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Investment directions

Fall 2018

Christopher Dhanraj
Director
Head of iShares Investment Strategy

Gridiron action

The recent return of volatility is a reminder that investing is more like a ground game, and less the long bomb. Read our take on major asset classes and markets.

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We continue to prefer U.S. equities over other developed countries. While we continue to favor growth-geared sectors, namely technology and financials, as well as the momentum and quality factors, a number of sectors also bear watching with the new political regime.

Looking past political gridlock

With the U.S. midterm elections behind us and producing widely expected results, we anticipate political gridlock but few long-term market implications for now. Instead, investors can return their focus to fundamentals. Our base case still sees strong U.S. growth underpinning the global expansion, and U.S. earnings continuing to impress. The divided government means a number of sectors are in focus, including defense, healthcare and infrastructure.

  • After the midterms. The results of the U.S. midterm elections—with the Democrats taking control of the House of Representatives and the Republican Party retaining the Senate—have few long-term market implications for now, we believe.
  • Policy gridlock. There is a low risk of rollbacks to the administration’s tax cuts and regulatory policies in the short term and a divided Congress most likely means policy stasis, which has often benefited equities historically.
  • Sector trends. We maintain a positive outlook for U.S. equities. Sectors that could be impacted by the new congressional makeup include aerospace, defense, healthcare and infrastructure.

Market pulse

Looking beyond the U.S. midterm election results, the United States remains our preferred region among developed markets. The underlying fundamentals are still favorable, including a strong economic expansion and continued earnings growth. Markets have often rallied in the months after midterm elections (see chart below), but we are focused on what the new government makeup could mean for these sectors:

Aerospace & Defense. Military spending has been a key priority for President Trump’s administration, with defense spending up 9% in 2018 from last year.1 Even after the 13% quarter-to-date decline in the Dow Jones U.S. Aerospace & Defense Index (as of October 29, according to Bloomberg), the industry group is still up 46% since Election Day 2016 and remains the purest way to play any change in defense spending outlook.

Healthcare. Drug pricing should remain a key issue in coming months. Still, healthcare has fared well in the past year, benefiting from a defensive rotation by investors and strong corporate earnings growth. Additionally, investors have been digging even deeper to gain exposure to specific industries such as medical devices, which have gained 16.8% year-to-date, handily beating both the sector and the broad S&P 500.

Infrastructure. Infrastructure represents both an opportunity and a promising area of political consensus. While differences on how to fund infrastructure spending remain, a bipartisan solution could be a catalyst for this industry group.

The key for investors is to look beyond the political noise heading into 2019. Taking industry level views can be an effective way to play postmidterm election market trends, with the tailwind of more favorable valuations providing an opportunity for investors.

Figure 1: Asset classes before and after U.S. midterm elections

Figure 1: Asset classes before and after U.S. midterm elections

Sources: BlackRock, Thomson Reuters, as of November 2, 2018. Commodities are represented by the S&P Goldman Sachs Commodities Index, dollar represented by the US Dollar Index (DXY), investment grade represented by the Bloomberg Barclays US Aggregate Bond Index, large-cap by the S&P 500 and small-cap by the Russell 2000. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

A tale of flows

Within U.S. equities, technology remains the front-runner in sector flows this year, with $14.7 billion of net inflows gathered. Healthcare sector exchange-traded products (ETP) inflows surged in the third quarter, totaling $6.7 billion, as the sector started to gain momentum relative to the broader U.S. equity market in the second half of 2018.

In this late-cycle environment, investors tend to prefer the more defensive factors, including minimum volatility, over the more pro-cyclical factors such as value and momentum. Recent stock market volatility sparked a large outflow from momentum exposures, as they saw their first monthly outflow this year in October after attracting more than $4 billion of inflows as of October 25. Amid the rising market uncertainty, quality and minimum volatility factors have started to see consistent inflows as investors shift to a more cautious tone.

Figure 2: 2018 ETP flows into equity sectors

Figure 2: 2018 ETP flows into equity sectors

Sources: Thomson Reuters, BlackRock, as of October 25, 2018.


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Japan offers solid fundamentals and attractive valuations. Still, we are neutral with no catalyst for growth in sight.

Japan: A lot to like, but where’s the catalyst?

In Japan, a weaker yen, solid corporate fundamentals, bargain valuations, a stable political environment and central bank buying support an investment case for the country. Indeed, Japanese equities are outperforming the global developed ex-U.S. equities benchmark—and are less expensive. But we see no catalyst for a rally and remain neutral.

