Macro Outlook Retakes Spotlight

The pandemic shocked the U.S. labor supply, creating worker shortages. The labor market remains extremely tight, as confirmed in the latest payroll data, with workforce participation not having improved. That is keeping core inflation sticky. This has presented the Fed with a sharp trade-off: crush growth with even higher rates or live with some inflation. We think the Fed will have to keep policy tighter. Markets have already started to mull the possibility of another rate hike even after the Fed signaled a potential pause. Markets are no longer pricing in repeated Fed rate cuts, waking up to our long-held view that rates are likely to stay higher for longer to combat persistent inflation.

Attention could also eventually shift to the broader U.S. fiscal position with rates staying higher, in our view. In our view, the relatively smaller spending cuts in the U.S. debt ceiling deal aren't likely to put a dent in the debt load. They stand in stark contrast with the aftermath of the 2008 financial crisis when the focus swiftly shifted to fiscal austerity. Interest rates were near zero then and debt servicing costs were at record lows. But now rates have jumped in the fastest rate hiking cycle since the 1980s.

Higher rates mean higher debt servicing costs. We think persistent inflation and high debt levels could cause investors to demand more compensation for holding U.S. assets over time, especially long-term Treasuries.

We also expect a burst of Treasury-bill issuance as the government seeks to replenish the money drawn down since the debt ceiling was hit earlier in the year. We estimate bill issuance could balloon to as much as $1 trillion in the next few months – well above normal issuance levels outside of past crises like the 2008 financial crisis and the pandemic. In our view, that could add to volatility in fixed income, especially in very short-dated maturities. We tweak our preference for short-term Treasuries as a result, extending the preferred maturities beyond short-term paper to encompass two-year Treasury notes that have repriced in recent weeks.

Bottom line: The U.S. debt ceiling deal removes near-term uncertainty – we now expect markets to focus on the macro picture. We see higher-for-longer rates, so we keep our quality tilt in equities and bonds and prefer income for now. We like short-term Treasuries, emerging-market local currency debt, and inflation-linked bonds.

Market backdrop

U.S. stocks climbed to 2023 highs after the debt ceiling deal. Yields rose as markets eyed more rate hikes after Friday’s payroll report showed a jump in new jobs. The number of jobs added in May was well above market expectations. But the unemployment rate rose with no improvement in labor force participation. We don’t think the labor shortage is easing, so wage growth remains elevated. We think that will keep core inflation sticky, making rate cuts this year unlikely.

Macro takes

Last week’s U.S. jobs report showed 339,000 new jobs were created in May, way above expectations of 195,000. Unemployment rose to 3.7% from 3.4% but the employment-to-population ratio – the share of the total population in work – was little changed. See the chart. That means the labor supply hasn’t increased. The worker shortage doesn’t appear to be easing.

The labor shortage persisting means pay growth isn’t slowing down either. Average hourly earnings grew by around 4% in May, still too high to see inflation come back down to the Fed’s 2% target. But this measure doesn’t adjust for the pandemic’s impact on the services sector. The employment cost index (ECI) measure does, and it shows wages rising even more quickly.

This is still a very tight labor market, beset by shortages, and this report leaves the possibility of further Fed hikes firmly on the table, in our view.

Investment themes

1 Pricing in the damage

• Recession is foretold as central banks try to bring inflation back down to policy targets. It’s the opposite of past recessions: Rate cuts are not on the way to help support risk assets, in our view.
• That’s why the old playbook of simply “buying the dip” doesn’t apply in this regime of sharper trade-offs and greater macro volatility. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price.
• In the U.S., it’s now evident in the financial cracks emerging from higher interest rates on top of rate-sensitive sectors. Higher mortgage rates have hurt sales of new homes. We also see other warning signs, such as deteriorating CEO confidence, delayed capital spending plans, and consumers’ depleting savings.
• The ultimate economic damage depends on how far central banks go to get inflation down. The Federal Reserve signaled a pause after hiking rates in May. But it also reiterated that persistent inflation means no rate cuts this year. We see the European Central Bank going full steam ahead with rate hikes to get inflation to target – regardless of the damage that entails.
• Investment implication: We’re tactically underweight DM equities. They’re not pricing the recession we see ahead.

2 Rethinking bonds

• Fixed income finally offers “income” after yields surged globally. This has boosted the allure of bonds after investors were starving for yield for years. We take a granular investment approach to capitalize on this, rather than taking broad, aggregate exposures.
• Very short-term government paper looks more attractive for income at current yields, and we like their ability to preserve capital. Tighter credit and financial conditions reduce the appeal of credit.
• In the old playbook, long-term government bonds would be part of the package as they historically have shielded portfolios from recession. Not this time, we think. The negative correlation between stock and bond returns has already flipped, meaning they can both go down at the same time. Why? Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets. If anything, policy rates may stay higher for longer than the market is expecting. Investors also will increasingly ask for more compensation to hold long-term government bonds – or term premiums – amid high debt levels, rising supply, and higher inflation.
• Investment implication: We prefer short-term government bonds over long-term government bonds.

3 Living with inflation

• High inflation has sparked cost-of-living crises, putting pressure on central banks to tame inflation with whatever it takes. Yet there has been little debate about the damage to growth and jobs. We think the “politics of inflation” narrative is on the cusp of changing. The Fed’s rapid rate hikes will stop without inflation being back on track to return fully to 2% targets, in our view. We think we are going to be living with inflation. We do see inflation cooling as spending patterns normalize and energy prices relent – but we see it persisting above policy targets in coming years.
• Beyond Covid-related supply disruptions, we see three long-term constraints keeping the new regime in place and inflation above pre-pandemic levels: aging populations, geopolitical fragmentation, and the transition to a lower carbon world.
• Investment implication: We’re overweight inflation-linked bonds on a tactical and strategic horizon.

BlackRock Investment Institute

The BlackRock Investment Institute (BII) leverages the firm’s expertise and generates proprietary research to provide insights on macroeconomics, sustainable investing, geopolitics, and portfolio construction to help Blackrock’s portfolio managers and clients navigate financial markets. BII offers strategic and tactical market views, publications, and digital tools that are underpinned by proprietary research.

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