2023 Global Outlook

[00:00:00] Oscar Pulido: In 2022, the economy has experienced volatile and decelerating growth as well as high inflation, leading economists to believe that economic soft landings are unlikely to occur as central banks are set to over tighten policy. So what does 2023 have in store for investors?

Welcome to The Bid where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido. 

The new regime of greater macro and market volatility is playing out as we [00:00:30] concluded in our mid-year outlook episode. And this does not seem set to change. Aging populations, geopolitical fragmentation and the net zero transition are long-term drivers that will constrain production capacity and keep us locked into this new regime over time. 

I'm pleased to welcome Wei Li BlackRock's, Global Chief Investment Strategist, and Vivek Paul Head of Portfolio Research and UK Chief Investment Strategist from the BlackRock Investment Institute. Today we'll look ahead to next. [00:01:00] And the lessons learned from 2022 that we carry into the new year as Investors Wei and Vivek, welcome. 

[00:01:07] Wei Li: Thanks for having us. 

[00:01:08] Vivek Paul: Hey, Oscar. Thanks for having us. 

<<THEME MUSIC>> 

[00:01:10] Oscar Pulido: Vivek. Perhaps let's, start with you. This has been to say the least, a very tumultuous year for the markets. so perhaps you can give us a highlight reel of 2022 and set the scene as we begin to talk about what to expect next year. 

Well, thanks Oscar. It's been an incredible year and I could try and list out all their huge features of it, but actually [00:01:30] I'm going to point to two. And the two big things I guess are just the sheer scale of moves in key asset classes across the year, the amount by which yields rose the amount by which equities have done various round trips, as the year's gone on. 

[00:01:44] Vivek Paul: But actually crucially and importantly, the fact that they've moved in the same direction. So if you think about a 60 40 portfolio that's been the sort of bedroom or the staple of investing for so long that's had a terrible performances here and actually thinking about that in particular, really isolates and [00:02:00] why this is a new market, a macro regime, the stuff that worked well in the course of the last 30 to 40 years isn't necessarily going to work well now.

So if I had to point to one thing that is defining this year and defining the era that we're about to enter, it's the idea that traditional 60:40 portfolio doesn't perform as well. And portfolio construction, which has been so crucial for so long, we think in this new environment is even more important. If you look back over the last sort of 30 or 40 years [00:02:30] actually, you've basically seen a joint rally, bull market in both equities and bonds at the same time, interest rates have come down. 

That's meant the equities have done really well, that's meant that fixed income was done really well. Now we're in an environment where they may not do really well at the same time, and I think that's really crucial as we look forward to the future. 

[00:02:48] Oscar Pulido: It's true. 2022 did feel like an inflection point, which I think is what you're touching on Vivek. And one of the other things that inflected this year seemed to be inflation. So Wei maybe, coming over to you when we think about [00:03:00] inflation in the US, the US just reported lower than expected inflation. In October, it was only 6.3%, which is kind of interesting because a year ago I think we would've thought of that as a high number. But do you think that inflation rates have peaked and do you think central banks will adjust their monetary policies, just yet? 

 The short answer is yes, but also how quickly inflation comes down is important as well when it comes to the calculus for central banks. Given base effects, [00:03:30] yes inflation will fall, but sequential inflation matters more. And here when we look at service inflation and wage pressure, they're still somewhat persistent. 

[00:03:40] Wei Li: So if you look at our forecast for inflation for the entirety of next year, we do see headline CPI in the US trending to 3% year on year by the end of next year. And this assumes some supply side recovery, not all the way back to pre-pandemic levels, but some [00:04:00] recovery nevertheless and similar level of inflation is our expectation in the Euro area. But we expect higher inflation in the UK finishing next year around 4.3% year on year. So implicit in this inflation forecast is our expectation that central banks will pause their aggressive rate hikes early next year because the focus, in our view, will shift from the [00:04:30] politics of inflation, which was driving this inflation fighting at all cost campaign in 2022. So the focus is going to shift from the politics of inflation to the economics of inflation as the damage from over tightening as the damage from fighting inflation at all costs becomes clear. Also, rounding out our expectation for the macro environment for next year, we are expecting a recession in the US of [00:05:00] about 1% fall in output first half of the year before rebounding. So, a shallow recession for the calendar year next year. And this is primarily generated by the Fed over tightening peak rate of around 5%, to be achieved early next year. And we also expect a Euro area and UK to hit recession actually this year in 2022 already. Again, more of a shallow recession rather than a deep one because we expect central banks [00:05:30] to pause. 