  • Seeking direction. Japanese equities have traded sideways for most of 2018, catching the October sell-off before slowly recovering. Still, they are outperforming the global developed ex-U.S. equities benchmark—and are less expensive.
  • Sound fundamentals. A weaker yen, solid corporate fundamentals, bargain valuations and central bank buying are positives. Japan’s political environment is relatively stable.
  • No catalyst apparent. Forecasting suggests there is potential upside to Japanese inflation in the coming months, but structural challenges and global trade headwinds counterbalance our optimism. On balance, we maintain our neutral view on Japanese equities but prefer them to their European counterparts.

Market pulse

Japanese equities are down 6.5% in U.S. dollar terms this year and are convalescing from October’s lows, when their forward price-to-earnings multiple dipped below 12 for the first time since August 2012. Dollarhedged investors have done only marginally better as the yen cancelled out its gains earlier in the year. Investors appear skeptical about the outlook for Japanese stocks: Though earnings have grown by 11%, multiples have compressed 17% over the course of the year.2

In other words, Japanese equities are beginning to intrigue investors. On the positive side, the Bank of Japan (BOJ) continues extreme monetary accommodation (while other central banks shift toward tightening) and is purchasing local stocks. Corporate behavior is also encouraging, with sustained capital expenditure growth. Furthermore, Prime Minister Abe’s consolidation of Liberal Democratic Party control in September provides political stability. Our forecasting suggests signs of an uptick in core inflation to around 0.75% in six months, albeit far short of the BOJ’s stated 2% target.3

However, the Japanese economy faces structural and demographic headwinds, particularly in the area of labor productivity. A major concern is the impact of a global trade war on Japanese firms: Although large caps source 57% of their revenues from within Japan, nearly half of the remaining foreign revenues are from the United States and China.4

Overall, we maintain our neutral position due to evenly balanced drivers. But Japan bears watching.

Figure 3: Year-to-date total return of Japanese and world ex-U.S. equities

Figure 3: Year-to-date total return of Japanese and world ex- U.S. equities

Source: Bloomberg, as of November 2, 2018. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Figure 4: Earnings-per-share growth of Japanese and European stocks 2013-2018, rebased to 100

Figure 4: Earnings-per-share growth of Japanese and European stocks 2013-2018, rebased to 100

Source: Bloomberg, as of November 2, 2018. Chart depicts the 12-month earnings per share of the MSCI Japan Net Total Return Local Index and the MSCI Europe Net Total Return EUR Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

A tale of flows

Japanese equities started the year with sizeable rotations into unhedged exposures and out of hedged exposures, before turning negative for both categories in March. Japan-focused ETPs suffered from seven straight months of outflows totaling $5.7 billion from February to September, shedding assets every week in the third quarter. However, the tide appears to be turning, with October inflows totaling nearly $2.3 billion (as of October 24, 2018). Interestingly, the flows were dominated by inflows into unhedged exposures as the Japanese yen started to strengthen against the dollar in October.

Figure 5: 2018 flows into U.S.-listed equity ETFs providing Japanese exposure

Figure 5: 2018 flows into U.S.-listed equity ETFs providing Japanese exposure

Source: Flow data sourced from Markit and calculated by BlackRock, as of October 24, 2018. ETP groupings and categories are determined by BlackRock.


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The sell-off in emerging markets this year has rattled investors. Minimum volatility strategies can offer a potential buffer in sell-offs. We remain overweight EM equities, with a preference for EM Asia.

Seeking a buffer

Emerging market (EM) assets have continued to struggle as decelerating global growth, along with greater macro uncertainty, has tightened financial conditions. We’re constructive on EM equities, but this year is a sober reminder of the risks of EM investing. We remain positive toward EM as valuations have cheapened this year, positioning remains light, and earnings growth remains strong. Still, investors may want to consider a minimum volatility strategy, which historically has provided some buffer during sell-offs.

  • Emerging market (EM) assets have struggled this year. Decelerating global growth, along with greater macro uncertainty, has tightened financial conditions.
  • EM equities slid lower as a result and suffered a 27% peak-to-trough decline this year. Such sell-offs aren’t new, but underscore the risks of EM investing.
  • We’re constructive on EM equities, with a preference for EM Asia, as EM valuations have cheapened this year, positioning remains light, and earnings growth remains strong. Still, investors may want to consider a minimum volatility strategy, which historically has provided some buffer during sell-offs.

