An economic slowdown in China, more aggressive central bank action and stagflation are the main risks to equities in 2022, according to BlackRock strategists.
In 2021, stock markets experienced strong gains while bonds suffered – a pattern that has only happened a few times since 1977, according to the BlackRock Investment Institute. Global equities were up 22.9% while bonds were down 3.8%.
Performance of MSCI World index vs Bloomberg Global Aggregate bond index in 2021
Source: FE Analytics
This year, BlackRock expects that markets will follow the same pattern but with more moderate equity returns this time around.
“We expect interest rates to end at a lower level than in the past given higher inflation,” the group’s strategists said. “That matters more for markets than what rates are going to do next year, in our view.
“We see the higher inflation regime and solid growth as positive for risk assets but bad for bonds for a second consecutive year.”
Although equities edging higher forms the asset manager’s base-case scenario, it warned of three major risks to this expectation. The first is a delayed activity restart due to a global resurgence in Covid-19 infections.
BlackRock said this could be “particularly acute” in China if its zero-Covid approach results in repeated activity shutdowns.
The group said it expects the People’s Bank of China to keep policy looser as a result, a shift already taking place after last year’s economic slowdown.
Another risk is if central banks revert to its previous monetary policy responses in the face of persistent inflation pressures.
The group said: “The BoE [Bank of England] may serve as a test case of a DM [developed market] central bank coming closer to hitting the brakes, prompting the market to price in a risk of a policy reversal on rates by 2024.”
The BoE was the first major developed market central bank to raise rates since the pandemic struck – whereas the US Federal Reserve and the European Central Bank have yet to raise interest rates despite noticeably higher inflation over the past year.
The third risk that BlackRock outlined was if inflation expectations become unanchored from policy targets in the “post-Covid confusion”, which then forces central banks to react aggressively.
The strategists said: “This could lead to stagflation: higher inflation becoming sticky amid stagnating activity.”
Although investors are bracing for three interest rate hikes in 2022 from the US Federal Reserve, BlackRock strategists expect a historically muted response to inflation.
Last year central banks brushed off consistently higher price rises and reiterated their view that it was transitory. They noted that once pressures of the pandemic were over, it would normalise.
This year, how central banks – particularly the Fed – responds to inflation will be the key story, according to BlackRock.
“We expect the Fed to raise rates but see its cumulative response to inflation as more muted than ever before,” the group said.
However, they added that there was a possibility that policymakers or investors misread the situation.
Fed funds rate vs. historical response and expectations, 2018-2025
Source: BlackRock Investment Institute.
Although central banks are set to raise interest rates, BlackRock’s strategists argued that this is “taking the foot off the monetary accelerator”, and not “hitting the brakes”. They said: “We don’t see them responding aggressively to persistent inflation.”
Although three interest rate hikes was more than BlackRock expected, they said what matters is the sum total of the rate hikes.
They noted how mild the Fed’s indicated policy response is as (yellow dots in the chart above), compared to how it would have dealt with inflation in the past, a series of rapid-fire hikes that would have brought the fed funds rate to near 4% over time (as indicated by the green dotted line).
“Importantly, no one is contemplating hitting the brakes – a factor for our modestly pro-equities stance and upgrade to US equities,” the strategists said.
Overall, BlackRock’s positioning going into 2022 remains overweight equities and underweight government bonds.
The group said it is overweight US equities because it does not expect monetary policy normalisation slowing the market’s strong earnings momentum.
It is also overweight European equities given its attractive valuations, and Chinese equities due to sightlier easier monetary policy and no further intensification of its regulatory clampdown.
When it comes to US Treasuries, BlackRock is heavily underweight due to the looming Fed taper and subsequent lift-off.
It is also underweight European government bonds due to rising yields and investment grade credit because of interest rate risk.