Investing in private markets takes time. So we see the repricing in private credit as an opportunity to be nimble with our strategic views and tap into our expectation that private credit can help fill a lending gap left by banks after the recent turmoil. Yields in direct lending, a subset of private credit, have risen (dark orange line in chart). These higher yields may better compensate investors for the risks we see ahead – even after factoring in lower credit quality. U.S. high yield and investment grade (IG) credit yields have faded from highs (yellow and pink lines), but we think they will rise eventually. We go overweight private credit as a result and move to neutral on global IG. Private markets overall are complex, with high risk and volatility, and aren’t suitable for all investors.

The fallout from the banking sector troubles and further tightening of credit conditions adds to the pressure on public credit but could be a potential boon for private credit, in our view. We think the rising interest rate environment and increased competition for deposits will put pressure on banks – and cause them to pull back some lending. We see this making room for non-bank lending and private credit to play a greater role

Private credit refers to a wide range of investments, from direct lending to infrastructure and venture debt. We’re focused on direct lending – financing that is typically negotiated directly between a non-bank lender and a borrower, often a small to mid-sized company. This private credit is mostly made up of floating rate debt that adjusts with policy rates that we see staying high. We think there are potential benefits from a borrower’s perspective in seeking out non-bank lending. Dealing with one private lender could be easier than with a broad group of banks in public markets. The private nature could also help avoid spooking financial markets, such as with the risks that come with tapping funds from public markets at inopportune times. This demand from borrowers creates an investment opportunity for lenders, in our view: more attractive pricing and deal terms than would have been the case before. But we think seeking out quality borrowers is key: That means a keen eye on deal terms and lending standards. We have had a conservative view on our assumptions about private credit default losses in our strategic views for some time because private credit is not immune to the credit risk from an economic downturn. Yet even after allowing for these more prudent assumptions that would be a drag on returns, the wider set of opportunities for private lenders in the wake of the banking fallout, coupled with the divergence between private and public credit yields is enough to spur an upgrade.

Our strategic view on equities is the mirror image of credit: We prefer public to private. We’re still strategically overweight developed market (DM) equities but underweight on a six- to 12-month tactical horizon because a strategic investor can look past some of the near-term pain. And the pressure from tighter credit conditions is also likely to have relented down the road. We remain strategically underweight growth in private markets such as private equity. Private equity has started to reprice the tougher macro environment but not as much as publicly traded equities.

Bottom line: We see the appeal of income in the new regime of greater macro and market volatility and favor private over public credit on a strategic horizon. We see a mirror image in equity, strategically preferring public to private.

Market backdrop

U.S. stocks hit 2023 highs last week on hopes for a debt ceiling solution. Yields climbed on expectations the Federal Reserve could hike rates again instead of pausing at its next meeting. First-quarter earnings contracted for the second-straight quarter – but less than expected. Inflation helped revenue and margins as firms passed on higher prices to a still-strong consumer. We think higher financing costs and dwindling savings could start to bite: Earnings expectations look too rosy.

Macro takes

Most developed markets are grappling with a shared problem. Core inflation – or inflation excluding more volatile food and energy prices – is proving more stubborn than expected and remains well above the central bank’s 2% targets. See the chart. The cause is persistent production constraints, especially worker shortages. That is making it difficult to comfortably meet demand. Worker shortages are driving up wages, including in Japan, where wage inflation is at its highest rate since the late 1990s. We think that means central banks can’t undo any of their inflation-fighting rate hikes any time soon, even if financial markets think the Federal Reserve will start cutting rates before the end of the year. We see the Fed simply taking a breather for now, while it assesses how much economic damage is still to come from the hikes already done. We see a recession ahead. But unlike in the past when central banks would cut rates to stimulate a struggling economy, we think the unresolved inflation problem makes that unlikely this time.

Investment themes

1 Pricing in the damage

• Recession is foretold as central banks try to bring inflation back down to policy targets. It’s the opposite of past recessions: Rate cuts are not on the way to help support risk assets, in our view.
• That’s why the old playbook of simply “buying the dip” doesn’t apply in this regime of sharper trade-offs and greater macro volatility. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price.
• In the U.S., it’s now evident in the financial cracks emerging from higher interest rates on top of rate-sensitive sectors. Higher mortgage rates have hurt sales of new homes. We also see other warning signs, such as deteriorating CEO confidence, delayed capital spending plans, and consumers' depleting savings.
• The ultimate economic damage depends on how far central banks go to get inflation down. The Federal Reserve signaled a pause after hiking rates in May. But it also reiterated that persistent inflation means no rate cuts this year. We see the European Central Bank going full steam ahead with rate hikes to get inflation to target – regardless of the damage that entails.
• Investment implication: We’re tactically underweight DM equities. They’re not pricing the recession we see ahead.

