BlackRock Changes its Investment Playbook in Real Time

According to BlackRock, the current regime of higher macroeconomic and market volatility stretches back about 18 months, resulting in the need for a new investment playbook. Central banks are dealing with a more challenging trade-off than they have at any other time in the last 40 years, being forced to choose between crushing growth or higher inflation.

Central banks are driving a recession

As a result, BlackRock believes central banks are deliberately causing recessions in the world's major economies by aggressively hiking interest rates. The firm chalked up the banking turmoil to the damage and financial cracks it had predicted would result from such aggressive hiking.

But the banking crisis isn't the only financial crack BlackRock sees. The firm highlighted multiple consumer, housing, and industrial indicators. Of course, credit conditions were already tightening before the collapse of Silicon Valley Bank, the first obvious victim of the hiking cycle.

BlackRock expects central banks to continue tightening, and although it doesn't predict a repeat of the 2008 financial crisis, it does see an imminent recession. The firm noted that central banks have clarified that reining in inflation isn't at odds with taking steps to contain the banking woes. However, the markets quickly priced in sharp rate cuts, which BlackRock described as "the old playbook."

According to BlackRock, the Fed is starting to realize the sharper tradeoff it's facing. The firm believes the central bank has repeatedly been too optimistic on growth and inflation. The Fed's latest projections suggest a recession is coming with growth stalling later this year despite the year's robust beginning.

The Fed is wrong about inflation

Despite the implied recession in the coming months, the central bank doesn't plan to cut rates because inflation is holding above its 2% target. As a result, the Fed expects to live with persistently high inflation above its 2% target through 2025, even in the event of a recession. BlackRock doesn't expect central banks to come to the rescue by cutting rates this year.

Additionally, the firm thinks the Fed is underestimating just how stubborn inflation is because of the tightness in the labor market. BlackRock believes the tight labor market is largely due to a labor shortage as an increasing number of workers enter retirement. As a result, employers are having to raise wages to attract employees.

Overall, BlackRock believes earnings expectations indicate that equities in developed markets aren't pricing in the damage that's yet to come. The firm predicts that cost pressures caused by persistently high inflation will pressure profit margins.

BlackRock’s investment playbook

As of the end of March, BlackRock preferred inflation-linked bonds and "very short-term" government paper for income. The firm noted that the U.S. Federal Reserve has been hiking interest rates at the fastest pace since the 1980s, damaging the economy and causing financial cracks to appear.

As a result, the firm was rethinking bonds at the end of March. BlackRock saw higher yields, especially in short-term government paper, as a "gift to investors after years of being starved of income." The firm expects central banks to halt their aggressive rate hikes when the damage to the economy and financial markets become clearer.

BlackRock also expects inflation to settle above the traditional 2% policy target, with one executive declaring at the European Asset Management Conference that "three is the new two."

BlackRock is overweight equities

As of April, BlackRock is overweight equities because it expects the overall return of the asset class to exceed that of fixed-income assets over the next 10 years. Looking out over the long term, the firm doesn't feel valuations are stretched.

However, BlackRock is tactically underweight developed-market equities. The firm emphasized that earnings expectations don't yet fully reflect even a modest recession.

Finally, BlackRock is overweight emerging-market equities, preferring EMs due to China's reopening after the pandemic. The firm also believes the rate-hiking cycles are already peaking in emerging markets and predicts broad-based weakness in the U.S. dollar.

Mixed views on credit

Meanwhile, the firm is strategically overweight global investment-grade credit, although it has reduced the overweight due to the tightening of spreads over the last few months. However, BlackRock is tactically neutral investment-grade credit due to the tightening credit and financial conditions.

On the other hand, BlackRock is strategically neutral high-yield credit because it believes the asset class is more vulnerable to recessionary risks. However, the firm is tactically underweight high-yield credit because it sees a recession coming soon and prefers to be in quality credit.

BlackRock is also overweight emerging-market debt in local currencies, seeing it as more resilient because tightening in monetary policy is further along in those markets than it is in developed markets.

BlackRock is overall neutral government bonds

Looking across the entire government-bond space, the firm is strategically neutral, reflecting an overweight to short-term government bonds, max overweight to inflation-linked bonds, and underweight to nominal long-term bonds. The firm believes the markets are not fully appreciating how persistent high inflation will be and that investors are probably demanding a higher term premium.

Meanwhile, BlackRock is tactically underweight long-dated developed-market government bonds for the same reason. The firm favors short-dated government bonds because higher yields now provide attractive income with limited risk from swinging interest rates.

Neutral to underweight on the private markets

Finally, the firm is underweight private-growth assets and neutral private credit from a much larger starting allocation than what most qualified investors hold.

BlackRock noted that private assets aren't immune to higher market and macroeconomic volatility or higher interest rates. In fact, the firm believes the selloffs in the public markets have reduced the relative appeal of the private markets.

However, BlackRock emphasized that private allocations are long-term commitments, and it sees opportunities over time as assets reprice. Of course, the private markets are complex, so they aren't suitable for all investors.

Thomas Young is running for Utah State House District 40. Outside of politics, he is an economist who builds models, researches the economy, advises on public policy, speaks at conferences, and enjoys thought leadership.

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