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Investment directions

Summer 2019

Christopher Dhanraj
Head of iShares Investment Strategy
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Staycation or vacation

“Sell in May and go away” is an old maxim for investors. Evidence is mixed on its validity, but given this year’s rally, the temptation now is understandable. Our take: consider taking some profits and rotating into exposures that offer more resilience if volatility returns. Think of it as the investor version of a “staycation” and catch up on chores. With that in mind, our take on the major investor themes for the weeks ahead.

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Investors should consider a moderately pro-risk position within U.S. equities. We favor technology, which historically has performed well in late economic cycles.

Reverting to technology

We remain overweight U.S. equities, and one of our favored sectors is technology. Even with strong performance this year, we believe the sector remains appealing. Technology firms tend to have strong balance sheets and enjoy support from longer-term trends, attractive qualities in a late economic cycle. Furthermore, tech stocks have historically fared well through various yield curve regimes.

  • We would rebalance to a moderately pro-risk posture in U.S. equities, our favored region. We see opportunities to take profits: U.S. stocks posted their best quarterly returns in 10 years and valuations have recovered dramatically after taking a battering to close 2018.
  • One of our preferred sectors is technology, and we think the case has regained strength. Tech, along with healthcare, displays attractive latecycle attributes: strong balance sheets and secular tailwinds.
  • Technology stocks have fared well through various yield curve regimes. With increased market attention on a flattening curve, a close look at sector performance through various regimes may provide a guide to sensitivities.

Market pulse

This year’s first-quarter equity rebound, in which U.S. stocks experienced their best quarterly return since 2009,1 was driven by multiple expansion and not by changes to earnings expectations. In fact, those declined. We consider this an opportunity to lock in some profits but would still rebalance back to a moderately pro-risk posture in U.S. equities (our favored region). It is worth noting that stocks historically have produced above-average returns late in economic cycles.

With macro indicators pointing toward a slowing global economy and pressure on corporate margins, we continue to prefer companies with quality attributes: strong balance sheets and healthy earnings trends (see Figure 1). One of our favored sectors is technology. Tech companies have more than double the cash on their balance sheets than the rest of the S&P 500,2 and are benefiting from secular transformation across the global economy. Greater optimism in relation to U.S.-China trade tensions has also boosted companies deeply linked to both markets.

Figure 1: The long game: Tech margins outperform

Figure 1: The long game: Tech margins outperform

Source: Bloomberg, as of March 31, 2019. The sectors are represented by the GICS 1 sector subindexes of the MSCI All Country World Index (ACWI). The 10-year average is based on monthly data from 2009 to 2019.
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. Index performance does not represent actual iShares fund performance. For actual fund performance, please visit or

The recent inversion of the U.S. Treasury yield curve—when shorter maturities yield more than longer maturities—has captured investor attention as it has presaged recessions in the past. Our research on the reaction of equity sectors to the yield curve points to historical outperformance of the tech sector during bear flattener regimes (when short-term rates rise faster than long-term rates) like the current one (see Figure 2).

Figure 2: Distribution of equity returns across different yield curve regimes

Figure 2: Distribution of equity returns across different yield curve regimes

Source: Thomson Reuters, as of February 22, 2019. Data covers 150 S&P 500 subsectors since 1995. Average returns are measured over 6 months for consistency with the lookback window to classify yield curve regimes. 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 is no indication of future results.

A tale of flows

Although the global technology sector has outperformed other sectors this year, U.S.-listed exchange traded products (ETPs) tracking technology specific investment exposures have shed $2 billion in assets.3 While this type of divergence is rare and may include structural, non-sentiment driven factors, it is also worth noting that other cyclical sectors experienced outflows in the quarter.

“Bond proxy” sector ETPs gathered the most inflows in 2019, led by $2.9 billion of inflows into real estate products, as the decline in interest rates stoked demand for interest rate proxies. This may also reflect investor demand for sectors that have historically offered resilience during economic slowdowns.

Signs of an economic pickup could indicate European equities, particularly Germany, are at or near a bottom. Europe offers attractive asset valuations compared to history, especially in risk assets.

Europe poised for revival?

Investors in Europe have had little reason for optimism for some time. But we expect European growth to accelerate this year given solid domestic demand. Valuations look attractive relative to history, although political and trade risks linger. China’s efforts to stimulate its own growth could help export-heavy economies, such as Germany.

