MBB - A New Investment Playbook In Action

2023-04-07 23:30:00 ET

Summary

• The old investment playbook is out and a new regime that considers high inflation and interest rates is in.
• Recent events in the banking sector around SVB and Credit Suisse have made clear the importance of staying nimble as investors.
• Our expectation is that the focus of market would shift from the broad brush, the prevalent market narrative being rates and duration and top down, to back to fundamentals, back to basics, and back to earnings.

The old investment playbook is out and a new regime that considers high inflation and interest rates is in. Wei Li, BlackRock's Global Chief Investment Strategist joins host Oscar Pulido to explain what investors can expect in the next quarter.

Transcript

Oscar Pulido: Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido.

Recent events in the banking sector around SVB ( SIVBQ ) and Credit Suisse ( CS ) have made clear the importance of staying nimble as investors. The old investment playbook is out and a new regime that considers high inflation and interest rates is in. Here to explain what investors can expect in Q2, I'm pleased to welcome Wei Li, Global Chief Investment Strategist for BlackRock.

Wei, welcome to The Bid.

Wei Li: Thank you so much, Oscar, for having me. I'm very excited to be here.

Oscar Pulido: Wei, the markets have given us quite a ride already in 2023. And just taking a step back, it feels similar to 2022, not so much in terms of the returns across asset classes but what is driving those returns. Last year we talked a lot about macro drivers in the market, so things like the Fed, interest rates, inflation, that seemed to have a big impact. Would you agree that this year is more of the same?

Wei Li: Absolutely. So, if you think about the whole of 2023, so far it has been a very macro market, right? So, if you think about the US equity market, for example, more than 90% of the year-to-date return, were driven by seven names. Mostly tech names.

So, we're talking about the market being a very macro-driven and duration-driven type of market so far this year which is, I think intuitive in that what we have seen is significant rate moves translating into parts of the equity market that are duration sensitive, reacting and overreacting.

But our expectation is that the focus of market would shift from the broad brush, the prevalent market narrative being rates and duration and top down, to back to fundamentals, back to basics, and back to earnings.

And on that basis, if you think about, the trends that we expected coming into this year, so specifically I'm talking about earnings would come under pressure and margins would compress, they're actually playing out.

If you look at the last earnings season, for Q4 last year, it was the first quarter of earnings contraction since late 2020 for the US Equity market. And we have seen negative operating leverage, we have seen decreasing margins.

So, all of those trends they are playing out. It's just that actually markets were not taking note of that because the prevalent narrative of the market is very macro-driven rather than micro-driven.

But it is my expectation that focus will shift to earnings and micro and fundamentals and basics over time as we look at the rest of 2023 because over a longer period, indeed it is the earnings that very much determine how equities would perform.

So just to put the year-to-date markets into context and frame that in a very macro perspective, but I do think that earnings will matter more and more as we navigate the rest of the year.

Oscar Pulido: So, as we enter the second quarter of the year, I can't help but think back to some of the themes that you and other members of the BlackRock Investment Institute have mentioned over the past year.

You've talked about the end of the great moderation and the beginning of a new market regime that we'll see higher volatility across things like interest rates and inflation.

You've also talked about how the investment playbook of the past may not apply going forward, specifically as it relates to central bank policy. So, take us through how your thinking has changed on some of these fronts.

Wei Li: That's a great question, Oscar. It's a great question because it's important to take stock right now in the second quarter of the year.

As we entered 2023, the overall framing that we had is that this year is likely going to be on aggregate a better year for risk assets in comparison with 2022 where we had bear markets in equity than bonds. And the reason why we had that view and why we continue to have that view, is because we think that the inflation is falling, but parts of it will stay persistent. That's number one.

Number two growth is falling, but we're talking about a shallow recession, so not a deep and protracted one.

And then number three is central banks instead of hiking rates aggressively at some point this year they're going to pause and that is a different type of environment versus surprising on the hawkish side throughout the course of last year. So that's number three.

