According to analysts at the BlackRock Investment Institute, Federal Reserve policymakers will surprise themselves — and not in a good way, when it comes to stocks and other assets considered risky.
BlackRock has argued that investors are dealing with “regime change” as the COVID-19 pandemic upended an unusual period of mild volatility in output and inflation, heralding a more volatile market environment reminiscent of the early 1980s carries. This is an environment where record levels of debt mean small changes in interest rates will have outsized effects on governments, households and businesses, the research arm of the world’s largest wealth manager has argued.
“Central bankers at the recent Jackson Hole forum began to recognize this reality. But we believe they do not prioritize economic impact over pressure to contain inflation,” the analysts said in a Tuesday note, referring to the monetary policy symposium held in Jackson Hole, Wyoming, in late August.
“It seems that for the time being they do not intend to manage the sharp trade-off between inflation and growth. That’s a big deal. We think bringing inflation back on target for the central bank means crushing demand with a recession,” they wrote. “This is bad news for risky assets in the near term.”
Powell is signaling that the Fed has no intention of backing down on rate hikes, but those hikes won’t solve the biggest problem, BlackRock analysts said, which is low production capacity (represented by the green dotted line in the chart below).
Fed Chair Jerome Powell said in an Aug. 26 speech in Jackson Hole that policymakers are determined to bring inflation back to its 2% target, but that the effort is likely to mark a “sustained phase of the “Below trend growth” would require, which “would mean some pain for households and businesses.”
The problem, according to BlackRock analysts, is that rate hikes will not solve the biggest problem: low production capacity (see the green dotted line in the chart below).
BlackRock Investment Institute
You explain:
The only way the Fed can bring inflation down quickly is to raise rates high enough to drag demand (orange line) down about 2% to what the economy can now comfortably produce. This is well below the pre-Covid growth trend (pink line). But the Fed has yet to acknowledge the high cost of growth or the unusual nature of the labor market restrictions since the pandemic. We estimate that an additional 3 million people would be out of work if demand fell by 2%.
We think the Fed will be surprised at the growth damage caused by its tightening. When the Fed sees this pain, we think they will stop raising rates. We believe that by then it will be too late to avoid a slowdown in economic activity, but the drop will not be deep enough to bring PCE inflation down to the Fed’s 2% target. Instead, we expect inflation to remain close to 3%.
What does this mean for investors? The main conclusion is that the new regime will require more frequent portfolio adjustments, the analysts said, while the time horizon is also crucial.
“In the short term, we are underweight developed market (DM) equities given the deteriorating macroeconomic outlook. Central banks are expected to overrun monetary policy and hold back the economic restart. In our view, the recessions we are forecasting are not priced into equities. That’s why we’re not buying the dip,” they wrote.
Longer term, they said they were slightly overweight DM stocks, which are relatively attractive versus private growth assets – which, like their public counterparts, have yet to be re-rated – and fixed income, where higher yields would likely weigh on expected returns. Meanwhile, sectors expected to benefit most from secular trends like the net-zero crossing, such as technology, are also particularly well represented in the DM stock universe, they said.
Shares fell on Tuesday as US investors returned from the Labor Day holiday, with the Dow Jones Industrial Average DJIA finishing -0.55%, down 173.14 points, down 0.6%, while the S&P 500 SPX down 0.4%, down 0.41% and the Nasdaq Composite COMP , down 0.74%, down 0.7%.