Opportunities emerge as central banks diverge

Contrasting inflation outlooks in the U.S. and eurozone suggest further monetary policy divergence, creating opportunities for investors. Richard explains.

We see steady above-trend growth globally in the fourth quarter, with inflation picking up in the U.S. but moving sideways at low levels in the eurozone. The contrasting inflation outlooks suggest further monetary policy divergence.

The chart below shows how markets are pricing in less than two 0.25% rate increases by the U.S. Federal Reserve (Fed) through the end of 2018, and a modest rise in European Central Bank (ECB) rates during the same period. We believe the former is too low and the latter not likely. Our new BlackRock Inflation GPS suggests U.S. core inflation will rise back toward 2%, giving the Fed comfort in raising rates up to four times by the end of 2018. Inflation in the eurozone, however, is likely to remain well below the ECB’s target over the next 12 months, making an ECB rate increase unlikely.

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We see the Fed pushing ahead with a rate rise later in the year given a strong labor market and steady above-trend economic expansion, reflecting Fed Chair Janet Yellen’s comments last week that rate normalization should proceed. Further Fed rate increases are likely in 2018, we believe, even with looming changes to the central bank’s leadership.

By contrast, we see the ECB proceeding cautiously. Extra-loose policy is needed to ensure that inflation climbs back to the ECB’s target and stays there, we believe. A lagging recovery is leaving plenty of slack in the economy, and our Inflation GPS shows core eurozone inflation staying at low levels as a result. Winding down monetary accommodation too quickly would risk inflation being stuck below target for even longer. We do see the central bank trimming its bond purchases, as it reaches the self-imposed limits of its bond-buying program, but the adjustment may happen at a slower clip than market participants currently expect.

The market implications? We see modestly higher yields ahead, with any U.S. tax cuts fueling further rises. Structural factors such as aging populations and strong demand for income should limit upward moves, we believe. We expect greater yield rises in the U.S. than in the eurozone and see the U.S. dollar strengthening gradually against the euro.

We prefer U.S. inflation-protected government securities over nominal bonds. Structurally lower yields underpin our positive view on equities and other risk assets, and we favor equities overall to credit. Relatively attractive valuations, ongoing easy monetary conditions and weaker currencies versus the greenback should support stocks in the eurozone and Japan. We also like emerging market (EM) equities on economic reform momentum, improving cash flows and reasonable valuations. We do not see a modestly stronger U.S. dollar undermining the investment case for EM, but acknowledge the risk of a China growth slow-down if Beijing were to step up its reform agenda. Read more market insights in my Weekly Commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

Listen to Richard Turnill and Jeff Rosenberg talk about BlackRock’s midyear investment outlook on the inaugural episode of our podcast, The Bid.

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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of October 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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