2 Rethinking bonds

• Fixed income finally offers “income” after yields surged globally. This has boosted the allure of bonds after investors were starved for yield for years. We take a granular investment approach to capitalize on this, rather than taking broad, aggregate exposures.
• Very short-term government paper looks more attractive for income at current yields, and we like their ability to preserve capital. Tighter credit and financial conditions reduce the appeal of credit.
• In the old playbook, long-term government bonds would be part of the package as they historically have shielded portfolios from recession. Not this time, we think. The negative correlation between stock and bond returns has already flipped, meaning they can both go down at the same time. Why? Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets. If anything, policy rates may stay higher for longer than the market is expecting. Investors also will increasingly ask for more compensation to hold long-term government bonds – or term premiums – amid high debt levels, rising supply, and higher inflation.
• Investment implication: We prefer very short-term government paper over long-term government bonds.

3 Living with inflation

• High inflation has sparked cost-of-living crises, putting pressure on central banks to tame inflation with whatever it takes. Yet there has been little debate about the damage to growth and jobs. We think the “politics of inflation” narrative is on the cusp of changing. The Fed’s rapid rate hikes will stop without inflation being back on track to return fully to 2% targets, in our view. We think we are going to be living with inflation. We do see inflation cooling as spending patterns normalize and energy prices relent – but we see it persisting above policy targets in coming years.
• Beyond Covid-related supply disruptions, we see three long-term constraints keeping the new regime in place and inflation above pre-pandemic levels: aging populations, geopolitical fragmentation, and the transition to a lower carbon world.
• Investment implication: We’re overweight inflation-linked bonds on a tactical and strategic horizon.

BlackRock Investment Institute

The BlackRock Investment Institute (BII) leverages the firm’s expertise and generates proprietary research to provide insights on macroeconomics, sustainable investing, geopolitics, and portfolio construction to help Blackrock’s portfolio managers and clients navigate financial markets. BII offers strategic and tactical market views, publications, and digital tools that are underpinned by proprietary research.

General disclosure: This material is intended for information purposes only, and does not constitute investment advice, a recommendation, or an offer or solicitation to purchase or sell any securities to any person in any jurisdiction in which an offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction. This material may contain estimates and forward-looking statements, which may include forecasts and do not represent a guarantee of future performance. This information is not intended to be complete or exhaustive and no representations or warranties, either express or implied, are made regarding the accuracy or completeness of the information contained herein. The opinions expressed are as of May 22, 2023, and are subject to change without notice. Reliance upon information in this material is at the sole discretion of the reader. Investing involves risks.