So essentially when you bring all of this together, we are forecasting a recession and higher inflation. But just to put that into perspective, this is not necessarily a bad outcome, Because the alternative could be worse, if the central banks do not pause the aggressive rate hikes, we could be looking at a deeper recession and higher unemployment rate than what we are forecasting. 

So bringing everything together next year could be a better year for markets than this year. 

[00:05:58] Oscar Pulido: Vivek. let's come back to [00:06:00] you and talk about labor markets and one of the things driving inflation that your colleague Alex Brazier has been talking about have been some of the constraints in the labor market feeding through to price pressure. So maybe you could talk a little bit about that and maybe also what impact is the aging population having on economies and how might we expect to see markets respond to this change over? 

[00:06:22] Vivek Paul: Yeah, I mean that's a key contributor as to why inflation is ultimately going to settle at greater rates than we've been used to for the last [00:06:30] decade or so. An increasing proportion of the adult population is over the age of 64. And if you cast your mind back to before the Covid pandemic or around about that time, we were saying a lot about the idea how certain key structural themes have been turbocharged. 

I think this is an example of that, the idea that there was this demographic shift that was occurring anyway, but it's had a rocket lit under it. We've had this acceleration by Covid. So those who were nearing retirement age effectively have had this catalyst to not come back [00:07:00] into the labor force. There were plenty of other examples of this, but I think this is one of those lasting legacies of that period. And in terms of how markets react I'm going to go beyond just this notion of demographics and more broadly to this idea of the fact that there are these supply constraints dominating now. 

This really is the heart as to why this is a different regime. This is the idea that it's not just the aging populations that cause inflation to settle at a higher rate, it's also the idea of the new geopolitical [00:07:30] environment that we're in and the journey towards net zero. These things are structural trends, which mean inflation will settle higher in different ways all about the supplier production dynamic. What that means, and why this is a new regime, is when those dynamics are causing the onset of inflation rather than explicitly demand dynamics, you have policy making, be that from central bankers or be that from governments, tougher than it was before because you have this environment where growth and [00:08:00] inflation aren't necessarily stable at the same time. Those policy makers have to choose one rather than the other. So coming to what this means for markets then, in that environment where you either stabilize growth or you stabilize inflation, you don't do both at the same time, It means that macro market volatility gets greater. 

[00:08:18] Vivek Paul: It means that effectively what investors do is they demand a greater compensation for bearing investment risk. So think about equity it means 'I want to have a greater amount of equity risk premium'. Think about, bonds, it means 'I want to have a [00:08:30] greater term premium or the compensation for holding longer dated securities'. 

So the amount we are demanding as investors for holding these key assets is going up, and that means that it's a more challenging time for long run returns all else equal. It also though, if I can round this out, means that building portfolios is more difficult in this environment because the macro environment is more volatile, and one of those things that we've relied upon for the last 30 to 40 years,, that negative correlation in general between government bonds and [00:09:00] between equity, that might be more challenged now. And so if you imagine you're building portfolios, you've had this kind of diversification benefit that's occurred for so long, maybe we don't get that as much anymore. So markets will react in a couple of ways, it means we'll demand a greater compensation for holding assets, but it also means how we put those assets together it's tougher to do, it's tougher to get right and it matters more now than it did.

[00:09:21] Oscar Pulido: And certainly one of the things that's contributed to the volatility Vivek, that you've touched on is what's been going on in the geopolitical arena. And so Wei maybe [00:09:30] coming back, over to you, early in 2022. we saw the beginnings of the war in Ukraine, that exacerbated a global energy crisis. It has caused, food supply chain issues, and we now see many countries pursuing self-sufficiency in sectors such as energy, food, and technology as a result of this. So how do you see these issues playing out on a global scale? 