Market pulse

EM assets have had a tough year. Global growth remains strong yet is decelerating, financial conditions have tightened, and trade risks linger. A stronger U.S. dollar has hurt EM countries, particularly those with large financing needs, such as Turkey and Argentina. This year’s twin U.S. dollar and oil rallies dealt a double blow to commodity importing EM countries, such as India. Despite strong earnings growth, particularly in EM Asia, equity returns have suffered as the market demanded a higher risk premium through a lower P/E multiple. As a result, the MSCI Emerging Markets Index has suffered a 27% peak-to-trough sell-off this year.

As the chart below shows, such drawdowns are not uncommon to EM. However, minimum volatility (“min vol”) strategies have historically helped mitigate downside risk while maintaining upside participation. For volatile, high-beta asset classes, such as EM equities, this asymmetry has been particularly well rewarded over the long term. For comparison, the MSCI EM Min Vol Index peak-to-trough drawdown was just 16% this year compared to the 27% drawdown in the MSCI Emerging Markets Index.

Figure 6: Min Vol has historically mitigated downside exposure for EM investors

Figure 6: Min Vol has historically mitigated downside exposure for EM investors

Sources: BlackRock, Thomson Reuters, as of November 1, 2018. Note: Drawdowns are computed on a rolling 1-year window. EM measured by MSCI Emerging Markets Index. EM Min Vol measured by MSCI EM Minimum Volatility Index. The EM Min Vol Outperformance series measures the relative outperformance of EM Min Vol against EM. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

A tale of flows

EM inflows have recovered some ground after the U.S. dollar’s rally sparked outflows in April. Investor conviction remains weak, however. October’s market weakness only compounded these fears, particularly as China’s policy stimulus aimed at easing regulatory, fiscal, and monetary policy failed to lift market sentiment. Investor anxiety is also evident in inflows to defensively oriented ETPs and outflows from cyclically oriented ETPs. Against this backdrop, EM equity inflows appear as an outlier. However, a closer look shows EM foreign exchange has in fact appreciated since September; the U.S. dollar rallied against DM currencies and depreciated against most EM currencies.

In light of our constructive view on EM equities—cheap valuations, attractive earnings, and adequate risk premiums priced in—we see the lack of investor positioning across EM as a positive once risk appetite stabilizes. However, we are also mindful that trade tensions will likely persist and represent a key source of uncertainty. For investors who wish to maintain some upside participation while seeking to minimize downside exposure, we believe the min vol factor can serve an important role across portfolios.

Figure 7: EM equity flows are tightly linked to the U.S. dollar

Figure 7: EM equity flows are tightly linked to the U.S. dollar

Sources: BlackRock, Thomson Reuters, as of November 1, 2018. Flows measure all U.S.-listed emerging market equity ETP flows on a rolling 3-month basis. U.S. Dollar measured by U.S. Dollar Index (DXY).


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Rates have risen and it is still a difficult environment for bonds. We favor TIPS over Treasuries, as well as Treasury floating rate notes.

The rise in Fall of rates

After trading sideways for most of the second quarter, Treasury yields rose steadily from the end of August through the beginning of October. This was largely due to increases in real rates, rather than inflation expectations. Clearly, the market is not yet worried about inflation. Nevertheless, we continue to favor TIPS over nominal Treasuries over the long term, as well as Treasury floating rate notes.

  • This fall has seen a steady climb in interest rates. After trading sideways for most of the second quarter, Treasury yields rose steadily from the end of August through the beginning of October.
  • The bulk of the increase in rates stems from real rates, rather than inflation expectations, indicating the market is not yet focused on inflation.
  • While the real rate increase was not positive for TIPS performance, we continue to favor TIPS as well as Treasury floating rate notes over nominal Treasuries over the long term.

Market pulse

The yield on the U.S. 10-year Treasury bond rose from 2.81% on August 24 to a high of 3.23% on October 5, a rise from peak to trough of 42 basis points (bps). Of this amount, a full 35 bps was attributable to increases in real (i.e., after inflation) interest rates while only 7 bps was attributable to an increase in inflation expectations. In fact, inflation expectations have barely moved outside of a stubborn 2.00%-2.15% range. The composition of the backup in rates indicates that the market is not overly concerned about rising inflation expectations, but, rather, is focused on further Federal Reserve tightening and the unwinding of quantitative easing.

Figure 8: 10-year TIPS real yield

Figure 8: 10-year TIPS real yield

Source: Bloomberg, as of November 5, 2018. Past performance does not guarantee future results.

