BlackRock：Market view of rate hikes too hawkish

We trimmed risk heading into 2022 because we thought confusion over the macro backdrop could stress markets. The confusion now is stemming from central banks, in our view. Many are opportunistically framing policy normalization to pre-pandemic levels as “fighting inflation.” Normalization is prudent, in our view, but justifying it as fighting supply-driven inflation is not. This is not a typical recovery, with a surge in demand overheating the economy, but a world shaped by supply where growth is still below potential. Central banks already have accepted more inflation, and we see this continuing given the costs of pushing it down. The problem: The tough talk may open a Pandora’s box of risks. Central banks may undermine their credibility. Markets could keep pricing in ever more rate rises, increasing the risk of market stresses. Yield spreads between peripheral European bonds and German bunds already widened significantly last week. All this translates into more volatility for now – even as we believe the eventual policy response to inflation will be historically muted.

Tough policy choices and bouts of market volatility are here to stay, we believe. Why? We expect the transition to reach net-zero carbon emissions by 2050 to transform the macro environment. Will it hurt growth or be inflationary? Compared with the past, yes. But we believe the rear-view mirror is irrelevant for what’s ahead. Climate change is here. An orderly transition should boost growth and mitigate inflation versus no climate action or an eventual rush to decarbonize, in our view. Energy prices are a key part of the supply-driven inflation story. Overall production costs will likely rise as the world shifts away from carbon-intensive energy sources. We see this happening whether the shift is prompted by carbon taxes, regulations or consumers simply choosing to pay more to avoid climate damages. The transition’s resource re-allocation will add to inflation, in our view, as demand and supply shift across companies and sectors. Understanding how the net-zero journey will unfold has never been more important. See Managing the net-zero transition.

Our bottom line: Many central bankers want to be seen as doing something about inflation, if only for fear of being seen out of touch. Markets are egging them on by pricing in ever more hawkish policy moves. Our compass: It’s not about what central banks say; it’s about what they will have to do. Central banks eventually will be forced to live with inflation, we believe, given the macro backdrop. We are underweight developed market government bonds as we see investors increasingly demanding higher compensation for the risk of holding government bonds. We keep our modest overweight on equities because of the still-low sum total of expected policy rate hikes, but are bracing for bouts of volatility along the way. We see this creating opportunities for those with long investment horizons after a tough start for risk assets this year.
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