[00:09:50] Wei Li: That's a great question. I believe that we have entered a new world order, like Vivek talked about, this macro framing of how we have seen the end of [00:10:00] the great moderation while as it relates to geopolitics we have also seen the end of the great geopolitical moderation tool, and this is the most fraught environment that we have seen in the world post World War. We have seen geopolitical, moderation, globalization and global coordination being supplanted by fragmentation into competing blocks with, actually if you look around the world, a large number of, hotspot. [00:10:30] So our current base case is that, a ceasefire in the tragic war in Ukraine seems unlikely, at this juncture and also strategic confrontation, competition between the US and China has only intensified. The US is actively trying to restrict China's access to high end technology and that is going to underpin, multiple themes when it comes to investing. But more broadly, if you look at how in the past Economies economics were [00:11:00] very much driving geopolitics, were very much driving, how geopolitical events could unfold. 

We're now in an environment where actually economics are being driven by geopolitical development, which is why geopolitical fragmentation is a permanent fixture and that warrants a more permanent risk premium from a portfolio construction perspective. So when we think about the new investment playbook in the context of new regime, we need to really think about [00:11:30] how to permanently factor in this geopolitical fragmentation theme that is here to

[00:11:35] Oscar Pulido: Vivek in the mid-year outlook, you talked about the net zero transition. So perhaps you could just remind everybody when we talk about net zero, what exactly do we mean by that? And how have the last six months shaped your views on this net zero transition? Is it still occurring or has anything, fundamentally changed with respect to that theme? 

[00:11:55] Vivek Paul: Great question. So at a high level, what this means is that economies [00:12:00] repositioning themselves, the functioning of the economy into one whereby we are moving to, an environment where we basically pollute less. We have an idea where it's net zero carbon emissions. It's an idea where it's more sustainable footing for the global economy. That's the idea, and that's the drive that we'll be talking about in this forum and others for a period of time. it's a great question, Oscar is it all over now or do investors care as much about it as they did before? One can ask the question when you look at the price of traditional energy stocks over the [00:12:30] last couple of years and say, hang on, look how well they've done, maybe that means therefore that this is something that investors care less about, and we take the other side of that. We think it does matter. It matters just as much as it did before. 

If anything, that transition that underpinned a lot of these conversations in the first place, we think that's accelerating. So let me expand on, why I believe that and what that means in terms of thinking about of building portfolios. Since we last spoke best part of what, six months ago or so now we've had the passage of the Inflation Reduction [00:13:00] Act bill in the United States with some 400 billion or so of investment and incentives in sustainable infrastructure, supply chains, et cetera. We've had key policy in Europe. We've had, the Repower EU, we've had Europe more broadly deliberately moving away from reliance on supply of energy from Russia. And actually part of the reason why we think that this transition is accelerated is because this has increasingly become something that is interlinked with national security, This is, increasingly [00:13:30] not just about if you like, doing the right thing for the planet, of course that's always crucial, but from the perspective of policy makers of politicians, it's about protecting the supply of energy that their citizens have access to, which is why we think ultimately the events of this year are an accelerating force. And we're recording this in the aftermath of the world again, focusing on the transition around climate more broadly in the aftermath COP 27. Now we've said before that this is transformational for asset allocation we can't ignore it. And the [00:14:00] simple parallel I'd give here is imagine if we said to investors who are out there the idea of look inflation's really difficult to predict, so we're going to build you a portfolio and ignore all that inflation because you know it's really tough. 

 Here's your inflation agnostic portfolio. We would rightly get laughed out of time trying to develop something like that. you have to have a view, And that is exactly the same when it comes to the climate transition. We have to have a view, we need to build a portfolio that takes into account the uncertainties around that. 

[00:14:27] Vivek Paul: But you can't ignore this. And this summer we [00:14:30] again re-looked at some of the key assumptions underpinning our long run risk and return estimates that govern how we build portfolios. And one of the things around that was this notion that markets aren't fully priced for the transition, So the idea that all of the dynamics we're going to see as economies shifting in the direction of net zero, not all of those are in the market price. And the long and the short of it is that we actually are even firmer of that view. Our latest research suggests that what we thought might be in the market price that has started [00:15:00] to to shift the market price in a statistically significant way. It wasn't always the case that before, but in the last few years we've seen evidence of this being statistically significant and over and above that the amount that we originally anticipated as the overall effect might be an underestimate. 

