Global Weekly Commentary: A new playbook for a new regime
In with the new
The new macro regime is playing out. We think that requires a new, dynamic playbook based on views of market risk appetite and pricing of macro damage.
Market backdrop
U.S. jobs data showed lower workforce participation is propping up wages and confirming labor shortages should help keep inflation persistently higher.
Week ahead
We’re watching services PMIs and key trade data for more signs of the damage from tighter financial conditions before key central bank meetings next week.
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. Read more in our 2023 Global outlook.
Recession foretold
U.S. GDP and potential supply, 2017-2025
Sources: BlackRock Investment Institute and U.S. Bureau of Economic Analysis, with data from Haver Analytics, November 2022. 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.
Week ahead
Dec. 5
U.S. and China services PMIs
Dec. 6
U.S. trade; UK PMI
Dec. 7
UK house prices; China trade
Dec. 8
University of Michigan consumer sentiment; U.S. and China PPIs
Source
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of Dec. 1, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point this year-to-date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
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