Energy Shock, Fed Spur New Outlook

Elga Bartsch profile picture
Elga Bartsch


  • We now prefer U.S. and Japanese equities over European stocks due to the energy shock. We stay underweight bonds because of the inflationary backdrop.
  • Bond yields sprinted higher last week, with U.S. 10-year Treasuries hitting near three-year highs. Signs of weakening economic activity emerged in Europe.
  • U.S. inflation and jobs data this week could guide the Fed in its rate hike path. We believe it will deliver on its hawkish rate projection this year - but then pause.

Federal Reserve Building in Washington DC

pabradyphoto/iStock via Getty Images


We entered 2022 with lower risk-taking, and within that we preferred equities over bonds. Within equities, we had a preference for developed markets over emerging markets, and within bonds, we preferred inflation-linked bonds over nominal government bonds.

Three weeks ago, we further upgraded the developed market equity call, and we downgraded global credit in order to fund that.

As we entered the second quarter of the year, we are making further tweaks to our developed market equity call. Specifically moving a bit more explicitly away from Europe given the greater energy vulnerability and upgrade Japanese equities to be on par with our higher-conviction view on U.S. equity markets.

Notably, we remain underweight developed market nominal government bonds, even after the year-to-date moves, because we believe that yields would continue to push higher.

And ultimately central banks, yes they are accelerating, getting closer to neutral [a rate of equilibrium], but they will be forced to live with inflation, and that is ultimately unfavorable for bonds.


Much has changed since our 2022 outlook. The tragic war in Ukraine has resulted in a global energy shock. We see this increasing inflation, pressuring consumers and hurting growth, especially in Europe. The Fed has started to talk tough on inflation and has projected a large increase in rates. In our latest outlook update, we remain underweight bonds even as nominal yields have shot up this year, and reduce our European equities overweight in favor of U.S. and Japanese stocks.

Low real yields support equities

10-year real yields in the US and euro area, 2017-2022

10-Year Real Yields In The US And Euro Area, 2017-2022 (BlackRock Investment Institute, with data from March 2022)

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Notes: The chart shows real yields in the euro area (shown as the GDP weighted yield of Germany, France and Italy) and the U.S., based on 10-year inflation-protected government bonds. The real yield strips out the expected impact of inflation over the next decade.

Russia's invasion of Ukraine has taken a horrible human toll and has resulted in a spike in commodities prices that is driving food and energy insecurity. This is dampening economic growth and exacerbating supply-driven inflation, with Europe most exposed among developed markets (DMs) as it tries to wean itself off Russian energy. Rising inflation has kept real, or inflation-adjusted, yields near record lows, as the chart shows, even as nominal yields have sprinted upward. Central banks are scrambling to normalize policy and raise rates this year - but we don't expect them to go quite as far in total hikes as markets currently expect. We expect long-term yields to edge up as investors demand more compensation for the risk of holding bonds amid high inflation. The result? We see more pain for bonds but believe stocks can thrive amid historically low real rates.

Markets respond to Ukraine war

Going into 2022, we nudged down portfolio risk as we saw a risk of markets pricing in aggressive central bank actions in an effort to contain inflation. This played out and pushed down both bonds and stocks - faster and harder than we expected. We added to our DM equities overweight at the expense of credit last month on a tactical horizon. Since then, three things have become clear to us: the commodities shock will make inflation even more persistent, the impact differs greatly by region, and central banks actually have made hawkish pivots in response.

Where does this leave our macro outlook?

We believe the Fed will go ahead with its projected rate increases for this year, but then will pause as the effect of tightening on growth becomes clearer. We expect that the Fed and other central banks eventually will be forced to live with supply-driven inflation, rather than take policy rates above their neutral level. Doing so would risk destroying growth and employment, in our view. As a result, we expect the sum total of rate hikes to be historically low given the level of inflation. Investors will start to question the perceived safety of government bonds, we believe, against this backdrop of high inflation and debt levels. What are risks to our base case? First, central banks could slam the brakes and cause a recession in an effort to contain inflation. Second, inflation expectations could become unanchored: markets and consumers could lose faith that central banks can keep a lid on prices. This possibility makes the first risk more real.

All this means that we see more downside risk for government bonds, even as 10-year U.S. Treasury yields are hoovering near three-year highs. DM government bonds are less-effective portfolio diversifiers in periods when supply shocks dominate, as they do now. Within the asset class, we prefer short-maturity bonds over long-term ones. Markets have been quick to price in the Fed's hawkish rate projections. We think this repricing in short-term rates is overdone, as we don't expect the Fed to fully delivering on its projected grand total of rate increases over the next two years.

We remain pro-risk on a tactical horizon and prefer equities over credit. The inflationary environment favors stocks, in our view, and many DM companies have been able to pass on rising costs and keep margins high. We also like the combination of low real rates, the restart's economic growth cushion and reasonable equity valuations. We reduce our overweight to European equities, as we see the energy shock hitting that region hardest. Also, prices have rebounded from the year's lows. Why not shift to an underweight? We expect the European Central Bank to only slowly normalize policy. We increase our overweight to Japanese stocks on prospects of higher dividends and buybacks, and supportive policy. We like the U.S. stock market, as we see its quality factor resilient to a broad range of economic scenarios, brightening its appeal.

Market backdrop

Government bond yields climbed last week, with 10-year U.S. Treasuries hitting near three-year highs, before falling back on worries of economic weakness. Data showed the Ukraine war's economic impact is starting to affect economic activity in the euro area. The U.S. economy for now looks resilient, and we prefer U.S. stocks over European ones as a result.

U.S. inflation and employment data may guide the U.S. Fed in the pace of raising rates after it delivered its first hike since 2018. We believe the Fed will deliver on projected rate increases this year but then pause. Inflation data won't reflect the jump in energy and food prices resulting from the Ukraine war, we think. Jobs data are likely to show a post-Omicron boost.

This post originally appeared on the iShares Market Insights.

This article was written by

Elga Bartsch profile picture
Elga Bartsch, Managing Director, Head of Economic and Markets Research of the BlackRock Investment Institute. Elga heads up economic and markets research of the Blackrock Investment Institute (BII). BII provides connectivity between BlackRock's portfolio managers, originates economic and market research and publishes insights.

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