Midyear Outlook 2018: Risk and resilience

Our views for the second half of 2018

Synopsis of BlackRock's key market views for the remaining six months and our views on how investors may interpret these expert might look to interpret and implement these market insights.

Capital at Risk: The value of investments and the income from them can fall as well as rise and are not guaranteed. You may not get back the amount originally invested.

Any opinions, forecasts represent an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. There is no guarantee that any forecasts made will come to pass.

All data is sourced from Bloomberg as at 2 July 2018, unless otherwise specified.


Setting the scene

Over the last few months, several geopolitical events have disturbed European markets and cast an uncertain shadow on the future. These events have led to large numbers of investors selling their holdings in European markets. So what’s been happening?

In Italy we saw the formation of a coalition between the 5 Star Movement and the League. These are two differing anti-establishment parties with not only strong Eurosceptic views but also a taste for radical reforms.

Spain, having barely recovered from the unrest in Catalonia, was faced with yet another challenge as the reigning Socialist Party (PSOE) failed to achieve a much-needed majority.

And after months of political paralysis in Germany, a Grand Coalition was renewed between the Union (CDU-CSU) and the Social Democrats (SPD).

In the UK, over two years after the Brexit vote, the country is still undecided on a clear blueprint for the country’s exit from the EU.

The US is grappling with its own political tension as possibilities of trade wars around the globe muddy the macro outlook. Many of Trump’s multi-billion dollar tariffs – taxes made on products abroad – have started to increase tension. Yet, as the US rattles markets in the Pacific, its own markets remains prosperous. We have seen its economic expansion remain persistent, leading to brighter prospects and optimistic markets.

Against this backdrop, we have updated our three 2018 investment themes for the second half of the year: dealing with increased macro uncertainty investing in times of tighter financial conditions, and how to build greater portfolio resilience.

There is no guarantee that any forecast made will come to pass.

1. Wider range of growth outcome

We see steady global growth ahead – but a broader set of possible outcomes. The baseline is still a constructive one, of steady growth across the world, with the US firmly in the lead across developed markets, and China still growing steadily despite signs of recent slowdown, but risks have increased and they have increased on both sides.

US growth could reach 3% this year, according to BlackRock’s growth outlook, propelled by the US fiscal stimulus – increased government spending and tax cuts. However, these actions have widened the range of possible growth outcomes.

Fatter tails

Distribution of two-year forward U.S. GDP forecasts, 2018 vs 2017

Forward-looking estimates may not come to pass

Source: Data from Consensus Economics, June 2018. Notes: the lines show the distribution of two-year forward US GDP forecasts as at June 2018 and June 2017. The vertical axis shows the relative frequency of each forecast.

As illustrated above, economists’ forecasts for US GDP growth by 2020, are dispersed: whilst some believe this US fiscal stimulus could surprise to the upside and be stronger than expected, there are those who believe it could overheat the economy.

Yet, we have seen an increase in those who believe in the latter – with more analyst predictions of sub 1% growth for 2020 than last year. Indeed, any further escalation in tit-for-tat trade actions also could have a knock-on effect on business confidence, hitting growth.

Investors who maintain the former, may wish to consider investing in the US tech sector  which remains our preferred section in the US, as it has shown both ‘quality’ characteristics –financially healthy companies, with strong balance sheets - and good ‘momentum’ – securities with upward price trends. Hefty US fiscal stimulus should boost US company activity as tax windfalls are put to work.

This backdrop should be supportive for US equities broadly, as well as the momentum factor specifically, which, by definition, are strongest in a growth environment.

If you are looking to gain exposure to US equities, or any of the other ideas discussed below, an exchange traded fund (ETF) could offer an efficient way of doing so. ETFs are designed to track the performance of an index – thereby providing exposure to many different securities in a single investment.

Please refer to the ‘Risks’ section at the end of the article for full explanations of all the fund risks mentioned.

