The writer is head of the BlackRock Investment Institute and former deputy governor of the Bank of Canada
Buy the dip when stocks go down. Find shelter in government bonds when growth worries mount or recession hits. Such staple strategies served investors well for decades. But they’re not working now.
The steady growth and inflation we saw in the 40 years before the pandemic — a period known as the Great Moderation — is over. We are instead in a world shaped by production constraints, making it difficult for economies to operate at the current level without stoking inflation. That leaves central banks with a sharper trade-off. They can raise rates enough to stabilise inflation at their 2 per cent target soon — but that will be bad for growth, for equities and, with public debt at record highs, for government finances. Alternatively, markets still need to adjust to persistently higher inflation — that will be bad for bonds. There is no perfect outcome.
And that’s not about to change. Three long-term trends are set to maintain production constraints and sustain inflationary pressures. First, ageing populations are reducing labour supply, and the resulting production hit is just starting to materialise in many major economies. Second, the rewiring of globalisation and the need to build more resilient supply chains means greater production cost. Third, the transition to a lower-carbon world is causing energy supply and demand mismatches, also increasing production cost.
Central banks can of course act to tame these inflationary pressures. But crucially that means they won’t ride to the rescue when recession strikes, as most investors have become accustomed to over the past 40 years. In fact, the opposite is happening. Central banks are deliberately causing recession by overtightening policy to rein in inflation. That makes for a recession foretold in 2023. Central banks are then likely to back off from rate hikes, as the economic damage becomes reality. That means inflation will cool but stay persistently above the 2 per cent target.
This new regime calls for a new investment playbook. In the Great Moderation, recession implied lower inflation. Now we expect recession and upside inflation surprises. That makes the case for being overweight inflation-linked bonds, even in the short run.
Market sentiment is likely to 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 for investors is continually assessing how much of the economic damage is reflected in market prices. Equity valuations, for example, don’t yet reflect the likely damage ahead. It’s still time to be underweight. The trigger to turn positive on equities is when the damage is priced, and visibility on the damage improves the risk environment.
The new playbook also calls for a rethink of bonds. Higher yields are a gift to investors who have long been starved for income. And investors don’t have to go far up the risk spectrum to receive it. Short-term government bonds and mortgage securities are appealing for that reason. High-grade credit yields also now compensate for recession risks. But this lure of income will need to be weighed carefully against the capital loss associated with a more rapid increase in rates.
In the old playbook, long-term government bonds would be part of the package because they historically have shielded portfolios from recession. Not this time.
The stock and bond returns have — and will probably — both go down at the same time. Why? Central banks are unlikely to cut interest rates rapidly in recessions they themselves engineered to crush inflation. If anything, policy rates may stay higher for longer than the market is expecting. Plus, investors will increasingly ask for more compensation to hold long-term government bonds given inflation, central banks reducing their holdings and record debt levels.
Rising debt servicing costs will put a different light on public finances, which will be further squeezed by an ageing population. We had a glimpse of this in the UK with the comeback of the so-called bond vigilantes sparking a yield surge to punish profligate UK fiscal policies.
The bottom line: The new investment playbook involves 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 on broad exposures. Even long-term asset allocations need to be more dynamic: The volatile regime is here and not about to change.