We keep risk at a low macro volatile level



At the heart of our asset allocation is the end of the Great Moderation – characterized by much more difficult trade-offs facing central banks.

In this environment, the fight against inflation causes real damage to growth and also financial disruption. And this compromise is not really avoidable, which is why a soft landing is unrealistic.

1) The UK at the epicenter of the growth-inflation trade-off

An example is the UK, where tax authorities have attempted to stimulate growth through unfunded tax cuts and additional spending.

But because the Bank of England recognizes that it needs to cause a recession to bring inflation down, we don’t really expect more growth, but more rate hikes.

2) Central banks will tighten their policy

In the short term, we believe this strengthens the resolve of other central banks to over-tighten [policy] in order to stay on top of the inflation story. But it’s causing real damage, and as that damage becomes clear in 2023, we think central banks will pause. [rate hikes] and not go all the way. And at that time we will also have to live with higher inflation.

Tactically, given the very difficult interest rate and growth environment, we are comfortable with our reduced risk taking. But strategically, as we think central banks won’t go all the way [on rate hikes] and they will take a break in 2023, there is reason to be strategically a little more positive about risk.


We’ve said a period of steady growth and inflation known as the Great Moderation is over – and we’ve made it a central part of our investment outlook. Central banks face a stark trade-off in this new regime: either live with inflation or suffer the economic damage necessary to quickly tame it. There is no getting around this, or no “soft landing”, in our view. Case in point: the UK tax madness. That didn’t raise growth expectations, it only raised rates. We stick to reduced risk.

UK rates rise as political forces clash

The chart shows that market expectations for Bank of England rate hikes have exceeded rate path expectations for the Federal Reserve and European Central Bank.

Market pricing of future policy rates, 2022 (BlackRock Investment Institute, with data from Refinitiv Datastream, October 2022)

Notes: The chart shows the pricing of expected central bank policy rates via forward overnight index swaps. The rate is the expected one-year OIS rate from one year.

The trade-offs facing central banks in a regime of heightened macroeconomic volatility and a world shaped by production constraints were highlighted last week. UK tax authorities have attempted to stimulate growth with unfunded tax cuts and spending increases. The markets trembled. Rate expectations for the Bank of England have moved ahead of other major central banks (see the pink line in the chart). Growth expectations were not – the pound fell to historic lows and stocks fell. All this shows how far we are in a new regime, where the authorities cannot spend to avoid recession. We believe that a rapid decline in inflation would require aggressive rate hikes and a recession. Central banks are trying to do whatever it takes to get inflation under control, but they haven’t recognized what it will take, in our view. We expect them to break growth as a result, but then come to a halt in 2023 once the economic damage is clear.

The macro image has deteriorated accordingly. We expect recessions in major developed markets (DM). It could be next year in the US, but sooner and deeper in the Eurozone given the energy crisis. The fact that central banks are prioritizing the pressure to bring inflation down quickly rather than the economic implications implies, in our view, deeper recessions overall.

Our short-term visions

This is why we stick to reduced risk taking in our tactical investment views. We are looking for the least bad options. We are underweight DM stocks. In our view, equities have yet to fully price in recession fears and rising rates. We think earnings forecasts also look optimistic. An energy crisis further clouds our view of European equities. Japan is different – still accommodative monetary policy keeps us neutral. Valuation remains an important indicator for us to consider being more positive on equities. Relatively attractive valuations also explain why we prefer credit to equities. Higher yields and strong balance sheets suggest to us that higher quality credit is better positioned than equities to weather recessions.

We are underweight emerging market bonds as we believe inflation will persist above central bank targets after the bullish stops. That said, we see some value in shorter maturities because of the security they offer as the closest investment to cash. Persistent inflation also underpins our overweight to inflation-linked bonds. We are overweight emerging market (EM) debt. Central banks are well ahead of others in their cycles. Emerging market currencies also held up fairly well in the risk aversion environment. But we remain cautious on the FX outlook as some emerging market central banks have paused tightening as growth deteriorates.

Look long term

The strategic positioning is shaped by our view that central banks will stop climbing next year and not go as far as necessary to quickly bring inflation back to target. Recent events reinforce our belief that they will halt rate hikes and live with inflation once faced with economic damage – in the form of a recession or cracks in financial stability, or both. This will be more supportive of stocks than bonds, so we are overweight DM stocks. We prefer public equity to private equity. Inflation will persist, which is why we prefer inflation-linked bonds to nominal bonds. We are overweight government credit due to attractive valuations and income potential.

Our bottom line

We stick to reduced risk taking, tactically. Increased macroeconomic volatility in a new regime creates difficult trade-offs for central banks that risk over-tightening in recessions. Tactically, this means that we prefer credit to equities. Equities remain relatively attractive alongside longer-term credit. Persistent inflation keeps us negative on nominal bonds and positive on inflation-linked bonds now and further into our strategic investment horizon.

Market backdrop

Yields on UK gilts fell from 14-year highs and the pound recovered to historic lows after the government’s surprise fiscal spree forced the Bank of England to temporarily buy long-term bonds to stabilize yields . The events illustrate the sharp trade-offs policymakers face in the face of higher inflation – and the potential financial disruptions from higher rates. We see risks of excessive central bank tightening in recessions. US 10-year Treasury yields briefly topped 4% and stocks hit new lows.

The main release this week is the US jobs report. The rapid pace of job creations has not masked the fact that the overall level of labor supply remains low relative to the pre-Covid period – a key production constraint driving up the inflation, in our view. Survey data has waned over the past year. The ISM manufacturing data should give more perspective on the risk of recession.

About Meredith Campagna

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