Recession is imminent — no longer will central banks ride to the rescue when economic growth slows. Instead, central banks are triggering recessions with aggressive tightening as they prioritise reining in inflation. Having enjoyed four decades of largely stable economic activity and low inflation, investors will now have to confine “The Great Moderation” to history.
BlackRock, one of the world’s largest asset managers, says central banks will “eventually” back off from rate hikes as the economic damage hits home. However, inflation will settle at a higher rate than before, significantly above the widely bandied 2% level at around 2.75%.
Investors now need a new portfolio playbook that involves more frequent changes, balancing views on risk appetite with estimates of how markets are pricing in economic damage. The playbook also calls for taking more granular views by focusing on sectors, regions and sub-asset classes rather than broad exposures, says the BlackRock Investment Institute (BII) in its 2023 Global Investment Outlook.
“The punchline is this fundamental change, in the particular context of inflation, and the related policy response is leading to structurally more volatile markets and persistently higher inflation for a long time to come,” says Ben Powell, BII’s chief investment strategist for APAC, in a webinar on Dec 1.
With the current market volatility expected to persist, investors ought to make portfolio decisions more frequently. “We have to be more specific and more granular in how we think about investing. We’ve had a broad bull market for the last couple of decades, but we think it’s going to be much more nuanced from here,” he adds.
One of BlackRock’s three themes for its 2023 outlook, “living with inflation”, addresses the damage to income, growth and jobs amid longer-term structural changes. Powell says that central banks — and, critically, the Fed — will ultimately choose to live with inflation higher than developed economies have grown accustomed to over the last several decades.
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He estimates that the “new normal” inflation levels will stand higher than 2% and possibly as high as 2.75%. “The pain of really wringing out that last 75 basis points (bps) to 100 bps to get inflation down to 2% will be too much to bear in terms of economic and social suffering from unemployment,” he adds.
As a result, Powell says that BlackRock’s strategic views have reflected persistent inflation — which market expectations and economist forecasts have only recently come to appreciate — with an overweight to inflation-protected bonds for several years. “The market’s wishful thinking on inflation is why we have a high conviction, maximum overweight to inflation-linked bonds in strategic portfolios and maintain a tactical overweight no matter how the new regime plays out.”
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Equity valuations not reflecting damage ahead
Considering the shift in monetary policy that began this year, BlackRock’s next investment theme for 2023, “pricing the damage”, calls for a continuous reassessment of how much of the economic damage generated by central banks is reflected in prices.
“Our stance right now is [slightly] cautious and conservative from a global risk perspective,” explains Powell. “This is because we think it is likely that we are about to move into a period of slower economic growth, maybe even an outright contraction in Europe and close to zero growth in the US.”
The economic damage flowthrough following the monetary policy tightening of central banks in 2022 keeps BlackRock “tactically underweight” developed market (DM) equities. BlackRock is relatively more “constructive” in Asia than underweights in the US and Europe. “In equities, we are underweight the US, underweight Europe and neutral on Japan, China and Asia (excluding Japan),” he says.
However, BlackRock is ready to turn more positive as valuations move closer to levels better reflecting the economic damage — as opposed to risk assets hoping for a soft landing. “We could see markets look through the damage and market risk sentiment improve in a way that would prod us to dial up our risk appetite — but we are not there yet.”
Even when that time comes, it will not regard this as a prelude to another decade-long bull run for stocks and bonds following the 2008–2009 Global Financial Crisis. “That’s why a new investment playbook is needed,” says Powell.
Yields finally up
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Another of BlackRock’s themes for its 2023 outlook, “rethinking bonds”, comes as yields surged globally, boosting the allure of bonds. For years, investors were starved of assured returns from fixed-income bonds. Bond investors are starting to enjoy real returns with central banks’ hiking rates.
