Stocks are adjusting to the new normal of high volatility, but haven't yet priced in coming 'macro damage,' BlackRock says

• Coming pain to the economy is about to pose a major headwind to stocks, BlackRock warned.
• The asset manager pointed to pressures stemming from earnings stagnation, inflation, & high interest rates.

Investors are adjusting to the new era of volatility in markets, but stocks still haven't priced in coming pain to the economy, BlackRock strategists warned.

The world's largest asset manager pointed to recent headwinds weighing on equities, with concerns over higher interest rates sending the 10-year Treasury yield past 5% on Monday while the S&P 500 continues its longest sell-off of the year. That shows that investors are adjusting to the "new macro regime," strategists said – a period defined by higher turbulence that will upend Wall Street's old investing playbook.

But there's likely more pain coming to stocks, as the US economy will slow and companies will face headwinds to earnings.

"Markets expect a pickup starting with Q3 reporting underway," strategists said in a note on Monday, referring to the slew of S&P 500 firms about to report their earnings for the last financial quarter. "We are cautious. Broad equities have started to adjust to the new regime of greater volatility, but don't fully reflect the macro damage we expect."

Earnings season looks to be on strong start so far. Of the 17% of S&P 500 firms that have reported financials, 73% beat analysts' earnings estimates, according to a recent FactSet report.

But earnings growth has largely stagnated over the past year. Around half of the expected earnings growth is attributable to mega-cap tech stocks, which have rallied on Wall Street's excitement for artificial intelligence:

"Expectations for broad equities are muted and overly optimistic, in our view," BlackRock said.

Meanwhile, the US economy has slipped into "stealth stagnation" mode for the past 18 months. When adding up income and profits and households and firms, the economy is in the weakest period outside of an official recession, something that's been masked by hot consumer spending, a strong labor market, and still-robust GDP growth.

Resurgent inflation and a weakening labor market are also posing a risk to earnings. Prices are bound for a "rollercoaster" path, and demographic issues are leading to a shrinking force, meaning the economy's ability to grow without stoking inflation will be capped.

"The risk of resurgent inflationary pressures is why we see the Fed holding policy tight. We expect higher rates to increase the interest expense for companies. We think markets are underappreciating profit margin pressure – even if that takes some time," they added.

The Fed is expected to keep interest rates in the economy higher-for-longer, which will weigh on stocks. Investors have priced in a 98% chance rates will remain above 4% by the end of next year, according to the CME FedWatch tool.

Instead of broad equity exposure, strategists advised investors to be selective in investments and tap into "mega forces" to gain an advantage. Those trends encompass five structural changes that are currently taking shape in markets, including AI, geopolitical fragmentation, and an aging global population.