iShares Q2 2019 outlook

Keep it brief

  • The new Q2 iShares outlook explores why and how we think investors can look to build resilience in their portfolios for the year ahead
  • Discover how these market views could translate into implementation ideas across asset classes, geographies and sectors
  • Download the full report to explore each theme in-depth

Our implementation ideas for the key themes in Q2 2019

Capital at risk. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed.

Theme 1: Weatherproofing portfolios

A global growth slowdown need not trigger a flight to cash; carefully balancing risk and reward is key when building all-weather portfolios.Read more

The global economy is now firmly into a late-cycle stage. Growth is slowing, with broadly weaker data and downgrades to forecasts over the past few months. Our Macro GPS points to a moderation in global GDP growth in the second quarter and our earnings tracker indicates a possible contraction in global earnings (see the Turning negative chart). Yet we see little chance of global recession this year and expect positive – albeit slower – growth rates to remain supportive for risk assets. Periods of late-cycle slowdown have historically been associated with higher volatility, but also with positive returns across asset classes.

Past performance is not a reliable indicator of future results. It is not possible to invest in an index.

Portfolio implementation ideas

  • Turning negative
  • Developed market equities
  • Stylistic caution
  • Diversification

Turning negative

Sources: BlackRock Investment Institute and MSCI, with data from Thomson Reuters, March 2019. Notes: The chart shows the annual change in 12-month trailing EBITDA for the MSCI World and our EBITDA tracker. Our tracker regresses MSCI World EBITDA on our G3 Growth GPS, Inflation GPS, our trade nowcast, a measure of global unit labour costs and global input prices. The tracker shows where MSCI EBITDA may stand in three months’ time. This model was created with the benefit of hindsight, has inherent limitations and should not be relied upon for investment advice. Forward-looking estimates may not come to pass.

We favour a barbell approach in portfolios, building defence but also maintaining exposure to areas where investors are being paid to take risk, such as emerging market (EM) equities. According to a recent survey, cash allocations within European portfolios stand at an average of 13%1. Yet at this stage in the cycle, we believe opportunities remain in other asset classes.

Developed market equities

US GDP and corporate earnings growth has slowed, but we still see the country as the global leader on both fronts. This underpins our preference for US equities over other developed markets. Our Macro GPS points to US real GDP growth of around 2.5% – slightly above consensus. S&P 500 average earnings growth slowed to 12.3% in Q4, but remains well above the eurozone rate (-6.1%)2. Although there could be a US-led earnings recession in 2019, last year set a high bar with US corporate tax cuts fuelling record earnings growth. A bias towards the quality factor – encompassing firms with strong balance sheets and high levels of free cash flow – also makes US equities relatively appealing. In particular, we favour US healthcare and technology firms for their quality characteristics. US technology firms have also posted higher profit margins and stronger sales growth than the broader market over the past five years, with vastly lower corporate leverage.

European and Japanese equities have shown signs of recovery this year, wIth easing by the European Central Bank (ECB) and Bank of Japan (BoJ) helping to support sentiment, while muted expectations in Europe lower the bar for positive news to push stocks higher. Yet these markets tend to be tilted towards the value factor – a perennial underperformer in late-cycle and recession phases – and we see little catalyst for a sustained uptick in either market.

Stylistic caution

Amid slowing growth, we favour defensive factors such as quality and minimum volatility. The quality style factor has historically outperformed other factors in late-cycle slowdown and recession scenarios. Global inflows into quality factor exchange-traded products (ETPs) have totalled US$3.6B so far this year, while minimum volatility inflows have totalled $8.6B3. Applying a quality screen to dividend paying companies can help to avoid exposure to firms with high but potentially unsustainable dividends. Our quality preference also applies in fixed income. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Diversification

Diversification is a key component of portfolio resilience, and the re-emergence of the negative correlation between stocks and bonds means that fixed income can once again play a role here. We also see precious metals – particularly gold and silver – as effective diversifiers due to their low correlation to traditional asset classes and perceived safe-haven status.

Diversification and asset allocation may not fully protect you from market risk.

