Stock prices are falling. Market volatility is rising. Geopolitical risk may be with us for a while. And let’s not forget that the Fed is about to launch its latest monetary tightening cycle later this month. The ETF Think Tank invited Russ Koesterich, a portfolio manager on BlackRock’s Global Allocation team, to offer his thoughts on everything from energy prices, inflation, the growth vs. value debate, and his outlook for the global economy. As he notes during the discussion, “we’re running out of hedges”.
With respect to the events in Ukraine, Koesterich says that we’ve gone through a lot of geopolitical shocks in the past, but many of them fade with little economic impact. The difference this time is that energy supplies are being impacted at a time where we’re already experiencing 7% inflation. The current oil impact will ripple across the global economy, but the question is by how much. The biggest risk could be the potential drag on consumer discretionary spending. We’ll be living in this environment for a little while.
There is some significant backwardation occurring in the crude oil futures market, so isn’t there a chance that this stalls out and things smooth out over the next 3-6 months? Koesterich says that you generally expect to see some pullback, but energy demand is still strong for now. We’ve just seen the most draconian sanctions we’ve seen in years placed on Russia, so there’s a huge risk premium that’s been embedded in oil prices. The electrification of vehicles is progressing, but not to the degree that it will impact oil demand this year. He thinks this is unlikely to get resolved in the next 3-4 months and prices remain high throughout this period.
Switching over to the inflation outlook, Koesterich thinks, like many, that inflation will decelerate in the 2nd half of the year, but it won’t get to the point where the Fed can pause. Inflation likely ends the year at around 3% but will need to remain a consideration for investors. His team generally believes that equities act as the best long-term inflation hedge. TIPS are fine, but investors are getting poor real yields. Companies that maintain pricing power, such as the transports, industrials, and some tech, tend to do better. One area that hasn’t worked is the financials because rates haven’t gone up that much even as inflation has quadrupled. You need to see the yield curve steepening for banks to work, but we’re seeing flattening.
What’s the best way to approach growth vs. value and where is the current opportunity? Even though it hasn’t worked well year-to-date, Koesterich believes that growth at a reasonable price, or GARP, has historically been the best all-weather approach and tends to work best over the long-term. Unfortunately, we’re not in an environment where much is working right now, so a focus on factors, such as quality and earnings consistency, could be best. Deep value and early growth may be areas to avoid.
Koesterich notes that correlations simply aren’t working anymore. The Treasury market is pricing in action from the Fed. We’re getting the shock on the inflation end, not the growth end, and that’s not usually the case. That’s the type of environment where stocks and bonds fall together. Bitcoin has behaved like a risk asset. His team has leaned into equities and is invested in energy infrastructure. This year has been about commodities and gold is a hedge against geopolitical risk. If the primary risk is Ukraine, gold can go up. If the markets focus elsewhere or risks deescalate, gold could slump, especially if real rates rise again.
Other key takeaways:
- What should advisors tell their clients in order to get them to stay invested and stay the course? Koesterich says it’s good to remind investors that the return on cash is still zero and that’s not going to help anyone reach their investment objectives. In the 1990s, you could hide out in 4-6% yielding CDs, but those don’t exist anymore. He believes that equities are still the choice.
- The next recession could be a rolling recession where different sectors are impacted at different times. Some of tech is washed out and valuations did get stretched, but they look much more reasonable now. Parts of the consumer space are now starting to look less attractive.
- Koesterich has a significant underweight to fixed income. In the past, you could get the capital appreciation even if you weren’t getting the income. Long duration was a really effective hedge. Today, it’s no longer providing the risk hedge or the income. Ironically, cash is working as the best risk mitigant at the moment.
- Credit spreads have not yet blown out and are nowhere near crisis levels. Nobody seems to be anticipating a huge recession risk just yet. Koesterich is more concerned about high yield than alternatives, such as senior loans, in this scenario.
- Is there an opportunity in China? There are parts to like, but it’s a tough market to navigate. The biggest challenge is on the regulatory front. You have to put a greater risk premium on these things because the regulatory risk is a big unknown.
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