BlackRock: Why it still prefers stocks over bonds

Of Eleftheria Kourtali

BlackRock recently reduced its risk in its portfolio, but currently maintains its preference for equities over bonds. And the main reason is that stock prices now reflect much of the deteriorating macroeconomic outlook and the aggressive Fed, in its view.

As BlackRock points out, stocks fell sharply this year amid the prospect of rapidly rising interest rates to curb inflation, the war in Ukraine and the slowdown in China.

She recently decided to reduce the risk, but maintains an overweight stance on stocks. Why is he doing that; The sell-off, he explains, means that most of these risks have now been priced, keeping valuations attractive. He also believes that the sum of the Fed’s interest rate hikes will be historically low and fears of a recession are exaggerated.

He sees that the Fed will eventually choose to live with inflation slightly higher than the 2% target, instead of fighting it because of the cost of growth and jobs. Thus, he estimates that stocks remain more attractive than bonds, although the historic sell-off of bonds has narrowed the gap between the two.

BlackRock started the year with an overweight stake and underweight bonds. The macroeconomic outlook has deteriorated since then. The war in Ukraine has added to the already high inflation caused by pandemic-related supply constraints.

The Fed started talking “aggressively” about inflation and the market quickly invoked a series of sharp interest rate hikes. “And now we see an increasing risk that the Fed will raise policy rates to a level that is slowing the economy,” he said.

At the same time, growth in China has slowed amid widespread restrictions on Covid. Both stocks and bonds sold-off due to these growing challenges.

“We downgraded European stocks in March due to the energy shock. This was followed by a downgrade of Asian assets last week, combined with an upgrade of corporate investment bonds and European government bonds,” he said.

The sell-off in the bond market narrowed the gap between stocks and bonds, in its view, while also creating value opportunities. BlackRock continues to see yields on longer-term bonds rise further as investors demand higher premiums or compensation for the risk of government bonds being held amid high inflation and high debt.

As a result, it does not change its general underweight stance on bonds and maintains its relative preference for stocks.

What are the risks?

Today’s inflation is very different from the last 30 years and central banks need a new strategy. Inflation is always caused by excessive demand in a certain supply amount. This is not to say that excessive demand has led to inflation, as has been the case mainly since the 1990s.

The real question is whether demand is unusually high or supply is unusually low. BlackRock believes the latter is true. The economy is going through two major shocks: the pandemic and the war in Ukraine. This has created supply constraints, such as a “tight” labor market, that will take time to resolve.

Why does all this matter? If inflation is driven by supply factors, the Fed is faced with a tough choice: to stop growing at a higher rate – the old strategy – or to live with more persistent inflation. The danger is that the Fed fails to recognize this dilemma and thus pushes interest rates to such levels that they ruin growth and jobs.

Markets are slowly recognizing the risks surrounding this compromise and now appear to be valuing a Fed Funds interest rate close to 3.5% on a very long-term basis.

If that happens, BlackRock points out, stocks may have more room to fall: higher discount rates make future cash flows less attractive. However, he believes that the Fed will not move so aggressively, fearing that it will hurt growth, but it is a fact that aggressive policy announcements may lead the markets to believe otherwise.

“This is why we are preparing for more volatility in the short term – and why – despite the overweight stance and improved valuations – we are not increasing our exposure to stocks,” he concludes.