New Regime, New Opportunities – A Midyear Outlook

As we look ahead to the second half of 2023, what are the emerging trends investors should be watching and what opportunities might these factors present? Alex Brazier, Deputy Head of the BlackRock Investment Institute helps us look ahead to the rest of the year.

Oscar Pulido: Welcome to The Bid, where we break down what’s happening in the markets and explore the forces changing the economy and finance. I’m your host, Oscar Pulido.

The first half of 2023 has seen its fair share of headlines and volatility across global markets, including higher interest rates, bank failures, and a dramatic US debt ceiling moment.

As we look ahead to the second half of 2023, what are the emerging trends investors should be watching and what opportunities might these factors present?

I’m pleased to welcome back Alex Brazier, Deputy Head of the BlackRock Investment Institute to help us look ahead to the rest of the year. Alex, welcome to The Bid.

Alex Brazier: Thanks Oscar for having me back.

Oscar Pulido: Well, Alex, you are back. In fact the last time we talked, we were discussing the relief that markets were feeling from the U.S. Debt ceiling agreement, and you mentioned that there was an upcoming investor Outlook forum taking place at BlackRock’s headquarters in London. So perhaps, we can start with some takeaways from that forum.

Alex Brazier: Yeah thanks, it’s been a busy few weeks and as you say, we did assemble, BlackRock’s most senior investors, in London two weeks ago now for two days of intense discussion. And really I think the top line conclusion I took from that is a wide acceptance that we’re in a new regime, a new macro and market regime, that brings new and different investment opportunities. So this new regime is something we’ve been talking about for a long time, it’s actually playing out now. We had 30 years of stability where central banks always came to the rescue whenever anything looked to be heading south in our economies, and we had sustained bull markets. And now we’ve seen major developed markets flirt with recession, and yet central banks have raising rates and certainly holding tight with their policies.

So that’s the new regime playing out from a macro perspective, but that’s really not a council of despair. And the thing I took away from our meetings in London the other week is that, far from it, the opportunities may be different, but they are no less than they used to be. So, sure, this is an environment where, simple static portfolios at the broad asset class level won’t any longer be the best you can do, and it’s not an environment really for taking big macro risks when central banks aren’t coming to the rescue.

The opportunities now come from zooming in being precise, finding the disconnects in the way markets are pricing some of the volatility, finding relative value, and also from harnessing some of the mega forces- the big tectonic shifts in our economies that are playing out now.

So yeah, I took away it’s a new regime. It’s a different regime. It’s playing out but actually that means there are new and exciting opportunities that are different from the past, but no less than the past.

Oscar Pulido: I love some of these terms that you mentioned, Alex. ‘Zooming in, being more precise’. I think you said ‘mega forces’ and tectonic shifts. So it sounds like it was a lively debate in London to say the least. And we’ve talked about this new investment regime with your colleague Wei Lee a little bit earlier in the year.

So maybe just go into a little bit more detail about what we think this looks like when we say new investment regime and how this is playing out?

Alex Brazier: The big shift here as I say, is we’re going from a world in which most major economies, their supply capacity was just growing steadily over time. And so the job of central banks was really just to keep stoking up growth and come to the rescue whenever growth threatened to head south. And that’s the way they achieved their inflation targets.

So they had a structural easing bias. Rates were always below their neutral level. Central banks were always stoking things up, now we’re moving to the opposite. And as I say, in develop developed markets, we’ve seen growth stall, Europe’s had a recession as the energy shock has squeezed incomes. The US even on some measures, may have just about had one too, if you look at measures like gross domestic income alongside measures like gross domestic product.

And all of this is before the full effect of central bank actions come through- tightening financial conditions, tightening credit conditions- and yet central banks are not coming to the rescue with rate cuts. In fact, they’re signaling further increases. Why is that? Well, it’s cuz their economies are basically overheating despite having had recessions. And that’s because economies aren’t able to produce as much now without generating inflation because of things like labor supply problems and energy supply problems.

So central banks have gone from, having this sort of structural easing bias to having a structural tightening bias. They’re constantly trying to hold back growth in order to get inflation down to their targets. So they’re, they’re holding tight, they’re holding policy tight, and markets have been gradually adjusting to this. We’ve seen it in fixed income markets, for example, as bond markets have started to price in that, central banks won’t be cutting rates this year, even as growth slows, they’ll actually be keeping rates pretty high. The U.S. two year yields now up pretty significantly, and that’s the market adjusting to the fact that central banks aren’t coming to the rescue.