1 Source: BlackRock Portfolio Analysis and Solutions, October 2018.
2 Source: Bloomberg, March 2019.
3 Source: BlackRock and Markit, 29 March 2019.

Theme 2: Selective risk taking in emerging markets

Global growth is slowing, but growth isn’t slowing globally. Some emerging markets are in early-cycle recovery phase and could present opportunities for selective investors.Read more

In the current environment of slowing global growth, we favour a barbell approach in portfolios, as outlined in Theme 1: Weatherproofing portfolios. We believe it’s important to maintain sufficient risk exposure – where investors are being paid to do so – in order to meet long-term goals, but also to take advantage of varying regional economic conditions. We think one such area is EM equities, which are trading at relatively attractive valuations despite outperforming their DM counterparts since last October. The recent rally in EM equities has led to US$21.4B of inflows into EM equity ETPs globally so far this year, accounting for 49% of all equity ETP flows - the highest roportion since Q1 20164. Despite this, our analysis shows that the asset class remains lightly owned, with many institutional investors still underweight compared to global benchmarks.

Dancing a different jig

Source: Thomson Reuters Datastream, IMF World Economic Outlook, BlackRock Investment Institute, as at 26 March 2019. Note: Real GDP Growth, data and forecasts from IMF World Economic Outlook. There is no guarantee that any forecasts made will come to pass.

While most developed markets are slowing, some emerging markets, such as Brazil and Russia, are in an early-cycle recovery phase (see the Dancing a different jig chart). We expect to see signs of growth bottoming in China in the first half of this year, as easier policy starts to translate into a stabilisation and potentially even a reacceleration of Chinese growth. This could support global growth rates and provide a tailwind for Chinese and broader EM equities. The pause in the Federal Reserve’s hiking cycle has also offered some respite so far this year, given that the strengthening US dollar was one of the biggest headwinds for EM assets in 2018.

Growth cycles out of sync with developed markets, and significant structural changes over the past decade – such as reduced cyclicality and leverage – mean EM equities can also provide diversification benefits within a portfolio. As DM equities rallied during the middle of last year, emerging markets fell, and the opposite occurred later in the year.

Diversification and asset allocation may not fully protect you from market risk.

  • China
  • Index Insights

China

Within EM equities, China A-shares have been the best performer so far this year, up 28.6% YTD5. The recent rally has removed some upside potential, but we think Chinese stocks could continue to move higher, with valuations still relatively attractive compared to broad EM and DM equities. Monetary easing introduced last year by the People’s Bank of China (PBOC) and fiscal easing measures announced this year should support the Chinese economy and, in our view, lead to a pick-up in growth rates this year. US-China trade negotiations – while still unresolved – are in a better state than in 2018, and any further improvement could support the rally. It is worth noting, however, that market attention on global trade tensions has dropped significantly, as reflected in the BlackRock Geopolitical Risk Index. This leaves room for downside surprise should trade talks fall through.

We believe Chinese equities offer a strategic investment opportunity over the long term. International adoption of Chinese assets is still in its infancy, with major index providers beginning to increase their integration into broader benchmarks (see the Index Insights box below). This is likely to spur additional focus on – and adoption of – Chinese assets by international investors in the years to come.

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Index Insights

2019 is shaping up to be a significant year for the integration of emerging market assets in global benchmarks. Three key index events are likely to focus investor attention on the asset class:

1. Increasing inclusion of China A-shares in global MSCI indices
MSCI will quadruple the inclusion factor of China A-shares in its global indices from 5% to 20% across three stages (in May, August and November 2019). Coinciding with the final stage in November, China A Mid Cap shares will also be added into MSCI’s global indices.

2. Inclusion of Saudi Arabia stocks in FTSE indices
After a four stage implementation process (March 2019 through to March 2020), Saudi Arabia is projected to have a 0.31% index weight within the FTSE Global Equity Index Series (GEIS), and a 2.86% weighting within the FTSE Emerging All Cap Index.

3. Inclusion of Saudi Arabia stocks in MSCI EM indices
Following a two-step inclusion process, to take place in May and August this year, Saudi Arabia will account for a 2.6% weighting within the MSCI Emerging Markets benchmark.