So you put it all together, of course in the last six to nine months there have been other things that have dominated markets. That doesn't mean that the net zero transition is any less important, and our view is actually that that transition is likely accelerated by what [00:15:30] we've seen and that actually maybe the overall size of the impact related to market prices might be greater than we originally anticipated. 

[00:15:36] Oscar Pulido: I can't help, but as I listen to both of you, I'll go back to using the term an inflection point, which is what 2022 really feels like, you talk about the acceleration in the net zero transition. Wei you talked about geopolitical coordination becoming geopolitical fragmentation, you've mentioned volatility in markets how that also, had a step change higher. So Wei, I'm looking back at the [00:16:00] last time we spoke and you mentioned that the old playbook can't be relied upon anymore and therefore we need a new playbook. So what is that new playbook and are there any new opportunities in this new regime to consider? 

[00:16:11] Wei Li: What a wonderful question to wrap everything up Oscar. so this idea of applying a new playbook in order to navigate a new regime absolutely is the right way to think about it. And while we know what is in the old playbook, right? like strategies like automatically by the dip and also a [00:16:30] mean revert frame when it comes to investing and also automatically hide in long duration bonds in a recession. So these are the things that we have to think through a lot more carefully and reevaluate and not take for granted as we think about navigating this new regime. So what is in the new playbook? 

I would start by saying for the first time in our year ahead outlook, we're not putting forward a set of investment views that are expected to work for the [00:17:00] entirety of the year. We recognize that the new environment, calls for more frequent adjustment to portfolios. So if you think about what are the characteristics of the new regime we're talking about higher macro volatility, higher market volatility. So dynamically assessing and understanding what's in the price is going to allow us to pivot between the different portfolio contours defined by different risk, budget and risk [00:17:30] appetites. So just to give an example of what's priced in, recently S&P 500 hit 4,000, price level that by our analysis represents, a peak rate of 5% and then starting to look at rate cuts next year. So looking at this components, that would be coherent with, a 4,000 price level for S&P 500, we would lean against rate cuts starting next year, and we will certainly, lean against 7% of years [00:18:00] growth for the US Equity market in the context of the upcoming recession.

So when we look at and analyze what's in the price systematically, it would appear that markets are getting ahead of itself, pricing in a Fed pause and also earnings rebound, which is why we see further volatility and adjustment ahead. One more thing I would say, in this new playbook, is that this is perhaps an environment where markets could move ahead [00:18:30] before all the bad news are in the price, because we're talking about an environment where recession is foretold because it's going to be caused by central banks over tightening.

[00:18:39] Wei Li: So from a risk positioning and portfolio construction perspective, there are other levers that we can pull that can allow us to pivot between the different portfolio count tools very nimbly. So currently underpinning our investment view is an implicit risk of starting point, but that could turn risk [00:19:00] on quickly as well. Again, just, going to show that we have to be a lot more nimble and expecting more frequent portfolio adjustment in the new regime. But as we wait to pull the trigger to perhaps become more positive on risk assets, we want to be paid waiting. We want to be paid by sitting in high quality credit and short end of the government bond market. 

And meanwhile, we're also finding some interesting opportunities in agency mortgages as well so given the spread [00:19:30] widening out and some isolation from the underlying housing market. So again, being nimble and being patient, but being ready to, put a trigger is what would, characterize the new playbook in a new regime.

[00:19:42] Oscar Pulido: Well, it sounds like 2023 is going to have a lot in store for us. Thank you both for your insights on 2022 and we look forward to, your insights helping us navigate these waters in 2023. Thanks for being on The Bid with us.

[00:19:56] Wei Li: Thanks for having us.

[00:19:57] Vivek Paul: Thanks Oscar.

[00:19:58] Oscar Pulido: Thanks for listening to this episode of the [00:20:00] bid. In our next episode, Mark Wiedman speaks to a leader who is impacting the net zero transition in the Real leaders of Net zero miniseries. Make sure you subscribe to The Bid wherever you get your podcasts.

