Positioning for higher macro and market volatility

We lay out how our strategic asset views are positioned for a new regime of greater macroeconomic and market volatility.

The Great Moderation is over

The Great Moderation, a period of steady growth and inflation, is over, in our view. Instead, we are in a new regime of heightened macro volatility driven by production constraints - due to post-Covid supply disruptions and labor shortages in the near-term and structural forces such as a bumpy net-zero transition and a rewiring of global supply chains amid geopolitical tensions over a longer horizon. This warrants higher risk premia – the compensation investors want for holding assets - for bonds and equities. We ultimately expect central banks to live with inflation, but only after stalling growth. The result? Persistent inflation amid sharp and short swings in economic activity.

End of the Great Moderation

 Volatility of U.S. GDP and CPI, 1965-2022

More frequent strategic view changes

The new regime means strategic views – that typically remain relatively stable – will likely need more frequent adjustments. The investment playbook will also be significantly different than the past. A higher risk premium and worsening macro backdrop lowers our expected equity returns, spurring a reduction in our overweight to the asset class to only a modest preference.

We overweight investment grade credit

In fixed income, the rising rate environment, higher inflation and elevated debt loads means we go maximum underweight nominal developed market (DM) government bonds. We prefer inflation-linked bonds (now maximum overweight) and credit, particularly investment grade, where we turn overweight for the first time in two years. Overall in duration, our preference for IG credit and inflation-linked bonds offsets our underweight nominal government bonds.

Higher risk premia ahead

We have adjusted our medium-term estimates of the risk premia for equity and credit markets to better reflect the wider range of macro outcomes ahead. Our new estimates are modestly higher than prior ones reflecting our view that a more volatile world should mean investors demand more compensation to take on risk. Our prior estimates were based on historical prices through the great moderation. We don’t see current levels of macro volatility to persist – yet we don’t see it falling back to pre-pandemic levels.

Bumpier net-zero transition factored in

Our capital market assumptions (CMAs) incorporate our best, current estimate of how the net-zero transition will unfold. We have revisited our assumptions around the transition in this update yet acknowledge there is great uncertainty around this. A key takeaway of our ongoing work is that we see a bumpier transition than before – manifesting as supply shocks and regional divergences – as economies and sectors such as energy and transportation are reshaped. The upshot: more macro volatility. We will update our views on the transition and strategic investment implications in a paper in coming months. Access all our portfolio construction work on our hub.

The new regime is a riskier one than the Great Moderation, in our view. That means investors should demand more compensation for taking the same levels of risk – higher risk premia.

Our CMAs and strategic views had already been positioned for a high inflation risk premium – most directly via an overweight to inflation-linked bonds and a long-standing underweight to nominal developed market government bonds. In our latest update, we incorporate the impact of a higher – currently unpriced equity risk premium – that lowers our expected risk-adjusted equity returns at a 10-year horizon. A higher equity risk premium and deteriorating macro backdrop trims our overweight to DM equities to a modest one at +1. We still have a strategic preference for equities for the long term as we see central banks ultimately pivoting to living with some inflation. Another notable change this quarter is that we turn overweight public credit for the first time in more than a year. The colored boxes on the chart on the right below shows our latest strategic preferences compared to our prior views shown by the dots. We think strategic allocations - that typically would have remained relatively stable in a world of low macro and market volatility – will likely need more frequent adjustments.

New regime calls for more dynamic strategic allocations

Hypothetical U.S. dollar 10-year strategic tilts, August 2022

3 factors driving regime change

• First, production constraints – stemming from a massive shift in spending and labor shortages - are hampering the economy and driving inflation. Over a strategic horizon, we expect structural forces such as a bumpier transition to net zero and a rewiring of global supply chains to contribute to supply shocks.
• Second, record debt levels mean small changes in interest rates have an outsized impact on governments, households and companies – limiting how far central banks can go in raising rates and forcing them to live with some inflation.
• Third, we find the politicization of everything – from inflation to climate change to geopolitics – raising the risk of oversimplified policy solutions in a more complex world.

The growth-inflation trade-off

Policymakers face a tougher trade-off between growth and inflation today than when demand shocks dominated. Monetary policy was more effective in influencing demand – and helped to suppress volatility. It is less suited to supply shocks, in our view, meaning policymakers may face a worse mix of higher output or inflation volatility. Reining inflation comes at a much greater cost to growth. Preserving growth comes with much higher inflation. That is at the crux of the problem central banks are grappling with currently. We see most developed market central banks taking policy into restrictive territory, but ultimately pivoting and choosing to live with some inflation as the cost to growth becomes clear. That’s why we think the volatility of each will be higher in the new regime. We expect inflation to remain above target in the U.S. over the next 5 years. The choppy restart following Covid offered a glimpse of the long-term impact structural supply shocks may have on the economy. A notable example is the net-zero transition, as we now believe it will be bumpier and a bigger drag in coming years than we previously anticipated.

