The Great Moderation, the four-decade period of largely stable activity and inflation, is behind us. The new regime of greater macro and market volatility is playing out. A recession is foretold; central banks are on course to overtighten policy as they seek to tame inflation. This keeps us tactically underweight developed market (DM) equities. We expect to turn more positive on risk assets at some point in 2023 – but we are not there yet. And when we get there, we don’t see the sustained bull markets of the past. That’s why a new investment playbook is needed.

We laid out in our 2022 midyear outlook why we had entered a new regime – and are seeing it play out in persistent inflation and output volatility, central banks pushing policy rates up to levels that damage economic activity, rising bond yields and ongoing pressure on risk assets.

Central bankers won’t ride to the rescue when growth slows in this new regime, contrary to what investors have come to expect. They are deliberately causing recessions by overtightening policy to try to rein in inflation. That makes recession foretold. We see central banks eventually backing off from rate hikes as the economic damage becomes reality. We expect inflation to cool but stay persistently higher than central bank targets of 2%.

What matters most, we think, is how much of the economic damage is already reflected in market pricing. This is why pricing the damage is our first 2023 investment theme. Case in point: Equity valuations don’t yet reflect the damage ahead, in our view. We will turn positive on equities when we think the damage is priced or our view of market risk sentiment changes. Yet we won’t see this as a prelude to another decade-long bull market in stocks and bonds.

This new regime calls for rethinking bonds, our second theme. 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. We like shortterm government bonds and mortgage securities for that reason. We favor high grade credit as we see it compensating for recession risks. On the other hand, we think long-term government bonds won’t play their traditional role as portfolio diversifiers due to persistent inflation. And we see investors demanding higher compensation for holding them as central banks tighten monetary policy at a time of record debt levels.

Our third theme is living with inflation. We see long-term drivers of the new regime such as aging workforces keeping inflation above pre-pandemic levels. We stay overweight inflation-linked bonds on both a tactical and strategic horizon as a result.

Our bottom line: The new regime requires a new investment playbook. It involves more frequent portfolio changes by balancing views on risk appetite with estimates of how markets are pricing in economic damage. It also calls for taking more granular views by focusing on sectors, regions and sub-asset classes, rather than on broad exposures.

Source: Black Rock Investment Institute - 29 Dec 2022