4 Source: BlackRock and Markit, 29 March 2019.
5 Source: Bloomberg, 29 March 2019.

Theme 3: Fixed income - what a difference a pause makes

Financial conditions look to be providing some relief, with global central banks indicating policy will remain easy for some time. We see opportunities emerging in fixed income.Read more

Having been at the mercy of central bank policy and fears over tightening financial conditions throughout 2018, fixed income has staged a recovery in early 2019. We have seen financial conditions trough, with central banks globally moving away from a tightening cycle. Most notably, the Federal Reserve (Fed) moved to appease concerns about rate hikes being on autopilot in December by reassuring investors that it was taking a data-led approach.

Last year was unusual, with stocks and bonds falling simultaneously for only the second time in 30 years. The negative correlation has returned in 2019, and we expect this to persist now that growth is the dominant driver of market sentiment. The return of the inverse relationship has increased the diversification benefits of fixed income and we see the asset class as a key component in building portfolio resilience. We favour exposure to government bond and credit ETPs within an overall neutral fixed income view. Sovereign debt can help to build ballast as a shock absorber during periods of late-cycle volatility in equity markets.

Fixed income has been in vogue so far this year, with the asset class accounting for 60% (US$62.2B) of flows into global ETPs, compared to 25% in 2018. Investment grade (IG) credit has accounted for more flows than any other fixed income category this year, with $23.7B added (see the Making the grade chart). Flows into US Treasuries have fallen significantly, from $28B in Q4 to just $6.4B in the year to date.6

Making the grade

Source: BlackRock and Markit, 22 March 2019.

  • Inflation-linkers
  • Credit
  • Emerging market debt

Inflation-linkers

We think inflation-linked bonds have started to offer value again after inflation expectations have moved to price in a muted inflation outlook. We like inflation-protected US government bonds (TIPS) given the Fed’s dovish pivot and recent indications that inflation would be allowed to breach their 2% target – albeit temporarily. A slowing but growing US economy also makes TIPS an attractive alternative to nominal bonds, which could suffer if inflation drives higher. Although the Fed pause comes in response to weakening macro data (including inflation rates), TIPS are also well-positioned in the event that the US economy fares better than expected, as their inflation-linked nature would capture higher inflation expectations.

Inflation-linked bonds in the eurozone also appear attractive. In our view, inflation-linkers are currently priced for an overly pessimistic macro outlook, particularly compared to the rebound in riskier European assets so far this year. This holds true even against our expectations for eurozone inflation to remain well below the 1.2% target set by the ECB.

Credit

We favour an up-in-quality approach to portfolios at this stage of the economic cycle, which feeds into our preference for IG bonds within an overall neutral fixed income view. Solid fundamentals are supportive for IG bonds in the US, but in the eurozone relative value earlier in the year in the BBB segment looks to have caught up. We continue to favour IG over high yield, specifically in the US, given the latter’s susceptibility to a growth slowdown.

Emerging market debt

Emerging market debt (EMD) has benefited from supportive macroeconomic conditions so far this year, following a challenging 2018. We see EMD yields as attractive on an absolute and relative basis. Spreads to IG bonds have tightened but remain relatively wide compared to the past few years. Valuations also remain reasonable following EMD’s lacklustre performance last year amid tightening financial conditions.

This year, headwinds that weighed on EMD in 2018 are abating. The Fed is on pause for at least the first half of the year, which has curbed US dollar strength. Quarterly inflows into EMD ETPs have totalled $9.7B globally in Q1 – the highest quarterly total on record7. Although evenly split between hard and local currency for most of this year, flows have started to tilt towards the latter. We have no clear preference for hard over local currency, given the waning dollar strength.

6 Source: BlackRock and Markit, 29 March 2019.
7 Source: BlackRock and Markit, 29 March 2019.

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In our latest quarterly outlook, we outline BlackRock's key market views for Q2 2019 and explore related implementation ideas.
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Meet the writers
Wei Li
iShares EMEA Head of Investment Strategy
Karim Chedid
Investment Strategist
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Natasha Sarkaria
Investment Strategist
Qassim Saeed
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