upward wage pressures.
The bottom line
We prefer DM equities in the inflationary backdrop of the restart’s momentum and a historically low sum total of rate hikes. We could see long-term yields rising further as investors demand a higher term premium, or extra compensation for holding them amid high inflation and debt levels.