A period when markets rose – often in unison – and where asset allocation calls were relatively straightforward is over. Investors need to be paid more to take risk, and decisions on economic issues are getting more political, the organization says.

Investors will demand higher risk premia to justify holding equities and bonds in a world of heightened volatility and political risks, argues BlackRock Investment Institute in its mid-year outlook report. It has cut developed market equity exposure to “underweight.”

And the US-based group, part of asset management titan BlackRock, also argued that investors must adjust to a world where central banks don’t necessarily ease monetary policy every time markets fall – as has been the case for more than a decade.

Another casualty of the changes going on is that a traditional 60/40 per cent split between equities and bonds, respectively, is no longer fit for purpose in a world where such asset classes have been moving closely together.

Investors must also be prepared to move faster and take a more tactical view of how they set asset allocation, than in the past, it said.

The Institute said it has “repeatedly cut” risk exposures in 2022 and continues to do so.

“A new regime is taking hold – but we do not see this yet reflected in the pricing of stocks and bonds. Heightened volatility creates greater market mispricing, and this is embodied in our tactical views. We have repeatedly trimmed risk this year – and do so again now. We have cut DM equities to underweight,” it said.

“We see an increasing risk of the Fed overtightening, expect growth to stall and see earnings estimates as overly optimistic. US stocks make up the bulk of DM equities, and other markets tend to move in synch with the US market. The exception: We are neutral on Japan equities because of still-easy monetary policy and increasing shareholder pay-outs,” it said.

The Institute said it is upgrading credit exposure to “overweight,” preferring to take risk there rather than in equities. It argues that investors are compensated for owning credit today. Most fixed income assets are yielding 4 per cent or more for the first time in more than a decade. 

“The policy response to the pandemic allowed companies to build up cash buffers and issue longer-term debt at record-low interest rates. We don’t expect a deep recession, so defaults should be manageable,” it said.

“We stay underweight long-dated US Treasuries as we see the term premium rising. We are overweight inflation-linked bonds, and now prefer the euro area. We are now overweight UK gilts as we see the Bank of England turning dovish,” it said.

Moderation is over
“The Great Moderation, a period of steady growth and inflation, is over, in our view. Instead, we are braving a new world of heightened macro volatility – and higher risk premia for both bonds and equities. This regime has echoes of the early 1980s, so we’re calling our Midyear Outlook Back to a volatile future. 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. We stay pro-equities on a strategic horizon but are now underweight in the short run,” the Institute said.

“The Great Moderation, from mid-1980s until 2019 before the Covid-19 pandemic struck, was a remarkable period of stability of both growth and inflation. We were in a demand-driven economy with steadily growing supply. Borrowing binges drove overheating, while collapsing spending drove recessions. Central banks could mitigate both by either raising or cutting rates,” it continued. 

“That period has ended, in our view. First, production constraints – stemming from a massive shift in spending and labor shortages – are hampering the economy and driving inflation.

Second, record debt levels mean small changes in interest rates have an outsized impact – on governments, households and companies. Third, we find the hyper-politicization of everything amplifies simplistic arguments, making for poorer policy solutions,” it added.