  • European equities: The bottom may be in sight. We expect European growth to accelerate as external headwinds fade, adding to a solid domestic demand backdrop. Germany is well positioned to benefit from external tailwinds.
  • Current valuations look attractive with risks heavily priced in. Eurozone and German equity valuations have cheapened over the past year, and we find eurozone political risks and trade tensions have largely driven this discount.
  • We remain underweight the region, but note reasons for optimism. We see signs for stronger growth, ECB policy remains accommodative, and positive effects from China’s stimulus could support countries like Germany.

Market pulse

After growth decelerated throughout 2018, we are cautiously optimistic of signs that Europe has found a bottom. Our eurozone financial conditions indicator and growth forecasts are both signaling a pickup in growth is underway, and many of 2018’s headwinds are likely to dissipate, in our view.

Those headwinds, which account for much of 2018’s soft patch, include declining global trade that weighed heavily on export-focused economies, like Germany. Now, positive spillovers from Chinese stimulus could reverse this trend and trade-reliant economies, like Germany, that suffered the brunt of the 2018 weakness are best positioned for a reversal.

Figure 3: At the bottom? Eurozone growth by countries

Figure 3: At the bottom? Eurozone growth by countries

Sources: BlackRock Investment Institute, with data from Thomson Reuters, April 2019. Notes: This chart shows the Eurozone Composite PMI relative to its long-run trend. The regional contributions, derived from individual country Composite PMIs, are broken down relative to their trends.

Valuations currently look attractive. The BlackRock Investment Institute estimates that non-growth related risks (e.g., political risks, trade uncertainty) shaved off more than 11% from the returns of the MSCI EMU Index from January 2018 to the beginning of this year. Those risks still account for a 5-6% risk premium, a healthy margin of safety for valueminded investors.4 Additionally, the inflection in the economic data hasn’t reached analyst earnings estimates yet. The earnings revisions ratio—the number of earnings upgrades to downgrades—for Germany ranks nearly last among developed countries at just 0.3x; earnings expectations seem too bearish given the improvement in the data.5 To be sure, political and trade-related risks are still a concern, but given the attractive value relative to its history, Germany and the broader eurozone bear watching.

A tale of flows

European equity ETP outflows have subsided after a rough 2018 and, like the economic data, appear to be in the early stages of a reversal. German-focused ETPs recorded $1.3 billion in outflows over 13 consecutive months before breaking the streak in April 2019.6 The German outflows were the largest among European countries in both magnitude and length and consistent with external headwinds.

The stretch of outflows across European countries, especially Germany, suggests investors may not be positioned for a pickup in eurozone growth. The April inflows into German-focused ETPs are less than 10% of the $1.3 billion in outflows over the past 13 months. Still, the April inflows are a nascent indication that sentiment may have bottomed out alongside the economic data.

Figure 4: Country-focused ETP fund flows: German flow trends

Figure 4: Country-focused ETP fund flows: German flow trends

Source: BlackRock, as of April 2019. The chart shows ETP flows for country-focused fund flows and excludes broad regional fund flows.

Although Brazil has lagged other emerging markets this year, the macro environment is positive. The key catalyst for a sustained rally is progress on fiscal reform. Overall, we remain overweight EM equities.

Brazil: Waiting on reform

Brazilian assets have underperformed the broad emerging market index this year, despite signs that economic growth is accelerating and earnings prospects remain intact. Instead, investors are focused on the negotiations around pension reform. We expect volatility around the negotiations to continue until reform is enacted.

  • Despite signs of accelerating growth, Brazilian assets have underperformed other EMs this year. Equities have largely traded sideways in 2019 while the real has depreciated marginally.
  • The main culprit: the pace of reform efforts. We expect volatility to remain elevated as long as this uncertainty lingers.
  • Brazil’s recovery and earnings prospects remain intact. Despite a lull in activity data in the first quarter, the earnings outlook remains favorable with broad breadth and strong earnings growth.
  • Pension reform is central to market sentiment. We expect pension reform to continue driving market sentiment. We expect reform negotiations will progress throughout 2019 and are overweight Brazilian assets.

Market pulse

Brazilian assets have lagged emerging market (EM) assets year-to-date. A lull in first-quarter activity data has partially contributed to the underperformance but more recently this has been outweighed by ongoing pension reform—also known as social security reform (SSR)— negotiations, a critical reform item to rectify Brazil’s fiscal position. We expect those negotiations to continue throughout 2019, along with accelerating growth. Bloomberg data shows consensus estimates of real GDP growth rising from 1.1% in 2018 to 2.0% and 2.5% in 2019 and 2020, respectively.7

The accelerating growth backdrop coupled with a very high degree of excess slack—negative output gap, low capacity utilization rates, and unemployment above NAIRU—creates a favorable earnings environment and supports free cash flow dynamics, where top-line revenue growth translates into bottom-line earnings growth.8 This dynamic explains why Brazil’s earnings prospects rank so favorably against EM peers. But to sustain earnings growth, Brazil will need to move forward with SSR.

