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The new regime’s higher interest rates and greater volatility are a sea change from the Great Moderation, the four-decade period of stable growth and inflation that was capped by ultra-low rates in the wake of the financial crisis. That helped suppress macro and market volatility, stoking bull markets in both stocks and bonds – but also limiting the reward of having investment insight. We find that reward is back.
The test: Imagine you could perfectly predict future U.S. equity sector returns and adjust your portfolio to capture them. That would have had little upside in the four years before the pandemic. “Buy-and-hold” strategies (the orange bar on the left-hand chart below) would have generated similar returns to portfolios allocating to outperforming sectors more frequently (the left yellow and green bars). The reward has been much greater since the pandemic, with rebalancing delivering more than double the hypothetical returns of a buy-and-hold strategy. See the gap between the orange bar and the others on the right-hand chart.
How do we try to capitalize on this new regime? First, we focus on managing macro risk – the first of three investment themes that help us identify opportunities to generate alpha, or above-benchmark returns. Markets have been swinging between hopes for inflation to fall as growth holds up and recession fears. Yet we think the context is that the economy has just climbed out of a pandemic-shaped hole. Plus, structural drivers such as shrinking workforces are poised to push up inflation.
One macro risk we’re watching is the uneven market adjustment to structurally higher rates. The income cushion bonds provide has increased, leading us to upgrade long-term Treasuries recently to neutral on a tactical horizon. We went overweight European and U.K. government bonds at the same time, but have since trimmed again given the fall in yields. This more dynamic approach contrasts sharply with our previously long-held underweight in developed market long-term bonds.
Greater dispersion of returns creates space for investment expertise to shine and means security selection is likely to be more impactful – as detailed in our second theme, steering portfolio outcomes. This involves being dynamic with both indexing and alpha-seeking strategies, while staying selective and seeking out mispricings.
For example, we upgraded Japanese equities twice without hedging against currency swings this year due to high compensation for the risk of holding them, strong earnings growth and shareholder-friendly corporate reforms. On sectors, we like European banks for their low valuations and positive outlook for net interest margins, as well as developed market technology.
Our preference for tech is supported by our third theme, harnessing mega forces, which offer opportunities uncorrelated to economic cycles. Case in point: Investor enthusiasm for digital disruption and artificial intelligence (AI) – one of five mega forces we track – has buoyed U.S. tech stocks and offset the drag of higher bond yields. Our expectation for high-for-longer rates would keep us underweight broad U.S. equities on a tactical, six-to-12-month horizon. Yet adding the AI theme has taken us closer to neutral.
Other mega forces present opportunities, too. Within the low-carbon transition, climate resilience – society’s ability to adapt to and withstand climate hazards – is emerging as an investment theme. And we see geopolitical fragmentation dialing up investment in strategic sectors like tech, energy, and defense.
The three investment themes of our outlook guide us on how to take a more active approach to investing. Mega forces help us get granular in DM stocks. And higher rates have increased the income in fixed income, boosting its appeal.
Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.
Alex Brazier is Managing Director, Deputy Head of the Blackrock Investment Institute at BlackRock Inc.
Wei Li, Global Chief Investment Strategist – BlackRock Investment Institute, and Vivek Paul, Global Head of Portfolio Research – BlackRock Investment Institute, contributed to this article.
Disclaimer
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
© 2023 BlackRock Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. This article first appeared December 11, 2023, on the BlackRock website. Used with permission.
Image: iStock.com/Jirapong Manustrong
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