[00:00:00] Oscar Pulido: In 2022, the economy has experienced volatile and decelerating growth as well as high inflation, leading economists to believe that economic soft landings are unlikely to occur as central banks are set to over tighten policy. So what does 2023 have in store for investors?

Welcome to The Bid where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido. 

The new regime of greater macro and market volatility is playing out as we [00:00:30] concluded in our mid-year outlook episode. And this does not seem set to change. Aging populations, geopolitical fragmentation and the net zero transition are long-term drivers that will constrain production capacity and keep us locked into this new regime over time. 

I'm pleased to welcome Wei Li BlackRock's, Global Chief Investment Strategist, and Vivek Paul Head of Portfolio Research and UK Chief Investment Strategist from the BlackRock Investment Institute. Today we'll look ahead to next. [00:01:00] And the lessons learned from 2022 that we carry into the new year as Investors Wei and Vivek, welcome. 

[00:01:07] Wei Li: Thanks for having us. 

[00:01:08] Vivek Paul: Hey, Oscar. Thanks for having us. 

<<THEME MUSIC>> 

[00:01:10] Oscar Pulido: Vivek. Perhaps let's, start with you. This has been to say the least, a very tumultuous year for the markets. so perhaps you can give us a highlight reel of 2022 and set the scene as we begin to talk about what to expect next year. 

Well, thanks Oscar. It's been an incredible year and I could try and list out all their huge features of it, but actually [00:01:30] I'm going to point to two. And the two big things I guess are just the sheer scale of moves in key asset classes across the year, the amount by which yields rose the amount by which equities have done various round trips, as the year's gone on. 

[00:01:44] Vivek Paul: But actually crucially and importantly, the fact that they've moved in the same direction. So if you think about a 60 40 portfolio that's been the sort of bedroom or the staple of investing for so long that's had a terrible performances here and actually thinking about that in particular, really isolates and [00:02:00] why this is a new market, a macro regime, the stuff that worked well in the course of the last 30 to 40 years isn't necessarily going to work well now.

So if I had to point to one thing that is defining this year and defining the era that we're about to enter, it's the idea that traditional 60:40 portfolio doesn't perform as well. And portfolio construction, which has been so crucial for so long, we think in this new environment is even more important. If you look back over the last sort of 30 or 40 years [00:02:30] actually, you've basically seen a joint rally, bull market in both equities and bonds at the same time, interest rates have come down. 

That's meant the equities have done really well, that's meant that fixed income was done really well. Now we're in an environment where they may not do really well at the same time, and I think that's really crucial as we look forward to the future. 

[00:02:48] Oscar Pulido: It's true. 2022 did feel like an inflection point, which I think is what you're touching on Vivek. And one of the other things that inflected this year seemed to be inflation. So Wei maybe, coming over to you when we think about [00:03:00] inflation in the US, the US just reported lower than expected inflation. In October, it was only 6.3%, which is kind of interesting because a year ago I think we would've thought of that as a high number. But do you think that inflation rates have peaked and do you think central banks will adjust their monetary policies, just yet? 

 The short answer is yes, but also how quickly inflation comes down is important as well when it comes to the calculus for central banks. Given base effects, [00:03:30] yes inflation will fall, but sequential inflation matters more. And here when we look at service inflation and wage pressure, they're still somewhat persistent. 

[00:03:40] Wei Li: So if you look at our forecast for inflation for the entirety of next year, we do see headline CPI in the US trending to 3% year on year by the end of next year. And this assumes some supply side recovery, not all the way back to pre-pandemic levels, but some [00:04:00] recovery nevertheless and similar level of inflation is our expectation in the Euro area. But we expect higher inflation in the UK finishing next year around 4.3% year on year. So implicit in this inflation forecast is our expectation that central banks will pause their aggressive rate hikes early next year because the focus, in our view, will shift from the [00:04:30] politics of inflation, which was driving this inflation fighting at all cost campaign in 2022. So the focus is going to shift from the politics of inflation to the economics of inflation as the damage from over tightening as the damage from fighting inflation at all costs becomes clear. Also, rounding out our expectation for the macro environment for next year, we are expecting a recession in the US of [00:05:00] about 1% fall in output first half of the year before rebounding. So, a shallow recession for the calendar year next year. And this is primarily generated by the Fed over tightening peak rate of around 5%, to be achieved early next year. And we also expect a Euro area and UK to hit recession actually this year in 2022 already. Again, more of a shallow recession rather than a deep one because we expect central banks [00:05:30] to pause. 

