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This has been a challenging year for stock and bond investors.

Inflation in Canada peaked at 8.1 per cent mid-year. The Bank of Canada has hiked interest rates at an aggressive pace with its seventh increase since March expected on Wednesday. This combination of high inflation and rapid rate increases has led to a steeply inverted yield curve – the difference between Canada two-year and 10-year government bond yields has widened to a multidecade high – a signal of a potential future recession.

Looking ahead to 2023, global investment management firm BlackRock believes a recession is on the horizon, North American stock markets are headed lower, and the housing market will remain under pressure. Last week, after BlackRock released its 2023 investment outlook, I spoke with Kurt Reiman, senior strategist for North America. He provided a cautious near-term outlook and offered recommendations on how investors may protect their portfolios amidst further market and macroeconomic volatility. Here’s an edited transcript of our conversation.

Your 2023 Outlook report says, ‘We find that earnings expectations don’t yet price in even a mild recession.’ Consequently, over the next six to 12 months, you recommend underweighting developed market stocks, expecting more weakness in corporate earnings.

In both Canada and the U.S., earnings expectations are still mid-single digit positive for 2023. Single digit earnings growth next year would be a huge victory for corporate America in an environment where the economy is experiencing a recession in the first half of the year.

Energy and financials are two sectors that we like and where earnings are already conservative. This well positions the Canadian stock market to have another year of outperformance because the earnings downside is more limited. When I think about the U.S., I would assume that this mid-single digits earnings growth would fall to flat or maybe mid-single digits negative next year.

Markets haven’t yet priced in the damage to earnings and market sentiment is still not pro risk, that’s why we’re still relatively defensive heading into next year. Our portfolios are about as defensive as they’re going to get.

You highlighted energy and financials stocks as attractive given their reasonable valuations. Would you say that value stocks will continue to outperform growth stocks?

I think investors should be looking for opportunities within value and growth. Within growth, I’m thinking globally about health care. I draw the distinction between Canadian health care, which is more cannabis, and the pharmaceuticals, medical devices and genomics that’s available in global indices – so more traditional health care that would tend to benefit from aging demographics. Then within technology, it’s becoming ever more necessary to think about digital hygiene and the potential impact of cyber security threats. So that’s something that companies are investing in irrespective of the economic environment.

What sectors do you see as particularly vulnerable to negative earnings revisions?

Thinking about this from the point of view of the impact of higher rates – this is going to weigh more heavily on the consumer-oriented parts of the stock market. And right now earnings estimates in the consumer sectors are still high.

So what do you make of the recent strength in the stock markets? The S&P/TSX Composite Index rallied over 5 per cent in both October and November.

That’s actually a really interesting point that you raise because we’ve seen a nice run up in stock prices since the end of September. Some of this may have to do with perceptions that central banks are mostly done. We have a different view. We think it’s unlikely that the Bank of Canada will be able to respond with rate cuts in 2023.

If interest rates remain elevated with no rate cuts until 2024, do you have a forecast for the Canadian housing market?

What I’ve said for years now is that for the Canadian housing market to cool and potentially even turn down would require two things: a higher unemployment rate and higher interest rates.

We don’t have a higher unemployment rate though.

We’ve got one of those two.

Rate increases operate with long and variable lags. So the effect of rising rates earlier in 2022 will start to show up. And that makes a recession foretold. And that means unemployment rates are likely to rise together with higher interest rates, which means there’s likely still forthcoming declines in Canadian housing.

The question here is whether the Bank of Canada will choose to bring inflation all the way back down to 2 per cent and suffer the much higher economic consequences of doing that, or will they choose instead to live with a somewhat higher level of inflation because of the economic costs? We think that they’re going to choose to live with higher inflation. We think inflation is going to settle back to something closer to 3 per cent. That limits the rise in the unemployment rate and it limits the decline in housing.

With stocks and bonds both under pressure in 2022, do you believe the traditional portfolio split of 60 per cent stocks and 40 per cent bonds has shifted going forward?

Due to the nature of the more volatile macro environment that we see, it’s likely going to require more frequent decisions, being more tactical and more granular about the assets that are held.

For fixed income investors, what portfolio strategy would you recommend?

We’re increasingly constructive on fixed income because there’s something in fixed income that hasn’t been there for a while, and that’s income. When you look at investment grade corporate bonds, there’s a yield of over 5 per cent now. We think that the corporate bond market, unlike the stock market, is already reflecting the possibility for higher default rates. Shorter-term bonds already reflect the next few rate hikes that central banks are likely to deliver – it’s priced in. These are yields that we haven’t seen in over a decade and that’s an opportunity.

We know investors have sought safety and protection in cash during a year when both stocks and bonds have fallen and it’s about deploying some of that into bond markets again. We like shorter maturity government bonds, investment grade credit and we like inflation-linked bonds, which we think will do well as the bond market prices in higher inflation. We’re cautious on intermediate and longer maturity government bonds.

In 2022, we’ve seen a depreciation in the Canadian dollar relative to the U.S. dollar. Directionally, where do you think the loonie is headed in the year ahead?

I think the direction is likely for modest strength in 2023 but not before you see some weakness around the eventual recession. Again, we’re thinking that risk assets are likely to weaken. The Canadian dollar is procyclical so it would tend to have that gravitational pull in the near term. But I think the Canadian dollar should strengthen as the year unfolds, up to the high 70s seems reasonable.

Lastly, I have a question from a reader who asks, ‘What are two or three things that investors should unlearn to succeed in 2023?’

I think we should start with the fact that the title of our report is, ‘A new investment playbook’ and that means that a lot of the historical assumptions that we’ve used for managing a portfolio won’t apply. We want to unlearn the idea that bond yields will reflexively fall in a recession and that bonds are our ballast – that’s point No. 1. Point No. 2 would be that we’ve been able to manage portfolios without thinking about having explicit inflation protection in the portfolio. Now we think that you need inflation protection in a portfolio because the recession foretold is not likely to bring inflation back to target. So we need to have assets like inflation-linked bonds, for example, and energy.