iShares Midyear 2022 Investor Guide


Gargi Pal Chaudhuri Jul 11, 2022

INTRODUCTION

INTRODUCTION

We have entered a new regime marked by high volatility, inflation, and uncertainty. The Great Moderation — a period of low inflation and stable economic growth that began in the mid-1980s — has come to end. The new regime, ushered in by pandemic scars and geopolitical conflict, will have many implications, not least of which is increased demand for more nimble investment tools. ETFs will be key in this transition.

We identify three investment themes that will be paramount for the remainder of 2022:

 

  1. Embracing volatility — As central bankers around the globe seek to balance sticky inflation with slowing growth, risk premia is on the rise. We believe defensive positions make most sense as minimizing drawdowns may be the new way to beat a benchmark. We prefer minimum volatility exposures, dividend strategies, and limiting duration.
  2. Living with sustained inflation — Cyclical drivers of inflation will fade as higher interest rates take their toll, but structural factors mean it will stay higher for longer. That argues for inflation-linked over nominal bonds and getting granular with sub-sectors that exhibit the highest pricing power, such as pharmaceuticals. The emerging trend of “friendshoring” will be a boon for countries that are more geographically and politically aligned with major powers, such as Mexico and Brazil.
  3. The long-term impacts of shortages — The global economy is grappling with commodity induced volatility that we haven’t seen in decades. From gasoline prices in the U.S. to food inflation globally, it doesn’t take much to see and feel the real economic impact. We believe there are near term opportunities in the energy and agriculture sectors, and longer term solutions in thematic exposures like clean energy and the future of food.

 

In this investment guide, we pair macroeconomic views and market positioning insights to identify potential investment opportunities using ETFs.

EMBRACING VOLATILITY

EMBRACING VOLATILITY

Central banks are reckoning with the tradeoff between tamping down inflation and destroying demand, thereby increasing the risk of recession. Whatever happens, our view is that market risks are set to rise, and investment horizons are likely to shrink. Portfolios will need to be nimbler to adapt to more frequent macro and policy shifts, and to capture investment opportunities across geographies and asset classes. Liquidity considerations will become more important as volatility and portfolio churn increases, adding to the appeal of liquid, transparent, and cost-effective ETFs.

Figure 1. ETFs’ share of total equity trading rises with volatility

Area chart showing the volume of ETFs traded as a percentage of the total equity tape rising concomitantly with the rise of the Chicago Board Options Exchange's CBOE Volatility Index (VIX)

Source: iShares Investment Strategy, iShares Markets Coverage, Bloomberg. As of June 22, 2022. ETFs comprised of U.S. listed ETFs.

Chart description: Area chart showing the volume of ETFs traded as a percentage of the total equity tape rising concomitantly with the rise of the Chicago Board Options Exchange's CBOE Volatility Index which is shown by a line chart (VIX).


For investors, elevated volatility may present opportunities. Staying invested for the long term remains our north star; however in this uncertain moment portfolios are best shifted to a defensive stance. In equities, we favor a tilt toward a minimum volatility strategy to reduce overall portfolio risk and to help hedge against significant drawdowns. The broad equity market has been down -1% or more in 33 sessions this year, and minimum volatility has outperformed in 30 of those by an average of 64 bps1. In the 12 down days of -2% or more, minimum volatility outperformed in all dozen days by an average of 87 bps.2

 

Moreover, minimum volatility tilts increase the quality characteristics of a portfolio, beating the broader market on metrics of financial health including gross margin, return on assets, return on common equity, and sales per employee.3 A rotation to less volatile and more defensive segments of the equity market could be reasonably funded out of positions in more expensive, non-profitable, speculative segments of the market that are most sensitive to higher discount rates. ETF flows suggest that investors have been doing exactly that: adding to minimum volatility and defensive sectors like healthcare and infrastructure.

 

Flows have also gone into dividend ETFs, which we see as a potential source of income, diversification, value, and quality in a portfolio. Compared to stocks whose prices reflect expected profits that extend further into the future, dividend paying stock prices tend to reflect near-term profits. Since rising interest rates can decrease the present value of future cash flows, the over 15% worth of outperformance of high dividend yield stocks versus the broader market suggests an investor preference for near-term cash flows.4 High dividend-paying companies also offer over double the sales per employee compared to companies representing the broader market, a benefit in a tight labor market. They also boast a free cash flow yield — the free cash flow per share divided by the current share price — of 5.9% versus 4.7% for the S&P 500.5

Figure 2: Flows into Min Vol or into defensive sectors/exposures

Line chart shows flows into minimum volatility factor-focused ETFs and into defensive-oriented ETFs year-to-date.

Source: iShares Investment Strategy, iShares Markets Coverage, Bloomberg. ETF groupings determined by BlackRock.

Chart description: Line chart shows flows into minimum volatility factor-focused ETFs and into defensive-oriented ETFs year-to-date. Inflows in all of the categories have stayed positive with quality gathering the most inflows as % of asset-under-management.


In fixed income, we prefer limiting duration as the Federal Reserve’s hiking cycle and quantitative tightening continues to lift yields, and as a flatter curve offers investors attractive yields in short-dated maturities with lower risk. Our expectation for long-term yields to rise adds conviction to our view to limit portfolio duration. Amid the sharp bond market movements this year, high front-end yields appear more attractive as equity volatility persists; ballast can be sought there in a slowing-growth environment.

