By IMAP Team

According to Katie, it’s the view of BlackRock that ‘The Great Moderation’ - a four-decade period of steady growth and inflation - is over. She says that with the rush by central banks to raise interest rates in a bid to contain inflation that’s rooted in supply constraints, they are failing to acknowledge the stark trade-off: crush economic growth or live with inflation.

“We see this driving a new regime of higher macro and market volatility, with short economic cycles,” says Katie. “As a result, we anticipate higher risk premia across the board - both equities and fixed income - and we believe portfolio allocations will need to become more granular and nimble, as portfolio managers and advisers embrace this volatility.”

BlackRock doesn’t view this more volatile period as a ‘buy-the-dip’ opportunity, as policy will not be able to step in quickly to elevate the situation. Central banks face tougher trade-offs in this new regime, as reining in inflation will come at a much greater cost to growth. However, preserving growth comes with much higher inflation. The result of this: higher risk premia.

“Under this regime, central banks won’t have as much ability to influence markets as they have had in the past. In this highly nuanced environment, central banks can’t manipulate rates to deal with the current inflation, which is essentially the result of lack of supply - such as energy and food supplies due to the Russia/Ukraine conflict - rather than being driven by excessive demand. By lifting rates too high, central banks run the risk of plunging their economies into recession, which will hurt equities.” 

Katie says BlackRock expects the market environment to become a lot more volatile, as central banks try to find the right balance between growth and inflation.

“That means the traditional 60/40 portfolio needs to be re-evaluated,” she says. “Traditional correlations just won’t work anymore, which means we need to re-consider our portfolios. And until policymakers acknowledge and act on the trade-off between growth and inflation, at BlackRock, we’re not going to get tactically more bullish on equities.”

Katie acknowledges that we are currently living in a world that is shaped by supply, which is unlike any time we have seen in recent decades. And while there has been a major spending shift from services back to goods, this still has to normalise post COVID.

“While we don’t have excessive demand, there are supply issues, which are rooted in the pandemic. And while central banks have been lifting rates to try and normalise inflation and get back to neutral, the problem now is that rate hikes really can’t do much to rein in inflation,” she says. “So, they are faced with a conundrum - they can stabilise output or they can stabilise inflation, but they can’t stabilise both.”

However, for all the noise about containing inflation, BlackRock believes central banks will ultimately be forced to live with inflation, because otherwise, the cost to jobs and social cohesion on economic growth will become too great.

In addition, Katie says the developed world is gripped by unprecedented debt levels. These debt levels surged during COVID to fund the fiscal response by governments to the pandemic. However, the ensuing sensitivity of high debt levels to higher rates makes it harder for central banks to raise rates, which makes it more tempting to live with inflation.

“So, policy trade-offs are going to be more difficult now. Therefore, we expect persistently higher inflation, and shorter, sharper economic cycles,” says Katie.

In this environment, BlackRock has responded by cutting risk tactically. It has done this by going underweight developed market equities, but remains strategically overweight equities long-term. It has also tactically upgraded global credit to overweight on what it sees as the low risk of defaults over the short-term.

As its third theme, BlackRock anticipates a bumpy transition to net-zero carbon emissions, which it believes will significantly shape this new volatile regime.

“We do believe that moving to a low carbon environment will be very bumpy. We have seen green and sustainable assets outperform less sustainable assets, and we believe that will continue. However, we continue to see a key role for fossil fuels in the transition.”

Although commodity prices have spiked post COVID with tightening supply due to the Russia/Ukraine conflict, BlackRock expects the war and the transition to a low carbon economy will continue to keep prices high, which means a continuing key role for fossil fuels in the net zero transition.

However, Katie adds that BlackRock doesn’t believe markets have fully priced in this net zero transition yet.

“We think there is a case for investors to invest in both sustainable assets, as well as high carbon assets that have credible transition plans that will enable companies to benefit from that transition,” she says.

“The implication of this is investors can be bullish both on commodities and sustainable assets. It’s our view that changing investor preferences are likely to give sustainable assets a return advantage for years to come.”

Against this backdrop of higher volatility and sustained inflation, BlackRock is taking risk off the table by downgrading portfolio risk.

For equities, it has done this by tactically cutting U.S. and European equities to underweight over the short-term. It has done so as it expects activity will stall as central banks prepare to over tighten on policy. In addition, historically elevated corporate profit margins are also at risk from rising input costs.

“However, we remain overweight equities in our strategic views of five years or longer,” says Katie. “We expect central banks to ultimately live with some inflation and look through the near-term risks.”

For credit, BlackRock has positioned to be underweight public credit on a strategic basis based on an expectation of a further rise in long-term rates, and prefers credit exposure in private markets.

“Tactically, we have upgraded credit to overweight. Relatively healthy corporate balance sheets mean credit could weather stalling activity better than equities - with wider spreads providing a valuation cushion,” Katie says. “We are also overweight local currency emerging market debt on attractive valuations and potential income. A large risk premium compensates for inflation risk.”

As for government bonds, BlackRock is strategically underweight nominal bonds, with a preference for short-dated maturities.

“We have stayed firmly underweight long-dated bonds, as we see investors demanding higher compensation amid rising inflation and debt levels. We prefer inflation-linked bonds instead,” she says.

Tactically, BlackRock is also underweight, as it sees the direction of travel for long-term yields as higher - even as yields have surged in 2022. Again, it prefers inflation-linked bonds as portfolio diversifiers amid higher inflation.

 Katie Petering is Head of Investment Strategy at BlackRock.

She spoke on ‘Important insights on asset allocation and portfolio construction’ at the IMAP Independent Thought Conference - Sydney