The author is head of the BlackRock Investment Institute and former Deputy Governor of the Bank of Canada
Buy the dip when the stock goes down. Find refuge in government bonds when growth worries rise or recession hits. These basic strategies have served investors well for decades. But they don’t work now.
The steady growth and inflation we experienced in the 40 years before the pandemic – a period known as the Great Moderation – is over. Rather, we are in a world shaped by production constraints, which make it difficult for economies to operate at current levels without fueling inflation. That leaves central banks with a cleaner trade-off. They may raise rates enough to stabilize inflation soon at their 2% target, but that will be bad for growth, bad for stocks and, with government debt at record highs, bad for public finances. Alternatively, markets have yet to adjust to ever-higher inflation, which will be bad for bonds. There is no perfect result.
And that’s not about to change. Three long-term trends are predicted to maintain production constraints and support inflationary pressures. First, aging populations reduce the supply of labor and the resulting impact on production is only just beginning to materialize in many major economies. Second, the rewiring of globalization and the need to build more resilient supply chains means higher production costs. Third, the transition to a low-carbon world leads to mismatches between energy supply and demand, which also increases production costs.
Central banks can of course act to control these inflationary pressures. More importantly, it means they won’t rise to the rescue in a recession, as most investors have grown accustomed to over the past 40 years. In fact, the opposite is happening. Central banks deliberately cause recession by excessively tightening policy to contain inflation. This leads to a predicted recession in 2023. Central banks are then likely to forego rate hikes, as the economic damage becomes reality. This means that inflation will slow but remain consistently above the 2% target.
This new regime calls for a new investment manual. In the Great Moderation, recession meant lower inflation. We now expect a recession and unexpected increases in inflation. This argues in favor of overweighting inflation-linked bonds, even in the short term.
Market sentiment should turn more positive in 2023. But when it does, don’t expect it to be the prelude to a decade-long bull market. What will matter most to investors is to continuously assess how economic damage is impacting market prices. Equity valuations, for example, do not yet reflect the likely damage ahead. There is still time to be underweight. The trigger to turn positive on equities is when the damage price is priced and damage visibility improves the risk environment.
The new playbook also calls for a rethink of bonds. Higher yields are a gift for investors who have long been hungry for income. And investors don’t have to go very far down the spectrum of risk to benefit. Short-term government bonds and mortgage-backed securities are attractive for this reason. High-quality credit yields are also now offsetting recession risks. But this income allure will have to be carefully weighed against the capital loss associated with a faster rise in rates.
In the old playbook, long-term government bonds would be part of the package because they have historically protected portfolios from recession. Not this time.
Stock and bond yields have – and likely will – fall at the same time. Why? Central banks are unlikely to cut interest rates quickly in recessions they themselves engineered to crush inflation. On the contrary, key rates could stay higher for longer than expected by the market. Additionally, investors will increasingly demand greater compensation for holding long-term government bonds in the face of inflation, central banks slashing their holdings and record debt levels.
The increase in debt service will shed a different light on public finances, which will be further compressed by the aging of the population. We saw a glimpse of this in the UK with the return of the so-called bond vigilantes who sparked a surge in yields to punish over-the-top UK fiscal policies.
Conclusion: The new investment manual implies more frequent portfolio changes, calibrated by balancing an assessment of overall risk appetite with estimates of what’s in the price. It calls for taking more granular views by focusing on sectors, regions and sub-asset classes, rather than broad exposures. Even long-term asset allocations need to be more dynamic: the volatile regime is here and not about to change.
