Strategic Views In The New Regime

Transcript

We’ve updated our strategic views of five years and beyond. This new regime of greater economic and market volatility means we need to more frequently re-underwrite what’s priced.

Traditional, market cap-weighted approaches – like a 60:40 or 50:50 equity-bond split – won’t do in the new regime.

1) Leaning into investment grade credit

Relative to a neutral starting point, we have an overweight to credit.

We’ve upped our global investment grade credit overweight due to the income potential and strong balance sheets.

We cut high yield to neutral. Mild recessions loom that may spur more defaults and downgrades in lower-quality credit.

2) Granularity in government bonds

We’re underweight government bonds. We see markets underappreciating investor demand for higher compensation to hold long-term bonds amid inflation risk and high debt burdens.

Granularity is important; however, on a relative basis, we like shorter-dated maturities given reasonable coupon income and less exposure to term premium.

3) Overweight stocks in the long term

We stay overweight stocks strategically. Stock markets may take a leg lower in the near run as markets wake up to no Goldilocks scenario. In five years’ time the downturn will be behind us.

We lean into investment grade credit as we position long-term views for the new regime.

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Our strategic views of five years and longer are positioned for the new regime of greater macro and market volatility. We go more overweight investment grade (IG) credit on attractive yields and healthy corporate balance sheets that can withstand the mild recession we expect. We stay modestly overweight developed market (DM) equities. We expect the overall return of stocks over the coming decade to be greater than fixed-income assets even if equities take a near-term hit.

Leaning into investment grade credit

Notes: The chart shows our asset views on a 10-year view from an unconstrained U.S. dollar perspective against a long-term equilibrium allocation. This material represents an assessment of the market environment at a specific time and is not intended as a recommendation to invest in any particular asset class or strategy, a forecast of future events nor or a guarantee of future results.

Since our last strategic view update, we increased our overweight on global IG credit and cut high yield to neutral from overweight (see chart). We like the income we can pick up in IG at higher spreads. And we see looming recessions having more ripple effects on high yield than IG. Other views hold true as the new regime plays out. Our expectation of sticky inflation favors inflation-linked bonds not yet pricing in that view. Nominal long-term bonds are challenged for multiple reasons that we see driving a higher term premium, or the compensation for holding them. We prefer short-term government bonds because they don’t face the same risks from investors demanding more term premia as in long-term bonds. Our modest overweight in DM stocks is because we think central banks will live with inflation, keeping recessions mild, and long-term valuations are fair.

Unpacking our views

The new regime warrants getting more granular than broad asset class views can convey – both between and within asset classes. For example, old correlations have broken down between equities and bonds that underpinned the bond role as portfolio ballast. We’re underweight government bonds because we think investors will demand higher term premium amid higher inflation and elevated debt burdens. Within government bonds, we like short maturities to collect attractive coupons. We prefer to take fixed-income risk in credit – and prefer public credit to private. We like the income potential and strong balance sheets in IG where credit spreads are near the widest in two years. We’re cautious on high yield and move to neutral – even mild recessions lead to greater defaults and downgrades in lower-quality credit.

We stay overweight in inflation-linked bonds because we see persistent inflation – and we still like long-term inflation-linked bonds. Why? We think the new regime of production constraints is set to persist, reinforced by three big transitions. First, aging populations mean shrinking workforces – one reason why labor supply is struggling to keep up with output. Second, we think geopolitical fragmentation is rewiring supply chains. Efforts to re-shore operations could also add to the upward pressure on wages and inflation. Third, we see the transition to net-zero carbon emissions reshaping energy demand and supply over time. Yet, market pricing shows expectations for inflation to slow back near pre-pandemic levels.

Over the next year, stocks don’t yet fully reflect our recession expectation and the resulting drag on corporate earnings. That’s why we’re underweight tactically. But strategically, we expect the overall return of stocks to be greater than fixed-income assets over the coming decade. That’s partly because we see the politics of recession taking over from the politics of inflation – and central banks will eventually live with some inflation. Staying invested in stocks is one way to get more granular with structural trends impacting sectors. We think lower-carbon sectors like tech and healthcare will benefit more on average than traditional energy stocks in the transition to net-zero carbon emissions, even as traditional energy firms with credible transition plans can do well. In private markets, valuations have not caught up with the public market selloff, reducing their relative appeal. But we think private markets should be a larger allocation than what we see most qualified investors hold.

Bottom line

Our strategic views are positioned for the new regime of greater macro and market volatility. We think portfolios need to be more dynamic and change more frequently by constantly assessing the economic damage in market pricing.

Market backdrop

Stocks flatlined this week, while the U.S. Treasury yield curve neared its most inverted levels since the early 1980s. Federal Reserve officials made clear that what matters is not the pace of rate hikes but the end-point for policy rates. The Fed is set to overtighten policy, causing a mild recession just as signs of damage become evident – such as a further drop in U.S. housing starts. We think the Fed will ultimately stop when the economic pain is clearer and live with some inflation.

This week’s global PMIs take center stage as we gauge activity relative to the looming recession we expect in major economies. We don’t see a soft landing outcome from central bank overtightening, but think they will stop short of causing deep downturns as the damage from sharply higher rates becomes clearer.