What's the investment playbook for impending recession and high inflation?

Managing portfolios is going to require a new investment playbook for the new economic regime, says one strategist as BlackRock Investment Institute released its 2023 Global Outlook.

“We’re now in an era that is defined by greater volatility in both output and inflation because we’re dealing with a number of production constraints that are likely to keep inflation higher than we, generationally as investors, have experienced: lower than where we are today, but higher than we’ve experienced over the past several decades,” Kurt Reiman, BlackRock’s managing director and senior strategist for North America, told Wealth Professional.

“Supply shocks are not something that we were used to when we lived in a world of abundance over scarcity. It was a world of falling interest rates and falling inflation, and bond yields were higher than inflation, so that was a positive real yield, and it was a boost to all assets.”

Reiman said BlackRock does not think that yields have finished rising because inflation is not properly priced. It also believes that we will certainly have a recession in 2023.

“We’ve been trained to think that a recession means lower bond yields and, we think that bond yields – although they’ve risen a lot – still have further to rise,” he said.

He said the current situation – with an impending recession and inflation expected to continue to be higher than the banks would like  – is making inflation-linked bonds the new source of ballast for asset markets. But, the value-oriented sectors, such as energy and financials, are important.

“Right now, we are still mindful of the risks that are inherent in fixed rate, nominal government bonds and in stocks in the developed markets. So, we are underweight in both of those,” said Reiman. “Another way to be able to navigate this new, more volatile world is to be more granular and selective and tactical, like following some of these recommendations.”

Reiman said BlackRock’s portfolios are as defensively positioned as they’re going to get, so it’s considering the signposts for becoming more positive on riskier assets, such as stocks. The company is anticipating that when the central banks finally pause their rate hikes, they’re going to leave rates where they are and not cut them right away, but the markets have priced that in. So, the policy rates are expected to remain at elevated levels for longer than they would have in the past.

“We want to see inflation start to trend down in a meaningful way to allow for central banks to pause their rate hikes, and all of these together would likely boost market sentiment. So, we go from a risk-off to a risk-on regime,” said Reiman. “But, even when that happens, we’re not looking for another decades-long secular bull market in stocks and bonds.”

Reiman expects the rallies to be more short-lived and stocks and bonds may not move in the same direction, as they did before. So, what should advisors do with all of this?

Reiman said investors have preferred cash since they’ve seen the declines, but now there’s an opportunity to start putting some of that money to work. He warned there was still further weakness in intermediate and long-maturity bonds but, on the front end of the curve, the yields are higher than a year or two ago because the central banks have raised the rates. The two-year Government of Canada bond yield, for instance, is now almost 4%, which provides an opportunity.

“Short maturity, government bonds may not sound all that terribly exciting, but income is income,” said Reiman.

He also suggested that advisors look at the corporate bonds, whose yields are above 5%.

“Unlike the stock market, which isn’t priced for recession,” said Reiman, “we think corporate bonds are priced for a rise in default rates, so investors are compensated for the risk.”

Advisors can also pick up some additional return from inflation-linked bonds, which will offer more return relative to what they would get by holding fixed-rate government bonds.

He said it’s also important to be patient with the financials and energy (including renewable) stocks and wait for the anticipated earnings decline as the stock market will price in the damage, providing some opportunities.

Overall, though, he is expecting more macro and financial market volatility. “But that doesn’t mean that, as investors, we should be paralysed,” said Reiman. “In fact, we should be doing our homework and finding where the better opportunities lie within the financial markets.”