A New Playbook For A New Regime

Transcript

Wei Li, BlackRock Global Chief Economic Strategist

The new regime of greater macro and market volatility is playing out – and that’s not about to change. We believe investors need a new playbook for the new regime, and the three themes for the 2023 global outlook are: pricing the damage, rethinking bonds, and living with inflation.

Our first theme is pricing the damage. We see major economies heading for recessions as central banks eventually back off from aggressive rate hikes. We need an ongoing dynamic assessment of the damage to come, as well as to what extent it’s reflected in market pricing.

Our second theme is rethinking bonds. This new playbook requires looking at bonds differently, including the role of duration in a portfolio at times of recession, and it also requires going more granular on fixed-income views beyond the broad asset class block.

The third theme is living with inflation. We see three long-term drivers – aging workforces, geopolitical fragmentation, and the net zero transition – keeping inflation higher versus pre-pandemic levels, even as headline inflation falls heading into next year.

The bottom line is we believe that the old recession playbook may not work in the upcoming recession, and investors should be prepared to make more frequent adjustments to portfolios based on balancing a risk-taking view with the estimate of how financial markets are pricing in economic damage.

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We see the new regime playing out and not going away. Persistent production constraints keep this regime of higher macro and market volatility in place, in our view. We think this means a new, dynamic playbook is needed – where tactical and strategic portfolios change more frequently to balance our views on risk appetite with the pricing of economic damage. It’s also about granular views within sectors and asset classes of portfolios.

Recession foretold

Notes: The chart shows demand in the economy, measured by real GDP (in orange) and our estimate of pre-Covid trend growth (in yellow). The green dotted line shows our estimate of current production capacity. We infer that from how far core PCE inflation has exceeded the Federal Reserve’s 2% inflation target.

We see a world shaped by supply that involves sharp trade-offs for central banks. Higher policy rates can’t resolve limited production capacity (green line in chart) that we don’t see changing soon. That means the only way for central banks to bring inflation down to target is to hike rates enough to crush demand (orange line) down to the level the economy can comfortably sustain. That’s well below the pre-Covid growth trend (yellow line). Central banks appear set on doing “whatever it takes” to fight inflation, making recession foretold, in our view. We think a new playbook is needed – one that balances an assessment of overall risk appetite with estimates of the economic damage priced. Equities still don’t reflect the damage we see ahead, so we’re underweight. The trigger to turn positive is when the damage is priced, and visibility on the damage improves risk appetite.

Our three investment themes help flesh out the new playbook. First, pricing the damage. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price. They are deliberately causing recessions and are unlikely to cut rates to cushion the impact. We stand ready to turn more positive as valuations get closer to reflecting economic damage – or if we think markets have enough clarity to sustainably dial up risk. But we won’t see this as the beginning of another decade-long bull market in stocks and bonds. We’re also rethinking bonds, our second theme. Fixed income finally offers attractive yield, especially in short-term government bonds and high-quality credit. But we don’t think long-term government bonds will play the role of portfolio ballast: inflation, central banks reducing their holdings and record debt levels will lead investors to demand more compensation for holding long-term bonds, or term premium. That leads us to our third theme: living with inflation. We see inflation cooling as spending patterns normalize and energy prices ebb – but we see it persisting above targets in the coming years.

Regime reinforcements

A new playbook is important because three long-term drivers of production constraints mean the new regime isn’t about to change, in our view. The first driver is aging. We see aging populations shrinking workforces and hitting growth. Second, a new world order. We think geopolitical fragmentation will lead to a rewiring of globalization and drive up production costs, while also creating mismatches in supply and demand. Third, a faster transition to net-zero carbon emissions. We believe the global transition could accelerate, boosted by significant climate policy action, by technological progress reducing the cost of renewable energy and by shifting societal preferences as physical damage from climate change becomes more evident.

What this means for portfolios

Our new investment playbook calls for more frequent portfolio changes and a granular approach. Take equities, we’re tactically underweight developed market (DM) equities. They’re not pricing the recession we see, but certain sectors are attractive, like healthcare. But we’re neutral in Japan given still-easy monetary policy. Strategically, we’re overweight DM stocks because we see better returns than fixed income over the coming decade. Within fixed income, we tactically like attractive income in investment-grade credit, U.S. agency mortgage-backed securities and short-term Treasuries. We stay underweight long-term government bonds though, because we see investors demanding more term premium due to inflation and other risks. Our view that markets underappreciate the persistence of higher inflation underpins our high-conviction overweight to inflation-linked bonds, tactically and strategically.

Market backdrop

U.S jobs data showed wages rising twice as high as consensus forecasts and the labor force participation rate, or the share of the adult population in the workforce, ticking down. We think this shows how labor shortages are putting upward pressure on wages, likely keeping inflation persistently higher. That keeps the Federal Reserve on track to overtighten policy and trigger a recession, in our view. It also underscores why the Fed may keep rates higher for longer than markets expect.

This week’s services PMIs and trade data will be watched for signs of further damage from central banks’ policy overtightening before next week’s key meetings, including the Fed. The University of Michigan survey will again be scrutinized to see if consumer inflation expectations remain contained.