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portfolio strategy

This remarkably bad year for investing still has almost six months to go. Both stocks and bonds have already fallen by double digits. Inflation is raging, interest rates are rising and economists are assessing the risk of recession ahead. For help in navigating the twists and turns still ahead in 2022, I spoke this week with Kurt Reiman, BlackRock’s senior strategist for North America. Here’s an edited transcript of our conversation:

Kurt, we spoke previously in the summers of 2021 and 2020 and your market outlooks now look prescient. The view from here seems more challenging than before, though. Have you seen a time when investors faced more adversity?

I think that there are more headwinds today. The overarching theme is that the period of steady growth, declining inflation and lengthening business cycles is over. We’re bracing for volatility. We think that central banks are going to have to veer between focusing on the politics of inflation and focusing on the economic consequences of controlling inflation. And that means the bull market in stocks and bonds that prevailed for most of the past four decades is unlikely to repeat itself.

BlackRock’s midyear outlook sums up this view as the end of the Great Moderation, a term economists use for the years of stable inflation and growth from the mid-1980s to 2019. How should investors adjust their approach?

Risk models and the standard 60-40 portfolio allocation [to stocks and bonds] are based on historical data. They might not work. I think investors are going to have to become more granular, selective, more tactical.

Can you give us an example of being more granular, selective and tactical?

The corporate bond market has priced in a recession outcome. You’re now getting a [higher] yield on corporate bonds that’s equivalent to what you would have found, say, 20 years ago. That’s a tactical opportunity that we are taking over six to 12 months to augment returns.

Your outlook talks about bracing for volatility, which has been a constant in the pandemic years. Where will we see the most pronounced volatility in the next six months?

We will have quite a bit of volatility in stocks. We don’t think that the stock market fully reflects the downshift in economic activity. Volatility is not just on the downside and I think we’re going to see stocks oscillate on the idea that while central banks are tightening, there are still signs of economic momentum from the restart [after pandemic economic lockdowns]. There’s also the potential for certain sectors to show earnings resilience relative to expectations.

Can you give us an example of resilient sectors?

Two that stand out are energy and materials. Next year’s earnings are expected to decline, but we think commodity prices are going to be elevated. Investors have not reflected that in prices for either of these two sectors. They’re still cheap relative to their long-term history, they’re still cheap relative to the broad market.

Inflation seems to be a driver of so much in the financial world today. Which investments are performing well as inflation hedges?

Commodities are the top-performing asset this year, and commodity stocks as well.

What’s your take on how long inflation will remain at levels above the 2-per-cent mark that seemed normal in the prepandemic world?

As far as the eye can see. Let’s say that in our five-year estimates for returns and risk for a range of asset classes, we assume that inflation will be above 2 per cent – close to 3 per cent – for the U.S.

The word ‘recession’ crops up more and more in financial outlooks. What’s the view at BlackRock on the potential for a recession in Canada and the United States in the next 12 or so months?

If we get a recession, in our view it’s likely to be more muted. Some might call it a technical recession, meaning that you get a contraction of economic output for a couple of quarters. But because people are employed and unemployment rates are low, it doesn’t necessarily feel like a traditional economic decline.

How should investors construct a portfolio, given the tug of war between inflation and recession? In particular, how should those who see themselves as candidates for a balanced portfolio choose stocks and bonds?

Assuming the traditional historical split of 60 per cent stocks and 40 per cent bonds, I think there’s a tilt within bonds away from government bonds towards inflation-linked bonds and towards investment-grade corporate bonds. Within stocks, the focus is on earnings quality and resilience.

Do bonds at some point become a ‘buy low’ candidate?

We’ve been asking the question of when we are going to love bonds again and the answer is, not yet. Oddly, we really haven’t seen inflation be fully priced in with both the inflation-protected bond market and the rest of the bond market. Bond yields have room to rise.

For stocks, how bullish are you on Canada versus the U.S. market?

The U.S. market has fewer resources and more interest rate-sensitive growth. We expect further outperformance from Canadian stocks versus what you might find in the U.S. or Europe.

Bank stocks have been a disappointment in the past year – what’s the outlook in that sector?

There’s pressure on financials globally from concerns about overtightening – potentially either stalling economic activity or causing a recession. In the near term, that’s a pressure point. But we also have to reflect on the fact that the banks globally have already priced for substantial bad news. If you get a dovish pivot from central banks, it’s financials that are going to be first out of the gate.

You singled out energy stocks earlier for their resilience. What more can you tell us about the outlook for energy?

We think the price of oil and natural gas are structurally elevated and that the risk of recession could for a time cause periodic weakness. But we see a higher floor for energy prices, and for broader metals and materials as well. Energy companies are generating outsize free cash flows because they’re not incentivized to grow production in the same way as a rise in oil prices in the past would have triggered. We think this continues even if, in a recession, we see a decline in oil prices. If companies aren’t using free cash flow to invest in new production, they have to do something with it. Likely, they’ll use it to either buy back shares or increase dividends.

In closing, what’s your top piece of advice for investors concerned about how their portfolio will bear up to what’s ahead?

The way investors today are going to succeed is not with a ‘set it and forget’ approach or by abandoning assets and moving to cash. Rather, it’s about being more granular – in bonds, that means finding exposures that are better; by being more selective – looking at Canadian stocks versus U.S. stocks; and, by being more tactical. Making changes to a portfolio in a more volatile world will help to improve outcomes.

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