Indeed, the latest Federal Reserve Open Market Committee minutes suggest that the Committee’s focus is shifting away from the pace of hikes to their long-term terminal level now that the Fed reinvestment tapering program is complete. With 5-year nominal Treasury yields projected five years forward already at 3.3% (near the median long-term terminal rate of 3.4%, and above the median longer-run Fed forecast of 3%), we believe the path of least resistance is toward stable/lower, not higher, yield levels, especially given the sharp deterioration in risk assets in the month of October. Market expectations are for two or three rate hikes next year and remain below the Fed’s projection.

We still prefer TIPS versus nominal Treasuries for risk diversification and potential inflation upside capture, but with somewhat tempered conviction. An alternative diversifying asset would be Treasury floating rate notes (FRNs). The coupons on Treasury FRNs would adjust to further increases in short-term rates, but unlike corporate FRNs, would not be subject to a deterioration in credit conditions should economic conditions begin to turn negative.

A tale of flows

Fixed income ETP inflows remained strong in the third quarter of 2018, totaling more than $22 billion across various investment exposures. U.S. Treasury products across the curve have gathered nearly $26 billion of inflows year-to-date with concentration in the short-term exposures. Despite weaker performance, investment grade bonds continued to draw investor interest, attracting $13 billion in flows this year. In contrast, high yield exposures have largely outperformed most other fixed income asset classes this year, but experienced large outflows in the past two months, losing more than $7 billion this year.

Investors turned bullish on emerging market debt again in the second half of 2018 as the earlier drawdown provided them with an attractive entry point into the integral segment of EM financial markets. Industry-wide ETP flows into EM debt products have remained in positive territory at $3.8 billion YTD.

Figure 9: Flows into bond ETFs

Figure 9: Flows into bond ETFs

Source: BlackRock, as of October 24, 2018.


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Rising macro uncertainties, led by elevated trade frictions between the United States and China, drive a heightened focus on portfolio resilience across our factor outlook for the fourth quarter. We favor momentum and minimum volatility in this environment.

Q4 factor outlook

Factors are broad, persistent drivers of return. They are present both across and within asset classes and include quality, momentum, value, size and minimum volatility. In this issue, we highlight the views of BlackRock’s Factor-Based Strategy Group regarding these factors. In the current environment, we favor momentum and minimum volatility, are neutral on value and quality, and underweight size.

  • Quality, momentum, value, size, and minimum volatility have historically been drivers of returns across asset classes.
  • Because they are driven by different economic rationales, they have tended to outperform at different times, presenting a potential opportunity.
  • We currently favor momentum and minimum volatility. Our views are relative to equal weights across five U.S. equity factor indexes and are guided by four signals: economic regime, relative strength, valuations, and dispersion.

Market pulse

Below is our factor outlook for November:

Quality. Our outlook for quality—financially healthy firms—is neutral. Our economic signal suggests a slowdown regime of moderating, yet robust, levels of growth, which has tended to favor this more defensive factor. While valuations also appear attractive, poor performance in October relative to the broad market tempered its relative strength.

Size. We maintain a firm underweight to size—smaller, high-growth companies—due to continued deterioration in its relative strength. It remains the worst-performing factor year-to-date relative to the broad market. The current slowdown regime is also unfavorable to size.

Momentum. Our outlook for momentum—stocks with strong recent performance—has moderated after October’s market reversal, but remains moderately overweight. Valuations appear stretched after more than a year of strong performance and a decline in forward earnings expectations. Momentum has tended to perform best in expansions, but has also been resilient in economic slowdowns where stable growth maintains trends.

Value. Our outlook for value—stocks that are inexpensive relative to fundamentals such as price-to-earnings—improved in October and stands at neutral. Value has tended to perform best in periods of accelerating growth, making the current slowdown regime more favorable to other factors.

Minimum volatility. Our outlook for minimum volatility is moderately overweight. A slowing global economy favors this more defensive factor, valuations are reasonable and its relative strength markedly improved in October amid an increasingly defensive tone in equity markets.

Portfolio trends: Notes from the field

The iShares Portfolio Solutions team recently analyzed more than 10,044 models provided by advisors from throughout the industry to discern key trends. Three main takeaways emerged:

  • The average advisor model contains 12 equity funds and more than 3,400 unique underlying stocks. We believe advisors have an opportunity to consolidate holdings if they want the unique skill of their managers to drive outperformance of the portfolio.
  • We evaluated advisors’ fund selection across five equity categories and found that they pick managers whose alpha potential is driven more by factors than unique manager skill. Better alpha options are available in these categories, and the factor exposures can be obtained for a much lower cost.
  • Advisors continue to increase their allocations to international stocks, including emerging markets, but they are still very underweight compared to global equity benchmarks.

Our View and Outlook

Portfolio trends: view and outlook