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The writer is global chief investment strategist at the BlackRock Investment Institute
Market sentiment has been swinging between extremes: one day the concern is runaway inflation; the next, the gloomy prospect of a deflationary spiral.
That financial markets are struggling to find their footing should be no great surprise: the world’s worst pandemic for 100 years shut down much of the global economy for close to a year. As it restarts, the question markets are grappling with is: what comes next?
There are no case studies that provide anything close to a working hypothesis. So much in financial markets and global trade has changed since the 1918 influenza pandemic that there is little to be gleaned from that experience — beyond, perhaps, the influence of a similar psychological trauma on our behaviour.
The extraordinary fiscal and monetary response to Covid-19 in many economies also makes forecasting harder. For example, BlackRock estimates that the US has had more than four times the stimulus of the global financial crisis for less than one quarter of the shock: a more than 16-fold difference.
While we are clearly on a different path compared with the post-2008 period, it is possible to envision a broad array of macroeconomic outcomes from here. These range from a “Roaring Twenties” scenario that could boost equity markets to runaway inflation deeply depressing stock and bond prices.
This wide range of macro outcomes explains financial markets’ twitchiness. Flying blind, market participants are desperate to see clues in individual economic data releases or in slight changes in the rate of national Covid cases, even where hospitalisation rates give less cause for concern.
During this turbulence, it helps to have a view that can act as an anchor. Our anchor consists of three prongs. The first is that the restart of economic activity is real and broadening out from the US earlier in the year to Europe and Japan, both of which are benefiting from accelerated vaccination rollouts and the tailwinds from a global capex cycle.
While powerful at the moment of restart, over time we expect growth to settle back to the pre-Covid trend, which is a very good outcome compared with the previous crisis.
Second, the evidence so far is consistent with vaccines proving effective, suggesting new virus strains will probably delay but not derail this restart.
Third, our deep conviction is that monetary responses to rising inflation will be more muted than in past crises or economic cycles. BlackRock calls this thesis the “new nominal”, a play on the idea that nominal yields will be slower to react than previously. Last week’s European Central Bank meeting — the first since its strategy review — provided another sign of accommodative policy support, via a dovish tilt to its forward guidance on interest rates and a higher likelihood of increased asset purchases.
The combination of these three prongs is why we advocate investors take an overweight position in equities in their portfolios on a tactical, or six-to-12-month, horizon.
Naturally, there is nuance. For instance, we recently further upgraded European equities to overweight and shifted our positioning on US equities to neutral — to reflect the relative stages of those regions’ restarts. This shift represents a cyclical tilt. Within US equities, meanwhile, we favour companies able to grow their earnings and profits even amid rising costs. And we also believe there is room for equity sectors such as quality and growth, which underperformed earlier in the year, to catch up.
By contrast, we are underweight nominal government bonds. With yields near the low point of their recent range, we see government paper as having a diminished ability to act as a hedge in the event of falling stock markets. Inflation-linked bonds — particularly in the US compared with the euro area — are more promising. Elsewhere, we advocate neutral tactical positioning in cash and credit.
July and August have often historically proved a stern test for investors. In the northern hemisphere, traders swap their screens for sunloungers and markets find it harder to assimilate surprises.
Our anchor view keeps us constructive on equities, but we acknowledge that markets may yet overreact amid thin summer liquidity and the potential for an unusually wide range of macroeconomic outcomes. We view temporary episodes of turbulence in markets as opportunities to readjust portfolios to a stance in favour of taking more risk.