Bad news for stocks: The Fed will be surprised by how much higher interest rates will affect the economy, says BlackRock

Federal policymakers are about to surprise themselves — and not in a good way when it comes to stocks and other assets viewed as risky, according to analysts at the BlackRock Investment Institute.

BlackRock argued that investors are dealing with a “system shift” as the COVID-19 pandemic upended an unusual period of moderate fluctuations in production and inflation, heralding a more volatile market environment that bore echoes of the early 1980s. This is an environment in which record debt levels mean that small changes in interest rates will have a massive impact on governments, households and businesses, argued the research arm of the world’s largest asset manager.

Central bankers at the recent Jackson Hole Forum are beginning to realize this fact. “But we believe they are not prioritizing economic impacts over pressure to curb inflation,” analysts said in a note Tuesday, referring to the monetary policy seminar held in late August in Jackson Hole, Wyoming.

It seems that they do not intend, for the time being, to manage the sharp trade-off between inflation and growth. This is a big deal. We believe bringing inflation back to central bank targets would mean crushing demand with stagnation,” they wrote. “This is bad news for risky assets in the near term.”

Powell points out that the Fed has no intention of backing down on rate hikes, but those increases won’t solve the bigger problem, BlackRock analysts said, which is low capacity (represented by the green dotted line in the chart below).

Federal Reserve Chairman Jerome Powell said in a speech on August 26 at Jackson Hole that policymakers are committed to returning inflation to its 2% target, but that effort is likely to require “Sustainable period of growth without trend” It could mean “some pain for families and businesses.”

The problem, according to BlackRock analysts, is that higher prices won’t solve the bigger problem: lower production capacity (see the green dotted line in the chart below).

BlackRock Investment Institute

They explain:

The only way the Fed can bring down the inflation rate quickly is by raising rates high enough to force demand (the orange line) down about 2% to what the economy can now comfortably produce. This is well below the pre-Covid growth trend (the pink line). But the Federal Reserve has yet to acknowledge the significant cost of growth or the unusual nature of the labor market restrictions since the pandemic. We estimate that 3 million people would be out of work if demand shrank by 2%.

The Fed would be surprised by the growth damage from its tightening, in our view. When the Fed sees this pain, we think it will stop raising rates. It will be too late to avoid a contraction in economic activity by then, we think, but the drop will not be deep enough to bring PCE inflation down to the Fed’s 2% target. Instead, we expect inflation to continue near 3%.

What does that mean for investors? Analysts said the main conclusion is that the new system requires more frequent portfolio adjustments, while the time horizon is also key.

“In the short term, we are underestimating developed market (DM) equities as the overall outlook deteriorates. It appears that central banks are prepared to over-tighten policy and impede the resumption of economic activity. We believe the recessions we expect are not counted in equities. Here is why In that we are not buying backtracking,” they wrote.

In the longer term, they said they are experiencing a slight increase in DM stocks, which have a relative attractiveness to private growth assets — those that are not priced like their public counterparts — and fixed income, where higher returns are likely to weigh on expected returns. Meanwhile, sectors that are expected to benefit most from long-term trends such as the transition to net zero, such as technology, are also particularly well represented in the equity world, they said.

Stocks fell on Tuesday as US investors returned from the Labor Day holiday, with the Dow Jones Industrial Average DJIA,
It finished 173.14 points lower, down 0.6%, while the S&P 500 SPX,
The Nasdaq Composite Index is down 0.4%,
Shed 0.7%.

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