BlackRock has argued that investors are dealing with a “regime shift” as the COVID-19 pandemic upended an unusual period of mild volatility in output and inflation, heralding a more volatile market environment that carries echoes of the early 1980s.That’s an environment in which record debt levels mean small changes in interest rates will have an outsize impact on governments, households and companies, the research arm of the world’s largest asset manager has argued.
“Central bankers at the recent Jackson Hole forum started to recognize this reality.But we think they’re not prioritizing economic implications over pressure to curb inflation,” the analysts said in a Tuesday note, referring to the late August monetary policy symposium held in Jackson Hole, Wyoming.
“It seems they do not intend, for now, to manage the sharp trade-off between inflation and growth.That’s a big deal.We think getting inflation back to central bank targets means crushing demand with a recession,” they wrote.“That’s bad news for risk assets in the near term.”
Powell is signaling that the Fed has no intention of backing off on rate hikes, but those increases won’t solve the biggest issue, the BlackRock analysts said, which is low production capacity (represented by the green dotted line in the chart below).
Fed Chair Jerome Powell in an Aug.26 speech at Jackson Hole said policy makers were committed to bringing inflation back to its 2% target, but that the effort would likely require a “sustained period of below-trend growth” that would mean “some pain to households and businesses.”
The Wall Street Journal on Wednesday reported that Powell’s commitment to reducing inflation even if it increases unemployment appeared to put the central bank on track to hike interest rates by 0.75 percentage point, rather than half of a percentage point, when policy makers meet later this month.
Traders had already largely priced in a 75 basis point move.
Fed-funds futures traders priced in an 82% chance of a 75 basis point move following the report, up from 73% on Tuesday, according to the CME FedWatch tool .
The problem, according to the BlackRock analysts, is that rate rises won’t solve the biggest issue: low production capacity (see green dotted line in chart below).
BlackRock Investment Institute They explain:
The only way the Fed can get inflation down quickly is by raising rates high enough to force demand (orange line) down by around 2% to what the economy can comfortably produce now.That’s well below the pre-Covid growth trend (pink line).But the Fed has yet to acknowledge the great cost to growth or the unusual nature of constraints in the labor market since the pandemic.We estimate 3 million more people would be unemployed if demand were to contract by 2%.The Fed will be surprised by the growth damage caused by its tightening, in our view.
When the Fed sees this pain, we think it will stop raising rates.It will be too late to avoid a contraction in economic activity by then, we think, but the decrease won’t be deep enough to bring PCE inflation down to the Fed’s target of 2%.Instead, we expect inflation to persist close to 3% What does it mean for investors? The main conclusion is that the new regime requires more frequent adjustments to portfolios, the analysts said, while time horizon is also key.
“In the short term, we’re underweight developed market (DM) equities on a worsening macro outlook.
Central banks look set to overtighten policy and stall the economic restart.The recessions we predict are not priced into equities, we think.That’s why we aren’t buying the dip,” they wrote.
Longer term, they said they are modestly overweight DM equities, which have relative appeal over private growth assets –– those have yet to reprice like their public counterparts –– and fixed income, where higher yields were likely to be a drag on expected returns.Meanwhile, sectors expected to benefit most from long-term trends like the net-zero transition, such as technology, are also particularly well represented in the DM equity universe, they said.
Stocks fell Tuesday as U.S.investors returned from the Labor Day holiday, with the Dow Jones Industrial Average DJIA, -0.55% ending 173.14 points lower, down 0.6%, while the S&P 500 SPX, -0.41% declined 0.4% and the Nasdaq Composite COMP, -0.74% shed 0.7%.
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