Bad news for stocks: Fed will be surprised by impact of sharp rate hike on economy, BlackRock says

According to BlackRock Investment Institute analysts, Federal Reserve policymakers are trying to surprise themselves.

BlackRock says the COVID-19 pandemic has reversed an unusual period of mild output and inflation fluctuations, ushering in a more volatile market environment reflecting the effects of the early 1980s Investors claim they are dealing with a “regime shift”. The research arm of the world’s largest asset manager argues this is an environment where record debt levels mean small changes in interest rates can have very large implications for governments, households and businesses.

“Central banks participating in the recent Jackson Hole forum have begun to recognize this reality, but I doubt they are prioritizing economic impacts over pressures on inflation,” analysts said Tuesday. In a memo, he referred to the monetary policy symposium held in Jackson Hole, Wyoming, at the end of August.

“They don’t seem to be trying to manage a sharp trade-off between inflation and growth right now. I think it means,” they wrote. “This is bad news for risk assets in the short term.”

Powell has suggested the Fed won’t back down on rate hikes, but those rate hikes won’t solve the biggest problem, BlackRock analysts said. It is low production capacity (represented by the green dotted line in the chart below).

In his Aug. 26 speech in Jackson Hole, Fed Chairman Jerome Powell said policymakers were committed to returning inflation to the 2% target, but that efforts included “below-trend growth.” It is likely that a period of duration will be required. It hurts homes and businesses. “

The problem, according to BlackRock analysts, is that rate hikes won’t solve the biggest problem: low production capacity (see dotted green line in chart below).

blackrock investment institute

they explain:

The only way for the Fed to bring inflation down quickly is to raise interest rates high enough to reduce demand (orange line) by about 2% to levels the economy can now comfortably produce. This is well below the pre-Covid growth trend (pink line). But the Fed has yet to acknowledge the significant costs to economic growth and the extraordinary nature of the constraints on the labor market since the pandemic. In addition, he estimates that 3 million people will be out of work if demand shrinks by 2%.

In our view, the Fed will be surprised by the damage to growth caused by tightening. We believe that when the Federal Reserve recognizes this pain, it will stop raising rates. By then it will likely be too late to avoid a contraction in economic activity, but that contraction will not be deep enough to bring PCE inflation down to his Fed target of 2%. Instead, he expects inflation to persist around 3%.

What does that mean for investors? The main conclusion is that the new regime will require portfolios to be adjusted more frequently, but the time horizon is also important.

“In the short term, we are underweight developed market (DM) equities as the macro outlook deteriorates. We don’t think the recession we forecast will be priced into equities, which is why we don’t buy dips,” they wrote.

Over the long term, he said, he is slightly overweight private equity and bonds, which are more attractive than private growth assets (like public stocks, which have not yet been repriced). Meanwhile, sectors such as technology, which are expected to benefit most from long-term trends like the move to net-zero, are also particularly well-represented in the universe of DM equities, they said.

Stocks fell Tuesday as U.S. investors returned from their Labor Day vacation, with the Dow Jones Industrial Average DJIA,
S&P 500 SPX,
Nasdaq Composite COMP, down 0.4%
0.7% decrease.

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