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Investors are still wearing rose-coloured glasses

The market view is still too optimistic, according to the BlackRock Investment Institute, and investors aren’t truly considering the risk of a recession.

The reopening of China’s economy, falling energy prices and cooling inflation are all long-term positive for equities, according to the BlackRock Investment Institute (BII) (headed up by Jean Boivin, photo at top) – but market optimism has come too soon, and investors are still unprepared for recession and vulnerable to negative surprises.

“Economic risks like a closed China and ultra-high inflation have lessened, further underpinning our strategic overweight of stocks, as the chart shows,” the BII wrote in a note titled Market view too rosy – for now. “Equity valuations look reasonable versus our long-term expectations. The stock rally hints at how markets will likely react once inflation eases and rate hikes pause, buoying prospects for long-term corporate earnings.

“Yet before this outlook becomes reality, we see DM stocks falling when recessions we expect manifest. We think the U.S. economy’s 2023 calendar year growth will then be positive. Investors with a longer-term investment horizon can position for the rebound now but could see more pain to come in the near term.”

The BII expects inflation will land closer to three per cent than the Fed’s two per cent target, while longer-term trends like aging demographics, geopolitical fragmentation and the energy transition mean inflationary pressures will be higher than in the past. Nominal sovereign bonds can no longer diversify portfolios, and BII’s preference is for inflation-linked bonds; stock returns might offer more compensation for risk than bonds.

“Investors with shorter investment horizons should be wary, in our view,” the BII wrote. “Falling inflation has raised market hopes for rate cuts this year but that optimism may be built on shaky ground. We don’t see rate cuts even once recessions hit. The reason: central banks are deliberately causing them to try to push inflation down to a tolerable level, we believe. We see them keeping rates higher for longer as a result. We think recessions are more likely in developed economies given the lagged effect of rate hikes.”

China’s reopening could support global growth, but this “cushioning” of growth could then temper the efforts of central banks in the developed markets to crush inflation. Recessions in the developed markets “should be the key focus tactically” but markets don’t appear to be pricing that outcome.

“We think that makes them vulnerable to more negative surprises –and volatility –in 2023,” the BII wrote. “… Our bottom line: time horizons matter a lot. We’re strategically overweight developed market stocks because we think downside risks have lessened, boosting potential long term returns. Yet we see near term risks tilted against developed market stocks, with earnings growth forecasts not fully reflecting the recessions ahead.”

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