2023 Global outlook

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.

“The environment that central banks find themselves in – which is an environment unlike anything we have seen in decades – is one in which the supply capacity of economies is being constrained. Central banks face a very stark choice: either create recession or live with the inflation,” says Alex Brazier, Deputy Head of the BlackRock Investment Institute.

The new regime the world find itself under requires a new investment playbook, according to BlackRock in their global outlook for the new year. The world’s largest asset manager unpacked why a new investment playbook is needed, as well as some of the key investment themes, at the release of the outlook last month.

Investment theme 1: Pricing the damage
To get inflation all the way down, in BlackRock’s view, will require recessions. This forces us to rethink the role of central banks, says Brazier. “In the past forty years, central banks have come to be thought of as some sort of a cavalry riding to the rescue whenever the economy turned out,” says Brazier.

“In this kind of environment, they are quite the opposite. They [central banks] are the creators of recession, rather than the rescuers from recession.”

Central banks are deliberately causing recessions by overtightening policy to try to rein in inflation. That makes recession foretold, says Brazier. He says the asset manager sees central banks eventually backing off from rate hikes as the economic damage becomes reality.

BlackRock expect inflation to cool but stay persistently higher than central bank targets of 2%.

What matters most, according to BlackRock, is how much of the economic damage is already reflected in market pricing. The asset manager says this is why pricing the damage is the 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.”

Investment theme 2: Living with inflation
High inflation has sparked cost-of-living crises, putting pressure on central banks to tame inflation – whatever it takes. Yet, there has been little debate about the damage to growth and jobs.

“The ‘living with inflation’ investment theme is one that BlackRock has had for some time now,” says Brazier. “The good news this year is that inflation should come down a long way.

“A lot of people have been saying that for a long time, but now is the time that it is likely to happen – energy prices have stabilised, and as central banks create these recessions, they close the gap between the level of activity in their economies and what those economies can comfortably sustain.”

He says we should see core inflation cooling. BlackRock sees inflation lingering past more than markets are pricing from this episode. “Central banks will not create quite enough economic damage to squeeze inflation all the way down,” says Brazier.

Why a new investment playbook is needed

What BlackRock did differently in this outlook, compared to its previous ones, is that they believe, given the new regime, more frequent [interest rate] adjustments are needed, including a new playbook, says Wei Li, Global Chief Investment Strategist at the BlackRock Investment Institute.

“As we look ahead to this year, we do expect, at some point, to turn more positive on risk assets. We do not think the time to do that is now. Also, importantly, even as we turn positive at some point this year, we do not think there is a prelude to a decade-long bull market that we have seen in the past.”

This is how BlackRock is thinking of potentially turning more positive in 2023.

Chart 1: BlackRock’s new playbook

The chart features two assessments that BlackRock would make as they think about building a tactical portfolio for 2023. The first assessment is market risk sentiment (BlackRock’s assessment of the market risk sentiment) on the vertical axis of the matrix, explains Li.

• The matrix shows how BlackRock plan to change their views and turn more positive as markets play out in the new regime. A few key conclusions from the asset manager are:
• They are already at their most defensive stance. Other options are about turning more positive, especially on equities.
• They are underweight nominal long-term government bonds in each scenario in this new regime. This is their strongest conviction in any scenario.
• They can turn positive in different ways: either via their assessment of market risk sentiment or their view on how much damage is in the price.

Essentially, the matrix determines how much of the risk budget we are willing to play with to start, says Li. “This then determines the portfolio construction process and underpins the investment views that we have.”

The second assessment is around gauging the macro damage in response to central banks over-tightening, but also gauging to what extend the macro damage is priced in by markets, says Li. In equities, BlackRock believe recession isn’t fully reflected in corporate earnings expectations or valuations – and they disagree with market assumptions that central banks will eventually turn supportive with rate cuts.

“Even as we expect them to start cutting rates in 2024, the magnitude of the rate cuts will be a lot more muted than what is currently in the price,” says Li.

BlackRock are looking to lean into sectoral opportunities from structural transitions – such as healthcare amid aging populations – to add granularity, even as they stay overall underweight. Among cyclicals, the asset manager prefers energy and financials.

“We see energy sector earnings easing from historically elevated levels yet holding up amid tight energy supply. Higher interest rates bode well for bank profitability. We like healthcare, given appealing valuations and likely cashflow resilience during downturns,” concludes Li.

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