It seems that the simple formula that dictates the economic balances around the world in recent months has already started to give its signals. The central banks raise interest rates in order to fight inflation and in the USA, for example, the annual inflation rate dropped to 7.7%. In Israel, on the other hand, the interest rate rose only last week to 3.25% and has not yet resulted in a decrease in inflation (the October index rose by 0.6%). But here too, the forecast is that inflation is expected to stop in the coming months and the Bank of Israel will start lowering interest rates next summer.
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1: The central banks are on the way to crushing demand
Despite the optimistic forecasts, the global investment giant Blackrock pours cold water and claims that the interest rate in the US, which dictates the tone in the global economy and currently stands at 4%, may still reach 5%.
“We expect that the banks will stop raising interest rates this year and that the activity will stabilize in 2023,” writes Blackrock in their economic forecast for the coming year. “However, central bank interest rates are not the tool to solve production constraints; they can only affect demand in their economies, leaving them to face a brutal trade-off: either return inflation to the 2% target by crushing demand, or live with higher inflation For now, everyone is still in the first option, so a recession is expected in light of the signs of a slowdown, but when the damage becomes real, we believe that the central banks will stop the interest rate hikes even if inflation does not drop to 2% and even though it will not drop there.”
Anat Levin, CEO of Blackrock Israel, explains in a conversation with Globes that the markets are probably too optimistic. “The markets are pricing in an increase in interest rates of 5% and then a decrease in mid-2023. But Blackrock’s claim is that this is a way of thinking that applies the ‘old rulebook’ according to which when there is too much damage to the economy, the central banks rush to correct it by lowering the interest rate. This does not mean that it will happen immediately – we may reach 5%, but in the new regime the central banks may stay at this level for longer, and will only go down from it in front of There is strong evidence for the trajectory of the decline in inflation that will probably be in 2024. Therefore, we believe that when the decline occurs, it will be much more moderate, and therefore the excitement of the markets is probably too early, even if we see a rally in the stock markets at the end of the year.”
2: The new rules of the game for investors
BlackRock predicts that the global economy is on the way to a recession while central banks are trying to “tame” inflation, and therefore call for the adoption of a new rule book for conducting the various capital markets and explain that navigating the markets in 2023 will require more frequent changes in portfolios.
“Investment portfolio management will have to be more agile, we do not believe that we will see conditions that will sustain a bull market in stocks and bonds of the type we experienced in the previous decade,” they advise. Compared to its cost during the period of great moderation (the last few decades, when inflation was relatively low, RO), and we see that the existence of a zero or positive relationship between stock and bond returns will require higher volatility in the portfolio to achieve return levels similar to the past.”
At Blackrock they also define a new formula to succeed in the challenging period: “a continuous reassessment of how much the economic damage created by the central banks is priced”.
“This damage is building. In the US, this is particularly noticeable in the sectors that are sensitive to interest rates. Rising mortgage rates led to sales of new homes. We are also seeing other warning signs, such as deteriorating confidence in CEOs, postponement of capital spending plans and dwindling consumer savings. In Europe, the damage to incomes from the energy crisis is being compounded by tightening financial conditions. The ultimate economic damage will depend on central banks, and what they are willing to do to lower the inflation,” they explain.
According to the investment giant, the expectation of profits is not yet priced in, not even a slight recession, and for this reason, Blackrock decided with tactical vision to reduce exposure to stocks in developed markets. However, they state that they are willing to increase investment in these shares, as long as the valuations reflect the economic damage caused to them following the changes in the macroeconomic environment. Blackrock adds that this is not a complete exclusion from the stock market, as they still estimate that the total return generated by the shares will be higher than fixed income assets in the coming decade.
“Investing in stocks is one of the ways to get more granularity (a surgical look at investments in a way that makes it possible to separate types of companies, sectors, etc.), with structural trends that affect sectors,” the investment giant explains. “We are looking to lean on opportunities in sectors that will benefit from the structural changes in the economy – such as health care amid aging populations – as a way to add granularity even though we are underweight stocks in general. We like health care given attractive valuations and relatively immune cash flow even during a recession. From a cyclical perspective, we We prefer the energy and financial sectors. We see that the profits of the energy sector are decreasing from historically high levels, but are still holding up against the background of tight energy supply, and as for finance, we see that the high interest rate bodes well for the banks’ profitability.”
3: Long-term government bonds have no value
Fixed income products are finally offering “income” after yields have risen globally. This has fueled the appeal of bonds after investors have been hungry for yield for years. As written in Globes at the beginning of the week, the fall in the value of the bonds with the start of the interest rate hikes requires rethinking about being a solid factor in the investment portfolio.
“The long-term bonds are no longer a balance sheet asset in the portfolio during a period of sharp interest rate increases, and therefore they will not be balance sheets in investment portfolios in the near future either,” explains Levin. “The lure of fixed income assets is strong, as rising yields mean bonds finally offer income in volatile market situations. Unfortunately, the long-term bonds have lost the protection they have against declines, so they have no value, and when managing an investment portfolio, it is better to take the risk in short-term bonds with a high investment rating, where the opportunities are precisely in such periods.”
At BlackRock, they are indeed increasing investment in bonds. “This view will last even during a recession, through investing in companies that have strengthened their balance sheets by refinancing debts at lower yields. “Mortgage-backed bonds, in which we are overweight from a tactical perspective, can also be a diversified asset for generating income,” the company says.
They also point out that short-term government debt looks attractive even at current yields and makes it possible to get a return for income and avoid interest risk, but on the other hand recommend avoiding long-term government bonds.
“In the old rule book, long-term government bonds were part of the package because historically they are considered a defensive asset for portfolios against recession, but that is not the case this time. The negative correlation between stock and bond yields has already reversed, and both could fall at the same time, this is because the central banks are not expected to save the markets with rapid interest rate cuts in the recession they engineered, to bring inflation down to the target. If anything, interest rates may remain higher for longer than that the market expects. Therefore, against a background of high debt levels, increased supply and higher inflation, investors will increasingly seek compensation to hold long-term government bonds – or a long-term premium.
“We like US agency mortgage-backed securities because of their high income and because they offer some credit protection through government ownership of issuers. Our expectation of continued inflation relative to market pricing keeps us overweight inflation-linked bonds. As part of the fixed income products, we prefer to take credit risk – and public credit over private.”