That does create challenges for risk assets. It means more volatility, means more growth, volatility, it means more earnings volatility means more equity volatility, and risk asset volatility, but… does also mean serious opportunities for income from particularly short dated bonds where yields have risen pretty sharply and increasingly emerging opportunities to lock in some of that income with longer duration too.

So this is a regime where there are challenges, sure, the macro regime creates more volatility, but also, central banks holding tight means higher yields means real opportunity for income in portfolios as well.

Oscar Pulido: Yeah, and it’s interesting to hear the side by side. On the one hand you’re saying there are big parts of the world that might be in recession, maybe you have to look closely at the data to really see it but by textbook definitionthey’re experiencing a recession or certainly a slower growth environment.

You’re saying there’s gonna be more volatility, central banks are not coming to the rescue as they have in the past. But despite all of that you mentioned the opportunities are there. They’re different, but they’re no less. So where can investors look for those investment opportunities?

Alex Brazier: I think this is actually the big thing coming out of our discussions in London the other week. So the first is obviously that income is back with yields, higher central banks holding tight, there are opportunities now in portfolios to lock in some of that income.

Now, it’s not a great environment for overweighting risk assets as a broad category in a portfolio, but nor is it an environment to bunker down and wait.

Partly because in this new regime, macro volatility is just something that’s here to stay. It’s a fact of the regime, so it’s something to adjust to rather than wait to pass. The big thing is that we’re not taking big macro risks in portfolios. We’re just taking different risks in portfolios. and let me, give an example of a few here.

The first is that zooming in, within equities, there’s an increasing population of stocks where investors are now compensated for some of the risks in the macro environment. And US equities, for example, remain the lion’s share of our baseline portfolio. But there’s also opportunity in zooming in further within developed market equities to tilt portfolios because we see opportunities, for example, in tilting equity exposures to towards Japan, where the macro pictures quite different to other developed markets.

The Bank of Japan is still in the business of ensuring inflation that actually gets up to its target rather than trying to squeeze it down like other developed market central banks. That means growth prospects are somewhat stronger there. We also see opportunities outside developed markets, tilting portfolios towards emerging market equities where many of the macro risks are actually better reflected in market prices.

And there’s opportunities from zooming in within fixed income exposures as well. For example, towards US inflation linked bonds and away from European inflation linked bonds, given the ECBs even greater determination, we think, than the Fed to get inflation down to its 2% target. Now. All of that is just examples of how broad asset class exposures might not be the way to generate additional return in this environment, but by being precise, by zooming in to find these relative value opportunities within asset classes, actually there’s real opportunities In the old regime where central banks were coming to the rescue, you didn’t need to be particularly precise- broad macro exposures did the job as well as anything else in terms of generating investment return.

But now you can do a lot better by being precise and finding some of these relative value opportunities within the asset classes.

Oscar Pulido: And it’s interesting you said don’t wait for macro volatility to pass. it’s here to stay, so adjust to it. And that gets me thinking that maybe investors tend to wanna wait for the coast to be

clear and everything is calm and then they start looking for those investment opportunities but maybe by then it might be too late and markets have moved and you’ve highlighted some of the areas that they should be identifying. You also mentioned mega forces. How many are there and why are these important?

Alex Brazier: we’re highlighting five,in our outlook. what do we mean by megaforce? we mean these sort of big tectonic shifts in the way the world economy works and the way economies work that are gonna have a big effect, not just at the macro level but also on which companies win out relative to others, so they’re gonna be a big driver of returns. And again, this is part of the general theme of focusing less on the macro picture and more on what are the underlying forces and what winners are they gonna create? So a good example of that’s in the first half of this year. Where one of these big forces, these mega forces, turned out to be as important as the Federal Reserve in driving the S&P 500. And that is, the growth of artificial intelligence.

Over the first half of the year, much of the US equity performance has been driven by a handful of stocks reflecting the realization, I think, of the potential of some forms of AI and in particular the need for semiconductors and other chips to enable that to happen. So it’s a real example of how even in a difficult macro situation, some of these mega forces, these themes, can be much more important as a driver of return. And actually, as we say in the Outlook document, we think that artificial intelligence theme could actually have further to run too, because looking carefully at it, there’s not just opportunities in some of the chip needs but also in the needs for data to actually really exploit the power of AI.

