iShares midyear 2021 outlook and ETF implementation guide

Focusing on inflation, climate and infrastructure

Gargi Pal Chaudhuri Jul 8, 2021

Key takeaways

  • We upgrade European stocks to “overweight,” and downgrade our view on U.S. stocks to “neutral.”
  • We remain “underweight” government bonds and “overweight” inflation-linked assets.
  • We emphasize potential opportunities related to the climate-related transition to net zero in stocks and commodities.
  • We see the potential for spending on infrastructure to boost related stocks, including those with ties to electric vehicles and cybersecurity, and municipal bonds.
  • We favor “quality” stocks with strong fundamentals as the pace of economic growth normalizes.

More than a year has passed since COVID-19 upended financial markets and global economies. And while many developed economies are reopening, the ripples of the pandemic are shaping the investment landscape headed into the second half of 2021.

Monetary and fiscal support are ample and economic growth is quickening. Many global stock benchmarks sit near all-time highs while bond yields remain stubbornly low. The varying pace of vaccinations worldwide, the rates at which consumers spend, and pandemic-related supply chain bottlenecks all influence where we see opportunities for the short, medium and long terms. We’re also closely watching the spread of the COVID-19 Delta variant as a key risk to the restart.

Inflation is rising but we expect central bankers to respond less forcefully than in the past to tamp it down. This key theme, which we call the “new nominal,” is front and center in “Looking beyond the restart,” the midyear global outlook from the BlackRock Investment Institute (BII).

Our second theme is thenet zero journey,” focused on the huge investments needed to achieve a more sustainable world and the opportunities in clean energy and commodities. “Infrastructure” represents our third theme given the global push for building a greener and more resilient physical and digital foundation for the post-pandemic economy and to make up for years of underinvestment in traditional infrastructure like roads, bridges, rail, and ports. Finally, we think investors should consider adding “quality” stocks as the pace of the reopening normalizes and with a host of uncertainties on the horizon.

In this quarterly investment guide, we pair macroeconomic views and market positioning insights to identify potential investment opportunities using exchange traded funds (ETFs). We consider fund flow trends and proprietary signals designed to capture crowded positioning and under-owned opportunities within each investment theme.

Index performance and ETF flows (YTD)

Graph: index performance and ETF flows (YTD)

Source: BlackRock, Bloomberg, chart by iShares Investment Strategy (as of June 30, 2021). Flows normalized by AUM as of Dec. 21, 2020. Past flows not indicative of future flows. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Past performance does not guarantee future results. Performance is measured by the following indexes: Energy: Dow Jones US Oil & Gas Total Return Index; Financials: Dow Jones U.S. Financials Capped Index (USD) TR; Real estate: The Dow Jones U.S. Select REIT Index;  Small- & Mid-Cap: Russell 2000 Total Return Index; Value: Russell 1000 Value Index Total Return;  Materials: Dow Jones US Basic Materials Total Return Index; Large-Cap: S&P 500 Total Return 4 JAN 1988 Index; Industrials: Dow Jones US Industrials Total Return Index; Growth: Russell 1000 Growth Total Return; Information Technology: MSCI USA Information Technology Index; Developed Markets ex-U.S.: MSCI WORLD ex USA IMI  USD NETR;  Emerging Markets: MSCI EM Emerging Markets IMI USD Net;  HY Credit: iBoxx USD Liquid High Yield Index; IG Credit: iBoxx USD Liquid Investment Grade Index; U.S. Treasury:  ICE BofA Current 10-Year US Treasury Index; Gold: iShares COMEX Gold Trust Net Asset Value Index.

“Reflation” trade goes global

We turn bullish on European stocks and remain constructive on certain parts of the U.S. equity market, inflation-linked bonds and a diversified basket of commodities in the second half of 2021 as the vaccine-led, fiscal and monetary policy-supported global economic restart continues. Importantly we think the restart-driven peak growth in the U.S. may be behind us; therefore, we are tempering our views on broad U.S. stocks and choosing to be more targeted in our preference for small-cap and cyclical oriented sectors.

