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Interest rates will remain higher for longer, say BlackRock analysts

Federal Reserve Chairman Jerome Powell, left, speaks with Governor of the Bank of England Andrew Bailey as they arrive for the plenary of the International Monetary and Financial Committee (IMFC) meeting, during the World Bank/IMF Spring Meetings at the International Monetary Fund (IMF) headquarters in Washington, Friday, April 19, 2024. (AP Photo/Jose Luis Magana)
Federal Reserve chairman Jerome Powell and the governor of the Bank of England Andrew Bailey are yet to cut interest rates, unlike the ECB. (Jose Luis Magana, Associated Press)

There is a growing consensus among markets that interest rates will remain high longer than expected because of sticky inflation.

BlackRock’s (BLK) analysts expect central banks to keep interest rates high compared to the pre-pandemic era to tackle persistent inflationary pressures. In a report that captured the asset manager’s semi-annual Outlook Forum discussions, investment professionals identified a new macroeconomic regime characterised by higher inflation, elevated rates and lower growth, primarily due to supply constraints.

This unique 'macro cocktail' is expected to persist, driven by factors such as population ageing, the restructuring of global supply chains and the transition to low-carbon economies, all of which constrain production and require increased capital investment.

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Just seven months ago, market expectations leaned towards repeated US Federal Reserve rate cuts in 2024. However, recent trends indicate a shift towards sustained higher rates.

Read more: What is a stock split and why are big tech companies opting for it?

The Federal Reserve has adopted a cautious stance, opting to maintain the current rate levels, rather than implement the anticipated cuts. This approach reflects a gradual acceptance that interest rates need to stay high, not just in the short term, but also in the longer term. This is evidenced by the Fed’s upward revisions of its long-run interest rate estimates, which have been reflected in market pricing.

When it comes to the UK, BlackRock is waiting on the latest inflation data - due on Wednesday – to see if falling goods prices are bringing inflation down enough for the Bank of England to start cutting policy rates.

The European Central Bank (ECB) recently cut rates amid improving growth, ongoing inflation above target and record-low unemployment. However, BlackRock analysts believe this does not signal the start of a significant rate-cutting cycle. They predict that even if the Fed initiates easing later this year, it will be a measured process, rather than a rapid reduction.

According to BlackRock's data, market pricing has adjusted to this new reality of prolonged higher rates. US stocks have reached record highs, with a year-to-date increase of approximately 14%. US 10-year Treasury yields have fallen by about 20 basis points, settling near 4.20%.

May’s Consumer Price Index (CPI) for the US came in below expectations, largely due to a broad moderation in core services inflation. Despite the Fed’s steady rate decision and projections indicating only one rate cut this year, BlackRock remains cautious about relying heavily on the Fed's policy signals due to their data-dependent nature.

Amid this market volatility, BlackRock forecasts a scenario where a concentrated group of AI winners drives returns over the next six to 12 months.

Read more: UK interest rates set to remain on hold ahead of general election

They remain overweight on technology and the AI theme, arguing that the AI rally is underpinned by earnings and has further potential. Unlike the dot-com bubble, today's mega-cap tech companies are profitable and have healthy balance sheets, supporting a pro-risk investment stance.

BlackRock analysts, however, caution that the initial capital expenditure (capex) required for AI development, such as building data centres, could be inflationary in the near term. Since the 'ChatGPT moment' last year, there has been a significant increase in spending on AI infrastructure and this trend is expected to continue. The resulting demand on resources could create bottlenecks, leading to short-term inflation before any long-term productivity gains are realised.

The firm notes that eight out of 11 S&P 500 sectors expanded net profit margins in Q1, indicating strong earnings momentum. That is why BlackRock prefers equities over fixed income, but it still recognises the appeal of short-term bonds for income in a higher-for-longer rate environment.

Here are BlackRock’s granular views per market:

United States: “We are neutral in our largest portfolio allocation. Falling inflation and coming Fed rate cuts can underpin the rally’s momentum. We are ready to pivot once the market narrative shifts.

"We are overweight overall when incorporating our US-centric positive view on artificial intelligence (AI). We think AI beneficiaries can still gain while earnings growth looks robust."

Europe: “We are underweight. While valuations look fair to us, we think the near-term growth and earnings outlook remain less attractive than in the US and Japan – our preferred markets.

UK: “We are neutral. We find attractive valuations better reflect the weak growth outlook and the Bank of England’s sharp rate hikes to fight sticky inflation.”

Japan: “We are overweight. Mild inflation and shareholder-friendly reforms are positives. We see the BOJ policy shift as a normalisation, not a shift to tightening.”

Emerging markets: “We are neutral. We see growth on a weaker trajectory and see only limited policy stimulus from China. We prefer EM debt over equity.”

China: “We are neutral. Modest policy stimulus may help stabilise activity and valuations have come down. Structural challenges such as an ageing population and geopolitical risks persist.”

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