So essentially when you bring all of this together, we are forecasting a recession and higher inflation. But just to put that into perspective, this is not necessarily a bad outcome, Because the alternative could be worse, if the central banks do not pause the aggressive rate hikes, we could be looking at a deeper recession and higher unemployment rate than what we are forecasting. 

So bringing everything together next year could be a better year for markets than this year. 

[00:05:58] Oscar Pulido: Vivek. let's come back to [00:06:00] you and talk about labor markets and one of the things driving inflation that your colleague Alex Brazier has been talking about have been some of the constraints in the labor market feeding through to price pressure. So maybe you could talk a little bit about that and maybe also what impact is the aging population having on economies and how might we expect to see markets respond to this change over? 

[00:06:22] Vivek Paul: Yeah, I mean that's a key contributor as to why inflation is ultimately going to settle at greater rates than we've been used to for the last [00:06:30] decade or so. An increasing proportion of the adult population is over the age of 64. And if you cast your mind back to before the Covid pandemic or around about that time, we were saying a lot about the idea how certain key structural themes have been turbocharged. 

I think this is an example of that, the idea that there was this demographic shift that was occurring anyway, but it's had a rocket lit under it. We've had this acceleration by Covid. So those who were nearing retirement age effectively have had this catalyst to not come back [00:07:00] into the labor force. There were plenty of other examples of this, but I think this is one of those lasting legacies of that period. And in terms of how markets react I'm going to go beyond just this notion of demographics and more broadly to this idea of the fact that there are these supply constraints dominating now. 

This really is the heart as to why this is a different regime. This is the idea that it's not just the aging populations that cause inflation to settle at a higher rate, it's also the idea of the new geopolitical [00:07:30] environment that we're in and the journey towards net zero. These things are structural trends, which mean inflation will settle higher in different ways all about the supplier production dynamic. What that means, and why this is a new regime, is when those dynamics are causing the onset of inflation rather than explicitly demand dynamics, you have policy making, be that from central bankers or be that from governments, tougher than it was before because you have this environment where growth and [00:08:00] inflation aren't necessarily stable at the same time. Those policy makers have to choose one rather than the other. So coming to what this means for markets then, in that environment where you either stabilize growth or you stabilize inflation, you don't do both at the same time, It means that macro market volatility gets greater. 

[00:08:18] Vivek Paul: It means that effectively what investors do is they demand a greater compensation for bearing investment risk. So think about equity it means 'I want to have a greater amount of equity risk premium'. Think about, bonds, it means 'I want to have a [00:08:30] greater term premium or the compensation for holding longer dated securities'. 

So the amount we are demanding as investors for holding these key assets is going up, and that means that it's a more challenging time for long run returns all else equal. It also though, if I can round this out, means that building portfolios is more difficult in this environment because the macro environment is more volatile, and one of those things that we've relied upon for the last 30 to 40 years,, that negative correlation in general between government bonds and [00:09:00] between equity, that might be more challenged now. And so if you imagine you're building portfolios, you've had this kind of diversification benefit that's occurred for so long, maybe we don't get that as much anymore. So markets will react in a couple of ways, it means we'll demand a greater compensation for holding assets, but it also means how we put those assets together it's tougher to do, it's tougher to get right and it matters more now than it did.

[00:09:21] Oscar Pulido: And certainly one of the things that's contributed to the volatility Vivek, that you've touched on is what's been going on in the geopolitical arena. And so Wei maybe [00:09:30] coming back, over to you, early in 2022. we saw the beginnings of the war in Ukraine, that exacerbated a global energy crisis. It has caused, food supply chain issues, and we now see many countries pursuing self-sufficiency in sectors such as energy, food, and technology as a result of this. So how do you see these issues playing out on a global scale? 