Still, BlackRock says it is taking a granular investment approach to capitalise on this shift rather than taking broad, aggregate exposures. It is now “outright constructive” on investment-grade credit, raising its overweight “tactically and strategically” as it expects the incoming economic slowdown to be prolonged but not “too sharp” to lead to a deeper recession. “Yields are higher, and the default cycle, given that we think the slowdown will not be too deep, should be [decent],” says Powell.
“Particularly in the quality area of investment grade, that’s a yield we think is real and can be owned by investors,” he adds. BlackRock is operating under the assumption that investment-grade credit can hold up in a recession, with companies having fortified their balance sheets by refinancing debt at lower yields.
BlackRock’s position on short-term government bonds and mortgage securities means that investors will not have to take on excessive risk to see rewards, while high-grade credit compensates for recession risks. Meanwhile, agency mortgage-backed securities — those issued by the three US mortgage associations, Government National Mortgage Association, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp — are seen as a new tactical overweight plus diversification for the investment firm.
Powell says that short-term government debt is looking attractive at current yields. On the other hand, BlackRock no longer sees long-term government bonds playing their traditional role as portfolio diversifiers due to persistent inflation. These will also see investors demanding higher compensation for holding them as central banks tighten monetary policy at a time of record debt levels.
While a cornerstone of traditional portfolio construction was that bond prices would go up when stocks sold off, this inverse correlation has broken. “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,” explains Powell.
“One of the important evolutionary changes in how we think about portfolio construction is that developed market government bonds simply don’t give you the [same] resilience within a portfolio that has been the case over the last several decades.”
Powell says that BlackRock will continue to be underweight in developed markets or government bonds. “We think yields will continue to go up over time, and given that yields move inversely to price, we think that the price of developed market government bonds will likely go down — a very different set-up.”
Playbook in action
In the same webinar, Thomas Taw, head of APAC iShares investment strategy of BlackRock, says that in implementing BlackRock’s new playbook, particularly through ETFs and iShares, what stands out is the need for investors to stay “nimble” and use “tactical and precision” instruments in their ETF portfolios.
“From what we have seen over the last 10 years, investors will buy broader types of exposures and rely on US tech growth for returns. In the current environment of volatility and rising rates, that playbook doesn’t work so well,” says Taw. “Throughout the year, investors have become adept at using instruments to get more defensive in their portfolios.”
Investors have thus far this year taken a “risk off” approach, especially in equities and minimum volatility strategies on the single market approach, as opposed to buying broad regional exposures or US exposures. Taw points out that investors have preferred single countries, particularly in Asia, with countries like India and Indonesia, which are more driven by domestic factors than global trade. “The beauty of ETFs is that there’s a flavour for everyone,” he adds. “So investors can be a little bit more
‘risk-on or risk-off’ if they want to.”
On fixed income, he says that the focus has been on shorter durations, as investors have seen yields pick up on the short end of the US Treasury curve. Moving into next year, Taw says he prefers a “defensive” position, although BlackRock is considering factors on the equity front, including emerging market funds as a proxy to the depreciation of the US dollar and also for the value factor as these
funds tend to perform well in a recessionary environment.
Taw adds that it is interesting that investors have been taking on more risk going into the rest of the year and in the context of China’s impending reopening. “We don’t necessarily think that’s because investors are becoming more optimistic on the fundamentals of the market, but simply the fact that throughout the year, they have become more and more defensive,” he says.
“As we start to see equity markets rally, particularly in places like China, investors need to get back into the market because, by the end of the year, the returns will have taken a double hit from being defensive and missing out on the risk rally,” says Taw, adding that investors are even looking for China “proxies” without moving directly into China, with markets like South Korea and Taiwan serving as intermediaries for Chinese trade.
“The view is to stay defensive into next year in single country allocations as well as factor, sector and fixed income allocations,” says Taw. “As we get through 1Q2023 and 2Q2023, that change will come with more risk on type proxies, like value and emerging markets and a bit higher duration on the fixed income side.”
