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What’s keeping investors awake at night?

Wei Li
Wei Li
iShares EMEA Head of Investment Strategy
April 2019

Keep it brief

  • Slowing global growth and tighter financial conditions are currently the biggest worries for investors
  • The global economy has entered a late-cycle slowdown but there are regional nuances, with some emerging markets now in an early-cycle recovery phase
  • No matter what risks are keeping investors awake at night, there are potential remedies that could help to build portfolio resilience

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Diversification and asset allocation may not fully protect you from market risk.

Despite a rebound in risk assets at the start of this year, exchange-traded product (ETP) flows remain cautious. In a recent poll, we asked investors what they are most concerned about for 2019. A global growth slowdown and tighter financial conditions ranked as the biggest worries. Below, we give our views on these topics and suggest ways for investors to help insulate portfolios.


1. Global growth slowdown

Over 40% of respondents identified growth as their biggest concern for 2019, and global ETP flows provide further evidence of this worry, with investors turning more defensive.

Caution prevails

Global ETP flows by asset class, 2014 – 2019 YTD

graph

Source: BlackRock and Markit, as of 1 March, 2019. Total ETP flows split into equity, fixed income and commodities (commodities not shown on chart).

The global economy has undoubtedly entered a late-cycle slowdown, as seen through broadly weaker data over the past few months. We see further downside risk to consensus GDP and earnings growth estimates in most regions, which could be a headwind for markets going forward.

We draw a distinction between slowdown and contraction, however, and expect global growth to remain positive through 2019. We see a sub-20% probability of global recession before year-end. Although periods of late-cycle slowdown have historically been associated with higher volatility, this has tended to coincide with quite positive returns across many asset classes.

There are regional nuances, too. The US economy is starting to slow, while Europe slowed significantly last year, almost to the point of recession. Yet some emerging markets – such as Brazil and Russia – are in an early-cycle recovery phase, especially in terms of corporate earnings. Our expectation is that in the first half of this year, easier policy will start to translate into a stabilisation of Chinese growth, which could support global growth rates.


2. Tighter financial conditions

The next biggest investor concern – tighter financial conditions – was a key driver behind the broad equity selloff in December. While economic data was weakening late last year, narrative and behaviour by central banks globally appeared unresponsive. A rate hike by the Federal Reserve (Fed) in December exacerbated fears about central banks tightening ‘on autopilot’.

More dovish and reactive comments this year from the Fed and other central banks have helped to ease concerns about rising interest rates. In fact, investors no longer expect a US rate increase in 2019, and see a cut in early 2020 – having previously forecast just under two 2019 hikes as recently as last November. This has supported a reversal in risk sentiment and triggered an equity rally in the first two months of 2019. However, in our view markets are now once again in danger of a volatility spike in the event that rate expectations adjust higher, so monetary policy remains a key risk.

We see the Fed pausing its rate hiking cycle at least until the middle of this year, amid uncertainty about the scale of the US economic slowdown and a lack of inflationary pressures. Beyond that, we think the next move in US rates is still more likely to be up than down, as the unemployment level is very low and rates remain below neutral, by our estimates. Outside the US, we expect a prolonged period of very loose monetary policy, particularly in Europe, where inflation remains a long way below the central bank’s target and economic growth is much weaker than the US.


Sleep remedies

With a multitude of risks keeping investors awake at night, building portfolio resilience is paramount, and we see various ways to achieve this.

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Diversification

In 2018, equities and bonds both fell for only the second time in 30 years, but the negative correlation between these asset classes is already starting to reappear. In a world where growth is becoming the dominant driver, we expect to see this negative correlation persist, so fixed income should provide ballast. In particular, we see opportunities in US Treasuries, and investment grade credit in the US and Europe. Gold is another effective diversifier and, with its perceived safe-haven status, offers a potential hedge against other risks such as geopolitical uncertainty.


Quality

Within equities, the quality factor typically performs well in late-cycle phases, but also in end-of-cycle and recession scenarios. From a regional perspective, we prefer the US over other developed markets, due to relatively resilient earnings growth and strong exposure to the quality factor.


Selective risk

As we outlined in our 2019 Outlook, building resilience is about more than just defence. In order to meet long-term goals, it is important to retain sufficient allocation to risk – but only where investors are being paid for that risk. We think one such area is emerging market (EM) equities. EM equities also present an element of diversification, as they tend to have different drivers to developed markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any financial instrument or product or to adopt any investment strategy.