[00:09:50] Wei Li: That's a great question. I believe that we have entered a new world order, like Vivek talked about, this macro framing of how we have seen the end of [00:10:00] the great moderation while as it relates to geopolitics we have also seen the end of the great geopolitical moderation tool, and this is the most fraught environment that we have seen in the world post World War. We have seen geopolitical, moderation, globalization and global coordination being supplanted by fragmentation into competing blocks with, actually if you look around the world, a large number of, hotspot. [00:10:30] So our current base case is that, a ceasefire in the tragic war in Ukraine seems unlikely, at this juncture and also strategic confrontation, competition between the US and China has only intensified. The US is actively trying to restrict China's access to high end technology and that is going to underpin, multiple themes when it comes to investing. But more broadly, if you look at how in the past Economies economics were [00:11:00] very much driving geopolitics, were very much driving, how geopolitical events could unfold. 

We're now in an environment where actually economics are being driven by geopolitical development, which is why geopolitical fragmentation is a permanent fixture and that warrants a more permanent risk premium from a portfolio construction perspective. So when we think about the new investment playbook in the context of new regime, we need to really think about [00:11:30] how to permanently factor in this geopolitical fragmentation theme that is here to

[00:11:35] Oscar Pulido: Vivek in the mid-year outlook, you talked about the net zero transition. So perhaps you could just remind everybody when we talk about net zero, what exactly do we mean by that? And how have the last six months shaped your views on this net zero transition? Is it still occurring or has anything, fundamentally changed with respect to that theme? 

[00:11:55] Vivek Paul: Great question. So at a high level, what this means is that economies [00:12:00] repositioning themselves, the functioning of the economy into one whereby we are moving to, an environment where we basically pollute less. We have an idea where it's net zero carbon emissions. It's an idea where it's more sustainable footing for the global economy. That's the idea, and that's the drive that we'll be talking about in this forum and others for a period of time. it's a great question, Oscar is it all over now or do investors care as much about it as they did before? One can ask the question when you look at the price of traditional energy stocks over the [00:12:30] last couple of years and say, hang on, look how well they've done, maybe that means therefore that this is something that investors care less about, and we take the other side of that. We think it does matter. It matters just as much as it did before. 

If anything, that transition that underpinned a lot of these conversations in the first place, we think that's accelerating. So let me expand on, why I believe that and what that means in terms of thinking about of building portfolios. Since we last spoke best part of what, six months ago or so now we've had the passage of the Inflation Reduction [00:13:00] Act bill in the United States with some 400 billion or so of investment and incentives in sustainable infrastructure, supply chains, et cetera. We've had key policy in Europe. We've had, the Repower EU, we've had Europe more broadly deliberately moving away from reliance on supply of energy from Russia. And actually part of the reason why we think that this transition is accelerated is because this has increasingly become something that is interlinked with national security, This is, increasingly [00:13:30] not just about if you like, doing the right thing for the planet, of course that's always crucial, but from the perspective of policy makers of politicians, it's about protecting the supply of energy that their citizens have access to, which is why we think ultimately the events of this year are an accelerating force. And we're recording this in the aftermath of the world again, focusing on the transition around climate more broadly in the aftermath COP 27. Now we've said before that this is transformational for asset allocation we can't ignore it. And the [00:14:00] simple parallel I'd give here is imagine if we said to investors who are out there the idea of look inflation's really difficult to predict, so we're going to build you a portfolio and ignore all that inflation because you know it's really tough. 

 Here's your inflation agnostic portfolio. We would rightly get laughed out of time trying to develop something like that. you have to have a view, And that is exactly the same when it comes to the climate transition. We have to have a view, we need to build a portfolio that takes into account the uncertainties around that. 

[00:14:27] Vivek Paul: But you can't ignore this. And this summer we [00:14:30] again re-looked at some of the key assumptions underpinning our long run risk and return estimates that govern how we build portfolios. And one of the things around that was this notion that markets aren't fully priced for the transition, So the idea that all of the dynamics we're going to see as economies shifting in the direction of net zero, not all of those are in the market price. And the long and the short of it is that we actually are even firmer of that view. Our latest research suggests that what we thought might be in the market price that has started [00:15:00] to to shift the market price in a statistically significant way. It wasn't always the case that before, but in the last few years we've seen evidence of this being statistically significant and over and above that the amount that we originally anticipated as the overall effect might be an underestimate. 