So people who are involved in putting data sets together, cleaning data, making it able to be accessed for large language models, for example, stand to gain from this trend. And it’s not the only mega force in town either. As I say, we’ve got five of them in the report, it’s not just the growth of artificial intelligence, it’s also aging populations.

It’s also a rewiring of globalization, of course, the transition to a lower carbon economy, and also a reshaping of the financial system as well. So these are big mega forces, big drivers of relative returns, and as we say in our outlook, things to be harnessed, opportunities to be gained to increase returns in this new regime.

Oscar Pulido: And these mega forces feel like they have a long-term nature to them. but you mentioned that they’ve also impacted year to date returns with artificial intelligence being just as important as what Jay Powell was saying at the Fed. And you see that in the performance of markets, but AI gets a lot of attention so maybe talk about a few of these other, mega forces in more detail. You mentioned aging population, the rewiring of the global economy, I think is how you phrased it. Why are these important?

Alex Brazier: Well, it’s not just that they’ll shape the macro picture looking ahead. The forces we’re looking at here, unlike AI actually are all things that will limit the capacity of economies to supply goods and services, at least for a period. Take aging populations, for example, as we age,as a collectively age at least, dependency ratios go up, there are more older people relative to people in the working age population. That means economies produce less, but they don’t, in and of themselves demand less. The mix of spending in economies shifts towards things like healthcare, and that means they’re generally inflationary. Central banks face a challenge. They have to, as we were saying in this new regime, hold tight to try and keep inflation down towards their targets, but they don’t just affect the macro picture. Because they change the mix of spending towards things like healthcare, they actually changed the mix of, earnings in the economy as well.

And so looking for opportunities where the aging of populations isn’t really fully reflected in company growth expectations in things like healthcare or elderly care. It potentially creates interesting investment opportunities.

The other around, the rewiring of globalization is really the ongoing fragmentation of the global economy. We’ve been through a very long period where the only thing guiding supply chain construction was economic efficiency. We’re now entering a period where it’s not all about efficiency, it’s about geopolitics as well. That’s gonna reduce the efficiency of supply chains. It’s gonna, again, hold back the supply capacity of economies, it’s gonna shape the macro picture, but potentially creates really interesting investment opportunities as those supply chains rewire.

So where will new industrial capacity be built as supply chains are rewired? Is that reflected in pricing of securities in those geographies? Those are interesting questions to us for harnessing this particular megatrend, which sounds like it’s a negative. And maybe is at the macro level, but actually creates interesting opportunities at the sector or company level.

And then of course, there’s the transition to a lower carbon economy, which to us is being driven by policy, by technology, by changes in consumer preferences. And we’re trying to assess how are those things changing? How is it gonna shape company earnings over time? And is that reflected again in, in market prices?

So to us we treat all of these mega forces in the same way as we treat Jay Powell. We ask, what does it mean for where the economy is heading? Is that reflected in prices and where it’s not? That creates interesting investment opportunities.

Oscar Pulido: So, Alex, if I were to summarize a lot of what you mentioned, there’s a lot happening. The new investment regime that you and colleagues from the BlackRock Investment Institute have mentioned. It’s playing out, it’s here to stay. And the investment opportunities are there. They might be different than what they’ve been in prior regimes, but they exist.

Alex Brazier: Absolutely right.Not the same opportunities, but lots of new opportunities.

Oscar Pulido: And Alex, maybe just a final question, which is when you describe this investor forum in London, is it a pretty cordial discussion or is it some good debate between the investors.

Alex Brazier: Yeah, it’s, it’s always pretty cordial, but, pretty healthy debate, I would say, especially in something like a new regime where we’re collectively getting to grips with what the new dynamics are and where the new opportunities are. But I think everyone feels this is an exciting time. It’s a new regime with a new playbook and new things to figure out, and that’s a real opportunity for us to help our clients.

Oscar Pulido: All right, we’ll look forward to hearing more c color commentary the next time one of these investor forms takes place. And Alex, as always, thank you for joining us on The.

Alex Brazier: Thank you.

Oscar Pulido: Thanks for listening to this episode, or The, Bid. Next up on The Bid. we’re introducing our new weekly short form series from the BlackRock Investment Institute called Market Take.

Market. Take is a quick digest of what’s driving markets and will be available as its own podcast where you can subscribe. You’ll be able to hear the first three episodes right here on The Bid for the next few weeks on Mondays. So look out for our new market take series starting in July.

This post originally appeared on BlackRock.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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