And number four for why we think that this year on aggregate will be a better year for risk assets is that China is restarting and reopening versus being in lockdown for 2022.

So, sitting at the beginning of Q2 and revisit all this framing that we had at the beginning of the year, what has changed? Did any of this change, let's go through them one by one.

Inflation is falling, yes, indeed. But also, our expectation that parts of inflation are persistent. And that's getting more and more appreciated. At the beginning of the year, there were hopes, not our hope, but there were hopes in markets that inflation would just fall down to target without pain to the economy.

And I think that's now looking less and less likely and being appreciated as well. So, inflation is falling, but part of is persistent. So, we haven't changed our view on that front. And I think that's more embraced now, as we see evidence of a tight labor market and sticky core inflation.

On the second point about growth slowing down, I think the time horizon over which recession would kick in, I think that has been pushed out a little bit versus expectation at the beginning of the year, given resilient consumers - you look at retail sales, for example.

So, we still think that recession is coming but instead of Q2/Q3, maybe second half of the year is looking more likely given the resiliency in the consumer side of the economy. I would say, though, the banking turmoil may represent a downside risk that would take time for us to fully understand the magnitude of this banking shock and related credit crunch.

But I would say recession core is still in place, but maybe pushed out a little bit more versus expectation at the beginning of the year.

Central banks, we're getting close to peak in Central Bank rate hike cycle, that we have not changed. But markets are hoping that central banks would come to the rescue of the economy with markets currently pricing two rate cuts into the end of the year and two, three rate cuts heading into next year - that we don't think would happen.

So, we're still leaning against market hopes for rate cuts this year. And that's, why we have been modestly underweight parts of the equity market because markets are hoping for the old recession playbook, and central bank's cutting rates. I just don't think that would happen for this year precisely because of the inflation dynamics. So that's point number three.

China restarts - we had a view that China growth for this year would have a six handle, and that was our view at the beginning of the year. I think consensus is moving closer to that now, and the momentum for China restarting is being more appreciated. So, we haven't changed the view, but I think it's becoming more and more of the consensus.

But what would say didn't quite appreciate is how strongly sentiment wanted to embrace the rebound. So you think about the strong momentum coming into 2023, our assessment is that it was really a fear of missing out rally, right? I hear from, clients and investors, across the world, that last year was really hard for portfolios because Equities were down and bonds were down.

So, it would be very costly, after experiencing last year, to miss out on a rebound, which is why some are positioning for the rebound, whilst recognizing that things could get worse before it gets better, and we could be heading into every session before we come out of it.

And yet some are already positioning for that rebound, and I think that fear of missing out is that sentiment boost to market. And it's always hard to quantify things like that, but I think that's the missing piece so far this year as I revisit what transpired in the first quarter.

Oscar Pulido: Wei, you touched on 2022 and how tough a year it was for both stock and bond investors, but also you shared the view that 2023 would be better. Can you talk a bit about bonds in particular? I think this was an area that most surprised investors last year, and specifically the losses they experienced in their bonds. So what opportunities are you seeing now in this particular asset?

Wei Li: I think bonds are more interesting now because income is finally back. So, if there is one silver lining out of a very traumatic year, that was 2022, is that, yeah, you get paid now. For sitting in reasonably, no risky fixed income assets.

For the most part of last year, and for most part of this year we were close to maximum overweight investment grade credit, so quality credit. We trimmed that maximum overweight to modest to overweight to take some profit because spread has tightened quite a bit. But that idea of being paid for taking very little credit or duration risk, for that matter, is very appealing.

So I, like bonds on aggregate, but specifically front end of the curve - very front end, I'm talking about T-view in the US treasury market, as well as still a relative preference for quality credit over high yield, credit given our view that we are still heading to a recession and default currently tracking at a low single digit could go up a little bit, and that could impact high yield bit more than investment grade.