So you put it all together, of course in the last six to nine months there have been other things that have dominated markets. That doesn't mean that the net zero transition is any less important, and our view is actually that that transition is likely accelerated by what [00:15:30] we've seen and that actually maybe the overall size of the impact related to market prices might be greater than we originally anticipated. 

[00:15:36] Oscar Pulido: I can't help, but as I listen to both of you, I'll go back to using the term an inflection point, which is what 2022 really feels like, you talk about the acceleration in the net zero transition. Wei you talked about geopolitical coordination becoming geopolitical fragmentation, you've mentioned volatility in markets how that also, had a step change higher. So Wei, I'm looking back at the [00:16:00] last time we spoke and you mentioned that the old playbook can't be relied upon anymore and therefore we need a new playbook. So what is that new playbook and are there any new opportunities in this new regime to consider? 

[00:16:11] Wei Li: What a wonderful question to wrap everything up Oscar. so this idea of applying a new playbook in order to navigate a new regime absolutely is the right way to think about it. And while we know what is in the old playbook, right? like strategies like automatically by the dip and also a [00:16:30] mean revert frame when it comes to investing and also automatically hide in long duration bonds in a recession. So these are the things that we have to think through a lot more carefully and reevaluate and not take for granted as we think about navigating this new regime. So what is in the new playbook? 

I would start by saying for the first time in our year ahead outlook, we're not putting forward a set of investment views that are expected to work for the [00:17:00] entirety of the year. We recognize that the new environment, calls for more frequent adjustment to portfolios. So if you think about what are the characteristics of the new regime we're talking about higher macro volatility, higher market volatility. So dynamically assessing and understanding what's in the price is going to allow us to pivot between the different portfolio contours defined by different risk, budget and risk [00:17:30] appetites. So just to give an example of what's priced in, recently S&P 500 hit 4,000, price level that by our analysis represents, a peak rate of 5% and then starting to look at rate cuts next year. So looking at this components, that would be coherent with, a 4,000 price level for S&P 500, we would lean against rate cuts starting next year, and we will certainly, lean against 7% of years [00:18:00] growth for the US Equity market in the context of the upcoming recession.

So when we look at and analyze what's in the price systematically, it would appear that markets are getting ahead of itself, pricing in a Fed pause and also earnings rebound, which is why we see further volatility and adjustment ahead. One more thing I would say, in this new playbook, is that this is perhaps an environment where markets could move ahead [00:18:30] before all the bad news are in the price, because we're talking about an environment where recession is foretold because it's going to be caused by central banks over tightening.

[00:18:39] Wei Li: So from a risk positioning and portfolio construction perspective, there are other levers that we can pull that can allow us to pivot between the different portfolio count tools very nimbly. So currently underpinning our investment view is an implicit risk of starting point, but that could turn risk [00:19:00] on quickly as well. Again, just, going to show that we have to be a lot more nimble and expecting more frequent portfolio adjustment in the new regime. But as we wait to pull the trigger to perhaps become more positive on risk assets, we want to be paid waiting. We want to be paid by sitting in high quality credit and short end of the government bond market. 

And meanwhile, we're also finding some interesting opportunities in agency mortgages as well so given the spread [00:19:30] widening out and some isolation from the underlying housing market. So again, being nimble and being patient, but being ready to, put a trigger is what would, characterize the new playbook in a new regime.

[00:19:42] Oscar Pulido: Well, it sounds like 2023 is going to have a lot in store for us. Thank you both for your insights on 2022 and we look forward to, your insights helping us navigate these waters in 2023. Thanks for being on The Bid with us.

[00:19:56] Wei Li: Thanks for having us.

[00:19:57] Vivek Paul: Thanks Oscar.

[00:19:58] Oscar Pulido: Thanks for listening to this episode of the [00:20:00] bid. In our next episode, Mark Wiedman speaks to a leader who is impacting the net zero transition in the Real leaders of Net zero miniseries. Make sure you subscribe to The Bid wherever you get your podcasts.