There is great uncertainty around how the conundrum facing policymakers gets resolved. Central banks have turned increasingly hawkish to counter elevated inflationary pressures, sparking a sharp repricing higher of expected policy rate paths. That rhetoric has intensified since our last update as policymakers continue to respond to the politics of inflation. We no longer expect central banks to pause at neutral – the level of rates that is neither restrictive or stimulative – even though tighter policy does little to address supply-driven inflation. It does mean growth over the near term suffers as interest rate-sensitive sectors of the economy bear the brunt. In our CMAs, we further raise our estimates for the policy path across major central banks that feed directly into our expected returns across asset classes, most notably fixed income.

Upgrading credit to overweight

We see nominal yields in five years’ time significantly higher than current levels. That repricing is a valuation drag on expected returns for nominal government bonds. We go back to a maximum underweight stance on the asset class and prefer to take duration risk in credit, particularly higher quality investment grade. We turn overweight both IG and high yield (HY) credit in developed markets for the first time in more than two years.

Widening credit spreads

Widening spreads – partly a reflection of growth fears – have pushed up our expected returns and brightened the risk-reward for credit. Slowing economic growth is a valid risk – yet we don’t expect the kind of deep recession that would cause defaults and downgrades to explode higher and damage the case for credit. In that backdrop, we think higher spreads and higher government bond yields – both drivers of our expected credit returns – make credit an asset class with attractive income potential. An anticipation of wider spreads and higher yields had kept us underweight public credit. Both are now at more attractive levels – and spreads are no longer a drag to returns. The chart on the left below shows how valuation, the impact of higher spot yields and higher expected income have pushed up our expected returns across DM credit markets. We see spreads compressing over a strategic horizon as the economy stabilizes following central bank pivots. We see spreads compressing over time, yet not immediately.

Higher inflation

Finally in fixed income, we return to a maximum overweight on inflation-protected government bonds. Why? We believe markets are once again underappreciating the persistence of higher inflation. The U.S. inflation breakeven rate fell sharply over the second quarter from its March 2022 peaks – see chart on the right below – due to broader risk-off sentiment and as recession fears took hold. The drop has taken market-implied pricing well below our estimates for forward inflation expectations over the next five years – the yellow dot in the chart.

Global equities struggled over the second quarter. Markets have recovered some losses in recent weeks, yet the broad MSCI World index of DM equities is still down 15% year-to-date, according to Refinitiv data as of Aug. 8, 2022. Typically, falling prices would mean we would expect to see higher expected returns as, all else equal, valuations become more attractive. Yet, all else has not remained equal. Markets have grappled with the difficult trade-off that central banks face between choking off growth via sharply higher rates or living with supply-driven inflation. Tough rhetoric from central banks on inflation suggests interest rates – across most of DM – are likely to move past neutral into restrictive territory. Beyond tighter monetary policy, the implications of the energy price shock – particularly painful for Europe – and China’s strict Covid lockdowns are weighing on the near-term economic outlook.

Factoring in a growth slowdown

The impact of these feed into our equity CMAs and inform our asset preferences by offsetting the boost from lower equity prices. Our estimate of where interest rates may get to has moved higher and the short-term path has steepened as discussed. Higher short-term rates mean a higher discount rate for equities – a drag on valuations that diminishes our expected returns. Also, the near-term outlook for corporate earnings growth has worsened. The chart on the bottom left shows that current earnings are not fully reflecting the deterioration in the underlying growth picture, in our view. We see current consensus earnings expectations as too optimistic and expect downgrades ahead.

Higher risk premia

We have also modestly increased our estimate of the five-year ahead equity risk premium (ERP). We prefer the ERP as a valuation gauge over PE ratios, as the ERP takes into account both the price earnings in the year ahead and interest rate outlook. PE ratios only consider price and year-ahead earnings. Our prior expectations of the level of ERP in 5 years time were partly informed by historical data from 1995 onwards – the period of the Great Moderation. This is no longer an accurate benchmark for the future, in our view as it does not consider the new regime. Our revised estimates for the U.S. are shown on the chart on the right below. We now assume an ERP of about 4.2% for the U.S. vs. 3.9% earlier. We think this increase in risk premia is justified, with moderately higher volatility over the coming years. 

Trimming the equity overweight

We still prefer equities to bonds in our strategic views, yet trim our stance on equities to a modest overweight of +1. Over a 10-year horizon, we expect some of the market factors roiling equities to wash out. We expect central banks to live with some inflation after the damage to growth and employment from fighting supply-driven inflation starts becoming apparent. We believe that pivot will ultimately be supportive of equities. Yet we also do not expect that central banks will cut rates back down to stimulative levels as inflation is likely to stay stubbornly above their targets. Our lower expected returns for equities – and trimmed overweight – reflects these dynamics. A similar dynamic is at play in growth private markets such as private equity. Valuations here are slow moving, yet are not immune to higher interest rates. We stay modestly underweight.

Download PDF report