We expect SSR uncertainty to linger given the complexity and inevitable political compromises necessary to advance through Congress. The eventual approval, even if diluted, should have broad-based spillover effects from fiscal sustainability, to greater business and consumer confidence, to higher potential growth rates and potential restoration of Brazil’s IG credit rating.

Figure 5: Brazilian earnings prospects rank favorably against EM peers

Figure 5: Brazilian earnings prospects rank favorably against EM peers

Source: BlackRock, Thomson Reuters, I/B/E/S. Countries shown are based on respective MSCI country indices. NTM EPS growth is the next 12 months earnings-per-share growth rate based on analyst estimates. The3-month earnings revisions ratio measures the number of company earnings upgrades to downgrades over the past 3 months.

A tale of flows

Brazil’s 2018 fund flow momentum has carried over into 2019. Brazilianfocused ETPs took in $375 million in flows year-to-date, building on an impressive $985 million of inflows in 2018. Across EM assets, this is behind only China and South Korea. The likely catalyst behind the surge is the new Bolsonaro administration and its economic reform agenda. Before the October elections, 2018 outflows totaled $274 million; post-election inflows totaled $1.3 billion. 2019 flows are building further on the fourthquarter 2018 momentum.9

The positive turn in overall EM sentiment this year bodes well for Brazil, but the market’s focus is likely to continue shifting toward catalysts specific to Brazil, namely SSR progress. So far, the market has largely acted on a “buy the rumor, sell the news” basis, allocating early on in Bolsonaro’s presidency on the hope of economic reform. Going forward, legislative progress on SRR is necessary to both retain and attract new money.

Figure 6: 2018 vs 2019: Emerging market (ex China) ETP flows

Figure 6: 2018 vs 2019: Emerging market (ex China) ETP flows

Source: BlackRock, as of April 19, 2019.

With the Fed on pause and the return of seemingly benign credit conditions, investors may want to consider highquality fixed income assets like investment grade corporate bonds and agency MBS.

Return of the benign regime

The Federal Reserve’s rate hike pause has benefited fixed income sectors and assets across the board. Given the market expects rates to remain contained this year, these seemingly benign conditions could last for some time. In this environment, we favor quality, intermediate-term fixed income spread assets, such as agency MBS and high-grade corporates.

  • A pause in interest rate hikes has benefited both risky and highquality fixed income assets. We’ve seen a rally in equities and high yield this year, as well as investment grade corporates and agency mortgage-backed securities.
  • The market expects rates to remain contained. This suggests that the seemingly benign conditions could last for some time.
  • While we have mixed views on these sectors individually, we do favor quality, intermediate-term fixed income spread assets such as agency MBS and high-grade corporates in a broader multi-asset portfolio context.

Market pulse

Since the Federal Reserve (Fed) indicated it would pause interest rate hikes, both fixed income and equity markets have responded strongly. As of April 17, the S&P 500 is up 16.40% and the Bloomberg Barclays US Corporate High Yield Index is up 8.47% YTD. While easy monetary policy is often a boon for risk assets, this environment illustrates that neutral policy can be as well.

Not only are riskier assets such as high yield performing well, so are highquality spread assets such as investment grade corporates and agency mortgage-backed securities (MBS). As of April 17, agency MBS (as based on the Bloomberg Barclays US MBS Index) have already returned 1.77%, ahead of similar duration Treasuries. Investment grade corporates (ICE BofAML US Corporate Index) have returned an impressive 5% as both investment grade and high yield spreads have tightened by 38 basis points (bps, or 0.38% points) and 146 bps, respectively, from their peaks in early January. Finally, inflation remains in check, with realized CPI running at 1.9% and 10-year breakeven inflation at 1.95%.

How long can these seemingly benign conditions last? Market sentiment implies that investors are expecting rates to remain contained for quite some time. Currently, the market believes that interest rate cuts, as opposed to hikes, could be coming even though the median interest rate projection of Fed officials points to zero hikes for 2019 and one hike for 2020. Based on U.S. Treasury forward curves, even five years from now the market is expecting the 10-year Treasury yield to be just above 3%, less than 50 bps higher than today. While market conditions can always shift suddenly (e.g., an unexpected increase in inflation), in an environment where the Fed is on hold and real interest rates are range-bound, we prefer to own high-quality, intermediate-term fixed income spread assets such as agency MBS and high-grade corporates.

Figure 7: Investment grade & high yield spreads

Figure 7: Investment grade & high yield spreads

Source: Bloomberg, as of April 17, 2019.