While the “reflation trade” centered around high growth and fast-rising inflation was most pronounced in the U.S. during the first half of 2021, we see it broadening to Europe and Japan, following the path of the global vaccine rollout. We think that central bankers globally will take additional steps to avoid undercutting the economic restart. For example, the European Central Bank (ECB) moved in March to quicken the pace of its asset purchases after bond investors unexpectedly drove bond yields higher globally. Since then, the euro area has been catching up on its activity restart, supported by the ECB remaining squarely focused on maintaining easy financing conditions. That’s why we are upgrading our view on European stocks to “overweight” and downgrading our view on U.S. stocks to “neutral.”

Inflation is likely to run higher in the U.S. relative to the last global economic recovery given a backdrop of economic growth, sustained fiscal and monetary policy support, higher production costs, and supply chain diversification in the wake of the pandemic. These trends potentially bode well for cyclically oriented value stocks in sectors such as financials that have been strong performers so far in 2021. The same is true for “value” and small-cap stocks, which have historically benefitted during periods of higher economic growth. Indeed, flows into cyclical sector ETFs have outpaced that of the defensive sector by $53 billion in the first half of 2021.1

Within fixed income, there is a risk in the second half of 2021 that bond yields move moderately higher, and we remain “underweight” government bonds including US Treasuries, anticipating a higher inflationary backdrop and reflecting the economic growth that has already taken hold in the U.S. Given our view on interest rates and inflation, we favor short-duration Treasury Inflation-Protected Securities (TIPS) and bonds that are linked to floating rates. Some $7.7 billion in flows have gone into U.S.-listed short-duration TIPS ETFs in 2021, compared with $6.8 billion into “blended” TIPS ETFs that hold all durations.2

Let’s get cyclical

Year-to-date flows into cyclical, inflation-related and value ETFs

Graph: flows into cyclical, inflation-related and value ETFs (YTD)

Source: BlackRock, Bloomberg, ETF groupings and categories determined by BlackRock, Markit, chart by iShares Investment Strategy. As of June 30, 2021. Past flows not indicative of futures flows.

Shifting to sustainable assets

A transition is underway toward a “net zero” global economy — one that emits no more greenhouse gas than it removes from the atmosphere by 2050.

Attaining net zero will require huge investments, changes in business models, and innovation. Recognition of climate risk as investment risk has recently accelerated as a result of four powerful trends, including record damages from extreme weather events in 2020, regulation, clean energy innovations that are reducing the cost and carbon intensity of energy production, and investor sentiment that appears to be turning in favor of sustainable strategies.3

To reach net zero emissions by midcentury, annual clean energy investment will need to more than triple by 2030 to around $4 trillion.4 We expect the transition to boost economic growth relative to a “no climate action” world of mounting physical climate damages. The implications are far reaching, and likely underappreciated by markets, in our view.

A growing number of investment strategies allow investors to customize portfolios around climate needs — from reducing carbon exposure, to prioritizing a low-carbon transition, to targeting themes such as clean energy.

Relatedly, we see long-term demand for certain commodities such as copper and lithium, which are used to generate, transmit, and store electricity. Current supply shortages across many commodities are the legacy of a decade of underinvestment after the last commodities boom, and higher prices may persist in the face of durable, price-insensitive demand. At the same time, traditional energy producers may be unable to tap fossil fuel reserves due to regulation and a scarcity of capital, which could support higher oil prices in the short term. All this has contributed to a record $7.4 billion inflow into U.S.-listed commodities ETFs year-to-date, but we still see room to run as demand for commodities stays elevated and infrastructure-focused fiscal spending materializes.5

Reaching for sustainability

Cumulative inflows into U.S.-listed sustainable ETFs

Graph: Cumulative inflows into U.S.-listed sustainable ETFs

Source: BlackRock, Bloomberg, ETF groupings and categories determined by BlackRock, Markit, chart by iShares Investment Strategy. As of June 30, 2021.  Past flows not indicative of future flows.