Concentration risk, counterparty risk, equity risk, investment in technology securities risk
Concentration risk, equity risk, factor focus risk, index methodology risk

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We also see some of this US growth positively trickling down to emerging market economies (EM). This has been supported by positive economic reforms from large EMs such as China, India and Brazil.

China, for example, which makes up around 30% of key EM indices, is focused on shifting its growth strategy from a quantitative one (growing fast) to one more focused on quality.  In India we’ve seen structural reforms which should make it easier for companies to do business in the country. Such structural reforms might influence US investors as spare cash increases in their balance books.

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2. Tighter financial conditions

The US Federal Reserve has increased interest rates twice this year and plans to increase it twice more by the end of 2018. Three more hikes are also expected in 2019. These measures are coming alongside projections that prices in the US will climb faster at the second half of 2018. This has created tighter financial conditions in the market because as interest rates rise the quantity of money circulating in the economy is reduced.

In a rising rate environment, some investors might buy what are known as 'floating-rate notes'. The premise is simple: income will move with interest rates. Floating-rate notes also act as a ‘tail-risk hedge’ in case of rising prices (inflation). A tail-risk hedge means an insurance against an unlikely outcome – in this case, the possibility that interest rates rise faster than expected. As a result, investors may choose to avoid ‘bond proxies’– shares that behave like bonds, and instead swap them for US bank exposures because banks, as net lenders, tend to gain from rising rates.

Concentration risk, counterparty risk, liquidity risk
Concentration risk, counterparty risk, credit risk, liquidity risk
Concentration risk, counterparty risk, credit risk, equity risk

Click here for full explanation of fund risks >

3. Greater portfolio resilience

A growing US economy, bouts of volatility and rising interest rates will likely generate uncertainty among investors. As a result, some investors will look to create more resilient portfolios. While our base case continues to be for shares to outperform bonds, we do think investors should look to protect their portfolios from this potential higher volatility.

How to make portfolios more resilient? In the current uncertain market environment, we would look to shortening duration in fixed income – meaning bonds with short maturities – or buying quality companies. Quality companies are those with earnings growth, proven cash generation, and balance sheets that show high return on equity.

Concentration risk, equity risk, factor focus risk, index methodology risk
Counterparty risk, credit risk, liquidity risk

Click here for full explanation of fund risks >

Investors may also wish to add resilience through diversification, which although cannot fully protect you from market risk, can help to mitigate it. Diversification can be achieved through investments which are less likely to be affected by geopolitical uncertainty or movements in global stock markets and therefore have a perceived status as safe-havens. Investors may look, for example, to invest in commodities such as gold to achieve this.

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Concentration Risk: Investment risk is concentrated in specific sectors, countries, currencies or companies. This means the Fund is more sensitive to any localised economic, market, political or regulatory events.

Counterparty Risk: The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Share Class to financial loss.

Credit Risk: The issuer of a financial asset held within the Fund may not pay income or repay capital to the Fund when due. If a financial institution is unable to meet its financial obligations, its financial assets may be subject to a write down in value or converted (i.e. “bail-in”) by relevant authorities to rescue the institution.

Currency Risk: The Fund invests in other currencies. Changes in exchange rates will therefore affect the value of the investment.

Equity Risk: The value of equities and equity-related securities can be affected by daily stock market movements. Other influential factors include political, economic news, company earnings and significant corporate events.

Factor Focus Risk: Indices with a factor focus are less diversified than their parent index because they have predominant exposure to a single factor rather than the multiple factor exposure of most indices. Therefore they will be more exposed to factor related market movements. Investors should consider this fund as part of a broader investment strategy.

Index Methodology Risk: Although the Benchmark Index was created to select securities within the Parent Index for their recent price increases on the assumption that such increases will continue, there is no guarantee this objective will be achieved.

Investment in Technology Securities Risk: Investments in the technology securities are subject to absence or loss of intellectual property protections, rapid changes in technology, government regulation and competition

Liquidity Risk: Lower liquidity means there are insufficient buyers or sellers to allow the Fund to sell or buy investments readily

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