The Case of Canada: A BlackRock Senior Strategist on Energy, Banks, Bonds and Why Our Market Rules in 2022

There are still nearly six months to go in this remarkably bad year for investment. Stocks and bonds have already fallen by double digits. Inflation is raging, interest rates are rising and economists are assessing the risk of a coming recession. To help me navigate the twists yet to come in 2022, I spoke this week with Kurt Reiman, BlackRock’s Senior Strategist for North America. Here is an edited transcript of our conversation:

Kurt, we’ve talked previously over the summers of 2021 and 2020 and your market outlook now looks prescient. The view from here, however, seems more difficult than before. Have you seen a time when investors faced more adversity?

I think there are more headwinds today. The general theme is that the period of steady growth, falling inflation and lengthening business cycles is over. We prepare for volatility. We believe that central banks will have to oscillate between focusing on inflation policy and focusing on the economic consequences of controlling inflation. And that means the bull market in stocks and bonds that has prevailed for most of the past four decades is unlikely to happen again.

BlackRock’s mid-year outlook sums up this view as the end of the Great Moderation, a term economists use for years of flat inflation and growth from the mid-1980s to 2019. How investors should- do they adjust their approach?

Risk Models and Standard 60-40 Portfolio Allocation [to stocks and bonds] are based on historical data. They might not work. I think investors are going to have to become more granular, selective, more tactical.

Can you give us an example of being more granular, selective and tactical?

The corporate bond market priced in a recession result. You now get a [higher] corporate bond yield equivalent to what you would have found, say, 20 years ago. This is a tactical opportunity that we are seizing over 6-12 months to increase returns.

Your outlook talks about preparing for volatility, which has been a constant over the pandemic years. Where will we see the most pronounced volatility over the next six months?

We will have quite a bit of volatility in equities. We don’t think the stock market is fully reflecting the slowdown in economic activity. Volatility isn’t just down and I think we’re going to see stocks swing on the idea that if central banks are tightening there are still signs of economic momentum since the restart [after pandemic economic lockdowns]. It is also possible that some sectors will show earnings resilience relative to expectations.

Can you give us an example of resilient sectors?

Two that stand out are energy and materials. Next year’s earnings are expected to decline, but we believe commodity prices are going to be high. Investors have not reflected this in prices for either sector. They’re still cheap relative to their long-term history, they’re still cheap relative to the overall market.

Inflation seems to be driving so much in the financial world today. Which investments perform well as inflation hedges?

Commodities are the best performing asset this year, and so are commodity stocks.

How long do you think inflation will stay at levels above the 2% mark that seemed normal in the pre-pandemic world?

Out of sight. Let’s say that in our five-year estimates of returns and risk for a range of asset classes, we assume that inflation will be above 2% – close to 3% – in the United States.

The word “recession” comes up more and more in the financial perspectives. What is BlackRock’s view on the potential for a recession in Canada and the United States over the next 12 months or so?

If we do get a recession, in our view it is likely to be more moderate. Some might call it a technical recession, which means you get a contraction in economic output for a few quarters. But because people have jobs and unemployment rates are low, it doesn’t necessarily look like a traditional economic decline.

How should investors build a portfolio, given the tug of war between inflation and recession? In particular, how should those who see themselves as candidates for a balanced portfolio choose stocks and bonds?

Assuming the traditional historical split of 60% stocks and 40% bonds, I think there is a trend within bonds to move away from government bonds towards inflation-linked bonds and into higher quality corporate bonds. Within equities, the focus is on earnings quality and resilience.

Do bonds ever become a “buy low” candidate?

We asked the question of when we would like the bonds again and the answer is, not yet. Curiously, we really haven’t seen inflation fully integrated into both the inflation-protected bond market and the rest of the bond market. Bond yields have room to rise.

For stocks, how bullish are you on the Canadian market versus the US market?

The US market has fewer resources and more interest rate sensitive growth. We expect further outperformance from Canadian equities compared to what you might find in the US or Europe.

Banking stocks have been a disappointment over the past year – what is the outlook for this sector?

Global financials are under pressure on fears of excessive tightening, which could either stall economic activity or trigger a recession. In the short term, it’s a pressure point. But we also need to reflect on the fact that banks around the world have already priced in substantial bad news. If you get a dovish pivot from central banks, financials will be the first to exit.

Earlier you distinguished energy actions for their resilience. What more can you tell us about the energy outlook?

We believe oil and natural gas prices are structurally elevated and recession risk could cause periodic weakness for some time. But we see a higher floor for energy prices, as well as broader metals and materials. Energy companies generate inordinate free cash flow because they have no incentive to increase production in the same way that a rise in oil prices in the past would have triggered. We believe this continues even though, in a recession, we see lower oil prices. If companies aren’t using free cash flow to invest in new production, they have to do something about it. They will likely use it to buy back shares or increase dividends.

In conclusion, what is your best advice for investors concerned about how their portfolio will hold up to what lies ahead?

The way investors today are going to be successful is not with a “set it and forget” approach or by dumping assets and moving into cash. It’s more about being more granular – in bonds this means finding exposures that are better; being more selective – looking at Canadian equities versus US equities; and, being more tactical. Making changes to a portfolio in a more volatile world will help improve results.

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