A tale of flows

Last year, the global fixed income ETF landscape saw tremendous inflows into short-maturity products as the Fed raised rates once per quarter and investors shed duration risk. However, this trend has reversed in 2019 with the Fed’s dovish policy shift and investors adding duration back into their portfolios. Flows into U.S.-listed intermediate- and long-term bond ETFs year-to-date are $5 billion and $3.6 billion of inflows, respectively, while short-term exposures experienced $0.25 billion of outflows.

With a record global equity rally in the first quarter, appetite for credit also returned as both investment grade and high yield attracted large inflows. As growth slowdown concerns remained a key risk, investors favored higher-quality exposures in the corporate credit universe. Year-to-date, U.S.-listed investment grade exposures experienced more than $17 billion of inflows while high yield bonds have seen ETF inflows of $8.2 billion, well ahead of Treasury ETFs, which saw $4.3 billion of inflows.

Figure 8: YTD fixed income ETP flows by sector

Figure 8: YTD fixed income ETP flows by sector

Source: BlackRock, as of April 17, 2019.

Despite the renewed market enthusiasm seen in the first quarter, there is widespread agreement that economic growth is slowing. We favor quality in this environment, and are neutral momentum and minimum volatility.

Q2 factor outlook

Our factor-tilting model examines multiple metrics including relative strength, which uses a simple measure of 12-month price momentum to determine the trending behavior of each factor and compare market sentiment in one factor versus the others. Changes in multiple factors’ relative strength have particularly driven our updated outlook this quarter: We’ve upgraded quality from neutral to overweight while downgrading minimum volatility and momentum.

  • Our outlook for quality has markedly improved from neutral to overweight this quarter. Strong outperformance has boosted its relative strength and drives our upgrade. Cash flow-based valuations also appear modestly attractive.
  • Our outlook for size has improved to moderately underweight. While a slowdown regime remains unfavorable to size, which tends to perform best in periods of accelerating growth, its relative strength has improved.
  • Our outlook for momentum has continued to decline this quarter to a neutral position. Cash flow-based valuations have modestly improved; however, its relative strength has weakened.
  • We move from a neutral to moderately underweight position in value. While both cash flow-based and forward-looking valuations appear attractive, the current slowdown regime and the factor’s relative strength are not supportive.
  • Our outlook for minimum volatility has declined to neutral from moderately overweight last quarter.

Market pulse: Insight into relative strength

Our factor-tilting model examines multiple metrics of attractiveness when determining our relative outlook across factors. One of those metrics is relative strength, or the momentum of the factors themselves. Just as we observe trending price behavior in single stocks (indeed, this is what the momentum factor seeks to capture), we too see trending behavior in factors, with the same behavioral rationales. For example, investors tend to pile into, and thus bid up, the prices of stocks that have exhibited strong recent performance. In factor terms, this means that a factor that has performed well over the last six months tends to perform well over the next six months.

Our relative strength metric uses a simple measure of 12-month price momentum to determine the trending behavior of each factor and compare market sentiment in one factor versus the others. This allows us to pick up the trends in each factor and to overweight/underweight those with recent high/low performance.

Changes in multiple factors’ relative strength have particularly driven our updated outlook this quarter. Our view on quality has moved from neutral to overweight this quarter, primarily driven by its sharply improving relative strength. Meanwhile, min vol’s relative strength peaked in late fourth quarter amid the market sell-off when we held a moderate overweight position. Its decline in the first quarter as markets have rallied has driven our downgrade to neutral this quarter.

We saw a similar decline in momentum’s relative strength in the first quarter from the sustained high levels seen throughout most of 2018. This change in leadership from momentum and min vol last quarter to quality currently reinforces our updated outlook.

Portfolio trends: Notes from the field

The iShares Portfolio Solutions team analyzed 11,161 models provided by advisors from throughout the industry over the past 12 months. Three main takeaways:

  • Protect and participate is the mantra of late-cycle portfolio construction: A “staircase” approach to portfolio de-risking—a gradual reallocation, in other words—can help balance the effects of higher volatility, greater uncertainty, and the risk of imperfect market timing.
  • Advisor models are still bullishly positioned: Our performance analysis of the moderate advisor model composite suggests that implementing any of the steps in our staircase approach would have improved performance over the ups and downs of the past two quarters. Managing the amount of portfolio loss in the fourth quarter was the key.
  • Non-U.S. stock allocations seem relatively stable, but at a very underweight level: A little more than half of that underweight is Europespecific, although emerging market exposures continue to advance.

Our View and Outlook

Portfolio trends: view and outlook