Building a new foundation for real and digital assets

There is growing demand for new projects to support the transition to a lower-carbon economy and a longstanding need to upgrade existing infrastructure.

Both types of infrastructure were included in the Biden administration’s “Build Back Better” proposals. These proposals outline projects to support highways, bridges, and public transit, as well as green initiatives to support electric vehicle production and charging, energy efficiency in buildings, expansion of electrical grids, and new funding for clean energy and water.

Investors have demonstrated an interest in targeting stocks that could benefit from an influx in infrastructure-related spending. Some $3.1billion has moved into U.S. infrastructure ETFs.6 We expect demand for liquid and transparent ways to invest in infrastructure  to increase as negotiations in Washington, D.C. move from rhetoric to reality.

Tax-aware investors may look to municipal bonds given the continued support for state and local credit from the COVID-19 relief package (American Rescue Plan) signed into law this year. In the first half of 2021, municipal bond ETFs ranked 4th in terms of flows across all U.S.-listed fixed income ETFs, taking in $10.4 billion net inflows.7 As tax becomes an ever more important consideration in investor portfolios, municipal bond ETFs could continue to see increased flows.

Looking ahead, tax breaks, fossil-fuel regulations, and increased renewable infrastructure spending all are poised to accelerate demand for electric vehicles (EVs). The Biden administration’s proposed infrastructure plan, which includes $174 billion to boost EV sales — including $15 billion to build 500,000 charging stations and $100 billion for new consumer rebates — could accelerate U.S. EV adoption.8 Another potential digital infrastructure related opportunity is information security. The frequency and severity of cyberattacks are accelerating and companies are ramping up spending on security in the face of increasingly sophisticated threats, presenting a potential long-term investment opportunity.

Striking a balance between value and quality

We expect the global economy to remain in a boom state as reopenings continue, but financial markets are anticipatory, and we think that some of the early-cycle, investment opportunities may have already played out, especially in the U.S.

Stocks selling at the deepest discount, those with the most financial leverage, have outperformed the most since November.9 It may be time to tilt  toward mid-cycle beneficiaries, which tend to be “quality” stocks — those with positive fundamentals (high return on equity, stable year-over-year earnings growth and low financial leverage). We favor taking a “barbell” approach to stocks, pairing value with quality to access companies that may be better poised to perform in a mid-cycle environment.

So far in 2021, many investors have avoided or sold quality in favor of cyclical stocks that performed best in the early phases of last year’s market upswing. This put higher-quality stocks at their largest discount to the broad market since the dot-com bubble of the early 2000s.10 We see the potential for quality’s performance to improve as the economic cycle evolves, investors anticipate more normalized growth, and potentially become cautious about taxes, inflation, and the timing of a Federal Reserve policy shift.

Flows are already picking up, with some $1.7 billion of inflows to global quality ETFs in the second quarter (following $2.6B out in Q1), the first quarter of net outflows for the factor since 2015.11

As part of the quality side of the barbell, we favor technology given the sector’s strong company balance sheets and free cash flows. Within technology, semiconductors offer exposure to the backbone of powerful, emerging technologies, and are integral to global trade and increasingly essential to devices that allow people to work and learn remotely.

Quality stocks can help investors prepare for a growing number of market uncertainties that could crop up headed into next year. In particular, key drivers of rising profit margins in recent years such as low input and labor costs, interest expense, and effective tax rates could start to reverse. Already, input and labor costs are rising due to inflation and supply shortages in many sectors. Financing costs are rising too, albeit from low levels. Corporate tax increases are on the table in the U.S., and a coordinated push for a global minimum tax may reduce the ability of multi-national companies to shift profits to low-tax jurisdictions.

The potential for this environment can favor quality-oriented companies that have the pricing power to pass rising input costs through to customers, and strong enough balance sheets to weather compressing margins and higher taxes.

Gargi Pal Chaudhuri

Gargi Pal Chaudhuri

Head of iShares Investment Strategy Americas at BlackRock

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