I would say last thing about investing in bonds, we currently also have a relative preference for emerging markets that over on aggregate developed market bonds because, emerging market central banks, they were ahead of the curve in hiking rates coming out of the pandemic to the extent that they now have a bit of a buffer, the number of emerging market central banks that are hiking rates is decreasing.

And some of them are even talking about cutting rates. So, there is something there that makes emerging market that bit more attractive. And also, if you look at traditionally the excess return for emerging market debt versus their developed market equivalent, that tends to be proportional to the economic momentum of the emerging market economies versus developed market counterparts.

And currently given the restart, that is happening in emerging markets, and also specifically in China, that is boosting the relative growth momentum in emerging market, which is another reason that we favor emerging market debt.

But more broadly, just to say, income is attractive in bonds for once. After waiting for decades of very low yield, that makes bonds more attractive compared to before in developed world preference for very front of the US treasury market. And also, still a preference for, IG quality, credit over high yield and emerging market debt looks quite okay

Oscar Pulido: Okay. Got it. So it sounds like there are definitely opportunities in the bond market. You mentioned the shorter end of the government bond market. You talked about investment grade. You mentioned emerging markets. You've also talked about inflation, and I just want to come back to that. You said earlier that it is falling, but it will remain persistent.

And I want to come back to this theme of living with inflation and this concept that central banks won't be coming to anyone's rescue. So, what is it going to look and feel like for investors right now in terms of living with that kind of inflation?

Wei Li: Yeah, we're going to be living with higher inflation, higher than pre pandemic levels of inflation for longer than many expected.

And I think if you look at market pricing markets are under appreciating the degree to which we're going to have to do that. If you look at 10-year break even at some point it was just about 2- 2.1%, in our view in the US 3 is the new 2 in terms of where inflation would settle.

So, part of the new investment playbook is being more dynamic, it's being more frequently assessing your investment views. So, when market dislocation like that present itself, we leaned into it and we added to our inflation-linked, bond, preference even more. So now actually looking at the market pricing 10-year break-even is now comfortably above 2.3.

So, we have what we view as a target level as we think about where things should settle and if market dislocation present opportunities, we take advantage of that. That's point number one.

Point number two, you are absolutely right, Oscar, where in an environment where there are structural forces, that means inflation. It's going to settle at a higher level than what we got used to previously. And that is considering some of the cyclical forces driving inflation down, right? So, we're talking about goods, deflation, like goods, service rotation coming out of the pandemic is bringing part of the inflation mix down.

But structural forces like aging demographics, labor shortage, geopolitical fragmentation, and the net zero transition, which ultimately is a series of supply shocks, means that inflation will settle at a higher level, which is why as we think about portfolio construction over both the medium and the long term, we need to think about inflation protecting our portfolios, which is why we think we've got to dig one layer below the debate of 60:40, 40:60, 50:50, or whatever it is, we actually need to go into another layer of granularity and think about, yes, 60:40, 50:50, but what is your 60, what is your 40 bonds?

But it's, going to be more granular than that. We have a preference for inflation links, bonds over long duration nominal bonds for the reason that I just talked about in that market pricing, is under appreciating that we're going to live with higher inflation than before, but also thinking about the role of real assets in portfolio construction from the perspective of inflation protecting your portfolio.

So, as we evolve portfolio construction, think about real assets, private markets, but of course also recognizing the higher rate environment, what does that mean? But also thinking about, going one layer below and thinking about what your bond allocation should be and currently we have a preference for inflation linked bonds over normal bonds.

Oscar Pulido: Well, it sounds very consistent with everything that you've been saying about the new investment playbook that is required going forward.

So, Wei, thank you so much, for all these insights and thank you for joining us on The Bid today.

Wei Li: Thank you so much for having me, Oscar.

Oscar Pulido: Thanks for listening to this episode of The Bid.

Next time on The Bid, Cristiano Amon, the CEO of Qualcomm, joins me to talk about the digital transformation that is underway and how it will transform industries across the board.

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This post originally appeared on the iShares Market Insights.

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