Weekly market commentary - BlackRock

We've expected inflation would be on a rollercoaster as the drag from falling goods prices faded and firm wage growth made services inflation stubborn. Yet the March pick-up in core services inflation shows that inflation is proving sticky. Further escalation of Middle East tensions could see oil prices staying elevated, reinforcing higher inflation and higher-for-longer interest rates. Sticky inflation has prompted markets to slash their expectations for Federal Reserve rate cuts to less than two this year (green line in chart) in line with our view. The Fed has gone from blessing market hopes for inflation to fall to 2% without a growth hit to implying policy may have to stay tight. The S&P 500 price-to-earnings ratio – a popular valuation metric – shows stocks feeling the heat from higher rates (orange line). We think that's why it's more crucial that companies keep meeting or beating high earnings forecasts.

We question whether the slide in stocks is a blip or a bigger shift toward pricing in inflation – and interest rates – settling higher than pre-pandemic. We stay overweight U.S. stocks on a six- to 12-month tactical horizon but are ready to pivot given that uncertainty. We have broadened out our stock view to include segments of the market with an improving earnings growth outlook. And we have leaned against small cap stocks whose earnings are at greater risk from higher rates. Earnings face a critical test this week, with some mega cap tech companies reporting. With stocks under pressure and rate cut hopes fading, we think the bar is higher for tech firms to deliver on earnings expectations – and for other sectors to show an earnings recovery. Confirmation of inflation settling higher and earnings misses could trigger a change to our view.

Moving up the tech stack

We still prefer artificial intelligence (AI) beneficiaries to tap into the AI and digital disruption mega force – a structural shift driving returns now and in the future. We went overweight early AI winners and enablers like chip and hardware makers in 2023. That view paid off as some valuations soared above historical averages. We are eyeing potential winners further up the technology stack – the layers of technology needed to develop AI applications – and beyond as AI adoption spreads. That's the case in healthcare, financials and communication services, sectors we like because they have more scope for productivity gains. Outside of tech, those sectors have had some of the most mentions of AI-related keywords in earnings calls and company filings, BlackRock's Systematic Equity team finds. AI mentions in non-tech sectors have soared 250% since 2022.

In fixed income, we stay neutral long-term U.S. bonds even as 10-year yields have risen this year. We think yields can swing in either direction as policy rate expectations shift in the near term. Long-term yields are moving toward our view that investors will demand more term premium, or compensation for the risk of holding long-term bonds in the long run. Term premium is muted for now. We prefer short-term bonds, euro area high yield credit and emerging market hard currency debt for income.

Our bottom line

U.S. earnings updates this week will be key to see if they can keep topping expectations and buoying risk appetite in a higher-for-longer interest rate environment. We're overweight U.S. stocks and see the AI theme broadening.