Easing macro tensions

Maintaining a risk-on posture

We stay risk-on as the Federal Reserve resumed cutting policy rates last week. A softening labor market gives the Fed space to cut, helping ease brewing political tensions from higher interest rates. We think rate cuts amid a notable slowing of activity without recession should support U.S. stocks and the AI theme. We turn neutral long-term U.S. bonds: Yields could fall further near term even if the structural pressures driving them up, including loose fiscal policy globally, persist.

We stay risk-on as a much softer U.S. labor market should ease inflation pressures and give the Fed justification to resume easing policy. Until recently, we saw sticky inflation as complicating the Fed cutting rates. Inflation has fallen this year even as U.S. tariffs halted a decades-long spell of goods deflation. This was possible due to surprisingly weak services inflation – a puzzle given a strong labor market. Then job gains stalled in recent months, suggesting an ongoing cooling of services inflation (see the chart below).

We see risks to that view, partly because it’s unclear why the labor market is soft. We may be in an unusual “no hiring, no firing” state: Fed rate cuts could boost confidence and spark hiring again just as inflation is still far above the Fed’s target. This could reignite political tensions between inflation and debt servicing costs – leading to a steeper U.S. yield curve and more cautious risk stance.

We stay risk-on as we have been since the policy-driven volatility in April. U.S. equities are among the best-performing markets since then: U.S. stocks are up 31% since April 8 versus 24% for overall developed markets, according to LSEG data. The lesson? Immutable economic laws – supply chains can’t be rewired overnight without major disruption – limit rapid policy change. This framing allowed us to lean against markets extrapolating big calls – and quickly deploy risk. Yet the market environment has changed a lot. The drivers have shifted from tariffs and policy uncertainty – which sparked questions about the appeal and haven status of U.S. assets – to the tensions between inflation, growth, and government debt.

We stick with the AI theme. The AI theme keeps driving U.S. equity performance, with the tech sector accounting for over 40% of total return and a similar share of earnings growth, LSEG data show. We think this can persist. Yes, these companies are generating less free cash flow, but only modestly. We think elevated valuations can be justified if they keep delivering on expected 15% to 20% future earnings growth. Their credit spreads – a sign of balance sheet health – have also held steady near historic lows but we watch them as a potential warning sign of market concerns.

We need to be ready for a few very different macro scenarios in coming months. Our base case: A soft labor market allows the Fed to cut rates, a positive for equities. This could spark broader equity gains and support long-term bonds.

On a six- to 12- month tactical horizon, we go neutral long-term U.S. Treasuries after having long been underweight. We also flip neutral on short-term Treasuries from overweight. Yet if the labor market were to weaken much more, Fed rate cuts won’t be enough to offset the pressure on risk assets, in our view – and we would be ready to reduce risk.

On the flip side, a hiring rebound could stoke inflation pressures and put the spotlight on Fed independence again, prompting investors to seek more compensation for the risk of holding long-term bonds. We prefer real, or inflation adjusted, yields to lock in income. On a strategic horizon, we stay underweight long-term government bonds and prefer inflation-linked bonds. We stand ready to pivot in all scenarios.

Bottom line

A softer labor market and slowing growth pave the way for the Fed to cut rates. We think this will benefit U.S. stocks and stay overweight. We close our long-term U.S. Treasuries underweight but see pressures for higher yields staying.

Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.

Wei Li, Global Chief Investment Strategist, Blackrock Investment Institute at BlackRock Inc., Glenn Purves, Global Head of Macro – BlackRock Investment Institute, and Vivek Paul Global Head of Portfolio Research – BlackRock Investment Institute, contributed to this article.

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