Central banks around the world have staged a coordinated response to inflation. In mid-December, the Federal Reserve and European Central Bank each hiked interest rates by half a percentage point, capping off a year of aggressive policy action to bring inflation down to more manageable levels. Analysts say the aggressive policy response tips the global economy closer to recession. Investors are betting that policymakers will come to the rescue before that happens.
Let us review the old playbook by which central banks have operated in the past to ride over recessionary phases and see if an alternate playbook can offer a better pathway.
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
The Old Playbook
This old playbook—central banks cutting interest rates to save the economy from a recession—is unlikely to materialize in 2023, according to BlackRock. In its latest note to clients, BlackRock Investment Institute said markets are incorrectly pricing in rate cuts starting in mid-2023. Those expectations have made U.S. yield curves more inverted and boosted equities. The S&P 500 Index dropped nearly 25% peak-to-trough between December 2021 and October 2022, only to stage a 13% rally over the next month and a half.
Although so-called core inflation is expected to fall next year, central banks will struggle to bring it back to its 2% target range. Fed policymakers expect their preferred measure of inflation—the core PCE index—to hit 3.1% at the end of 2023, up from their previous estimate of 2.8%. The ECB expects Eurozone inflation to hover around 3.6% in the last quarter of 2023 and only fall back to target levels in 2025 at the earliest.
Managing above-target inflation and keeping recessionary headwinds at bay will be a difficult balance for central banks to maintain. They will be forced to act, but not as quickly or as aggressively as investors expect, according to BlackRock. In practice, this means rates will stay higher for longer and market hopes of aggressive easing likely won’t be supported. As the “damage from policy overtightening becomes clearer” down the road, central banks will put on the brakes to avoid a deeper recession.
“So we see central banks living with persistently above-target inflation — and they won’t be able to cut rates as quickly as markets expect,” the BlackRock analysts wrote.
An Alternative Playbook
With recession expectations firmly rooted and policymakers’ hands tied by persistently high inflation, buying the dip on developed market equities isn’t advised, according to BlackRock. Beyond Fed action (or inaction in this case), developed market equities have not priced in the impact of recession on their earnings.
The earnings outlook on Wall Street has already begun to deteriorate. S&P 500 companies are expected to post a blended earnings decline of 2.8% in the fourth quarter of 2022, according to financial research firm FactSet. So far, 63 S&P 500 companies have issued negative EPS guidance for the quarter compared to 34 that have issued positive EPS guidance. The economic damage is already being felt by rate-sensitive sectors, with factors such as declining CEO confidence, delayed capital expenditure plans, and waning consumer spending ahead of the holidays also a source of concern.
Rather than a single strategy, the new investment playbook “calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price” of stocks, BlackRock said. Ultimately, investors need to continually assess how far central banks will go to tame inflation and the economic collateral damage it may cause.
Surging yields have made fixed-income securities more attractive for investors, but unlike the old-playbook strategy, long-term government bonds are unlikely to provide an adequate shield from recession. That’s because the negative correlation between equity and bond returns has already deteriorated, meaning both asset classes can go down at the same time. In this environment, investors will increasingly demand higher compensation for holding long-term government bonds. The new playbook calls on investors to be weary of traditional inflation hedges and to instead look at short-end, investment-grade credit as a potential opportunity. Inflation-linked bonds will likely prove useful as cost pressures remain above policy targets for years to come.
Make sure to visit our News section to catch up with the latest news about investing.
The Bottom Line
For investors, no foolproof method exists for thriving during a recession. However, unlike past economic cycles, central banks don’t have the luxury of aggressively easing monetary policy, not with the cost-of-living crisis fully entrenched in Western nations. In this environment, investors need to be extra vigilant and avoid over-reliance on strategies that worked in the past.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