In the U.S. and Canada, this material is intended for public distribution. In the European Economic Area (EEA): This is issued by BlackRock (Netherlands) B.V. and is authorized and regulated by the Netherlands Authority for the Financial Markets. Registered office Amstelplein 1, 1096 HA, Amsterdam, Tel: 020 – 549 5200, Tel: 31-20-549-5200. Trade Register No. 17068311 For your protection telephone calls are usually recorded. In the UK and Non-European Economic Area (EEA) countries: this is Issued by BlackRock Advisors (UK) Limited, which is authorized and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL, Tel: +44 (0)20 7743 3000. Registered in England and Wales No. 00796793. For your protection, calls are usually recorded. Please refer to the Financial Conduct Authority website for a list of authorized activities conducted by BlackRock. In Italy, for information on investor rights and how to raise complaints please go to https://www.blackrock.com/corporate/compliance/investor-right available in Italian. For qualified investors in Switzerland: This document is marketing material. This document shall be exclusively made available to, and directed at, qualified investors as defined in Article 10 (3) of the CISA of 23 June 2006, as amended, at the exclusion of qualified investors with an opting-out pursuant to Art. 5 (1) of the Swiss Federal Act on Financial Services ("FinSA"). For information on Art. 8 / 9 Financial Services Act (FinSA) and on your client segmentation under Art. 4 FinSA, please see the following website: www.blackrock.com/finsa. For investors in Israel: BlackRock Investment Management (UK) Limited is not licensed under Israel’s Regulation of Investment Advice, Investment Marketing and Portfolio Management Law, 5755-1995 (the “Advice Law”), nor does it carry insurance thereunder. In South Africa, please be advised that BlackRock Investment Management (UK) Limited is an authorized financial services provider with the South African Financial Services Board, FSP No. 43288. In the DIFC this material can be distributed in and from the Dubai International Financial Centre (DIFC) by BlackRock Advisors (UK) Limited — Dubai Branch which is regulated by the Dubai Financial Services Authority (DFSA). This material is only directed at 'Professional Clients’ and no other person should rely upon the information contained within it. Blackrock Advisors (UK) Limited - Dubai Branch is a DIFC Foreign Recognised Company registered with the DIFC Registrar of Companies (DIFC Registered Number 546), with its office at Unit 06/07, Level 1, Al Fattan Currency House, DIFC, PO Box 506661, Dubai, UAE, and is regulated by the DFSA to engage in the regulated activities of ‘Advising on Financial Products’ and ‘Arranging Deals in Investments’ in or from the DIFC, both of which are limited to units in a collective investment fund (DFSA Reference Number F000738)In the Kingdom of Saudi Arabia, issued in the Kingdom of Saudi Arabia (KSA) by BlackRock Saudi Arabia (BSA), authorized and regulated by the Capital Market Authority (CMA), License No. 18-192-30. Registered under the laws of KSA. Registered office: 29th floor, Olaya Towers – Tower B, 3074 Prince Mohammed bin Abdulaziz St., Olaya District, Riyadh 12213 – 8022, KSA, Tel: +966 11 838 3600. The information contained within is intended strictly for Sophisticated Investors as defined in the CMA Implementing Regulations. Neither the CMA nor any other authority or regulator located in KSA has approved this information. The information contained within does not constitute and should not be construed as an offer of, invitation, or proposal to make an offer for, a recommendation to apply for, or an opinion or guidance on a financial product, service, and/or strategy. Any distribution, by whatever means, of the information within and related material to persons other than those referred to above is strictly prohibited. In the United Arab Emirates is only intended for - naturally Qualified Investors as defined by the Securities and Commodities Authority (SCA) Chairman Decision No. 3/R.M. of 2017 concerning Promoting and Introducing Regulations. Neither the DFSA nor any other authority or regulator located in the GCC or MENA region has approved this information. In the State of Kuwait, those who meet the description of a Professional Client as defined under the Kuwait Capital Markets Law and its Executive Bylaws. In the Sultanate of Oman, sophisticated institutions that have experience in investing in local and international securities, are financially solvent and know the risks associated with investing in securities. In Qatar, for distribution with pre-selected institutional investors or high net worth investors. In the Kingdom of Bahrain, to Central Bank of Bahrain (CBB) Category 1 or Category 2 licensed investment firms, CBB licensed banks, or those who would meet the description of an Expert Investor or Accredited Investors as defined in the CBB Rulebook. The information contained in this document does not constitute and should not be construed as an offer of, invitation, inducement, or proposal to make an offer for, a recommendation to apply for, or an opinion or guidance on a financial product, service, and/or strategy. In Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no. 200010143N). This advertisement or publication has not been reviewed by the Monetary Authority of Singapore. In Hong Kong, this material is issued by BlackRock Asset Management North Asia Limited and has not been reviewed by the Securities and Futures Commission of Hong Kong. In South Korea, this material is for distribution to Qualified Professional Investors (as defined in the Financial Investment Services and Capital Market Act and its sub-regulations). In Taiwan, independently operated by BlackRock Investment Management (Taiwan) Limited. Address: 28F., No. 100, Songren Rd., Xinyi Dist., Taipei City 110, Taiwan. Tel: (02)23261600. In Japan, this is issued by BlackRock Japan. Co., Ltd. (Financial Instruments Business Operator: The Kanto Regional Financial Bureau. License No375, Association Memberships: Japan Investment Advisers Association, the Investment Trusts Association, Japan, Japan Securities Dealers Association, Type II Financial Instruments Firms Association.) For Professional Investors only (Professional Investor is defined in Financial Instruments and Exchange Act). In Australia, issued by BlackRock Investment Management (Australia) Limited ABN 13 006 165 975 AFSL 230 523 (BIMAL). The material provides general information only and does not take into account your objectives, financial situation needs, or circumstances. In China, this material may not be distributed to individuals resident in the People’s Republic of China (“PRC”, for such purposes, excluding Hong Kong, Macau, and Taiwan) or entities registered in the PRC unless such parties have received all the required PRC government approvals to participate in any investment or receive any investment advice or investment management services. For Other APAC Countries, this material is issued for Institutional Investors only (or professional/sophisticated /qualified investors, as such a term may apply in local jurisdictions). In Latin America, no securities regulator within Latin America has confirmed the accuracy of any information contained herein. The provision of investment management and investment advisory services is a regulated activity in Mexico and thus is subject to strict rules. For more information on the Investment Advisory Services offered by BlackRock Mexico please refer to the Investment Services Guide available at www.blackrock.com/mx

©2023 BlackRock, Inc. All Rights Reserved. BLACKROCK is a trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners.

A message from Advisor Perspectives and VettaFi: To learn more on this and other topics, check out our full schedule of upcoming CE-approved virtual events.

© BlackRock

Read more commentaries by BlackRock