LIVING WITH SUSTAINED INFLATION

LIVING WITH SUSTAINED INFLATION

2020 marked the end of a 40-year trend toward steadily falling inflation expectations. Recent survey data show longer-term inflation expectations have surged to their highest level in 14 years6. While we still expect cyclical inflation pressures to abate through tighter monetary policy and slower growth, we think inflation will be higher and more persistent than in the past. In short, we think inflation is likely to linger above the 2% pace that was considered most consistent with long-term growth in the recent past.

 

Why? For one, production constraints in the labor market, supply chains, and commodities are not fading quickly. The New York Fed’s Global Supply Chain Pressure Index has stabilized at relatively high levels. An aging population, a retreat from globalization and justified public health concerns are all longer-term factors which may make labor markets less flexible and contribute to faster inflation.

Figure 1: Supply Chain Bottlenecks

Chart showing GSCPI integrates global transportation costs, airfreight costs, and data from PMI surveys with the aim of providing a comprehensive summary of potential supply chain disruptions.

Source: BlackRock, Bloomberg. As of May 2022.

Chart description: The GSCPI integrates global transportation costs, airfreight costs, and data from PMI surveys with the aim of providing a comprehensive summary of potential supply chain disruptions. The line chart shows that the index level has increased meaningfully since the beginning of the Covid pandemic and has remained elevated.


Sustained inflation argues for inflation-linked bonds over nominal bonds. However, in contrast to last year, when the onset of the inflation shock catalyzed $12 billion of inflows to longer-dated Treasury inflation protected securities (TIPS), recession worries may weigh on longer-dated breakevens. Instead, inflation-linked bonds look attractive at the shortest durations, which have gathered $5.9 billion in flows so far this year. We believe that Fed rate hikes are now fully priced into the front end of the yield curve and higher inflation over the medium term will benefit short-term inflation-linked bonds outright and versus their nominal counterpart. For this reason, we like short-term TIPs exposures.

Figure 2: Inflation fears drive inflows in ’21, recession fears drive outflows in ‘22

Chart showing cumulative flows into TIP, end-2020 to June 23, 2022.

Source: BlackRock, Bloomberg. As of June 23, 2022. ETF groupings determined by BlackRock.

Chart description: Cumulative flows into TIP, end-2020 to June 23, 2022. Short term TIP funds gathered over $15bn of inflows in 2021, and just over $5bn of inflows in 2022 Year-to-date. Long term and blended maturities grew by over $20bn in 2021, but then saw outflows of over $5bn in 2022.


In equities, higher inflation and tighter financial conditions would seem to naturally support a weighting towards defensive sectors like healthcare, staples, and utilities. However, in practice, sector classifications are broad enough to include a wide variety of companies with a range of fundamental characteristics. We prefer focusing on industries within these broad sectors that include more quality companies with pricing power and strong balance sheets. For example, within healthcare, we like pharmaceuticals and healthcare providers.

 

COVID and geopolitical tensions exposed the fragility of just-in-time inventory management with a sprawling global supply chain. Manufacturers have learned that they cannot dependably source inputs exclusively from distant, politically risky producers. Rather, they need to build redundancies and relocate the production of vital inputs to closer, less antagonistic countries (friendshoring). This trend could benefit modestly higher cost producers that are close politically and geographically to the U.S. Many emerging markets and EM currencies appear poised to benefit from 1) Peak Fed expectations (recession fear reducing Fed hike expectations; 2) Major EMs front-loaded hikes in 2021 on expectations of extended Fed campaign, so already running tight policy; and 3) Emerging Market valuations vs Developed Market, in our view, look attractive, particularly if we are in a world starved of real growth. iShares J.P. Morgan EM Local Currency Bond ETF (LEMB) can provide exposure to countries impacted by friendshoring.

THE LONG-TERM IMPLICATIONS OF SHORTAGES

THE LONG-TERM IMPLICATIONS OF SHORTAGES

There is little in the macroeconomic picture that suggests an easing of commodity shortages, either. Recessionary fears amid slowing growth and higher interest rates only work to stymie necessary capital expenditures (both private and public) that would work to solve underlying frictions. However, we don’t believe outright commodity exposures effectively captures this trend. Although a broad commodity allocation has outperformed the S&P 500 by 75% since the beginning of 2022, we believe the pace of commodity price increases will only slow from here.7 Instead, we prefer to own companies that can translate structurally higher commodity prices into profitability. We see two sub-sectors within the commodity complex that are poised to benefit from this backdrop: energy and agriculture.

 

The energy sector has had a historic run since the depths of the COVID pandemic. Oil prices have risen to over $100/barrel, well-past their five-year average of $53/barrel prior to the pandemic.8 Although prices have moderated as slowing global growth looks to weigh on demand, we still see reason to have exposure to the energy space. After over a decade of easy monetary policy pushed investors towards less capital-intensive sectors, energy companies have learned to emphasize capital discipline amid underinvestment (Figure 1). Coupled with a relatively long capex cycle that ensures capacity constraints won’t be lifted immediately, we expect margins within the energy sector to remain robust, while valuations are also below historical averages.9

Figure 1. Free cash flow yield and EBITDA of energy sector

Line chart showing the EBITDA rise since 2021 to around $80bn.

Source: BlackRock, Bloomberg, chart by iShares Investment Strategy. Reference index is the S&P 500 Energy Sector GICS Level 1 Index. Free cash flow yield is the trailing 12-month free cash flow per share divided by share price. EBITDA is the earnings before interest, taxes, depreciation, and amortization. As of June 24, 2022.

Chart description: Line chart showing the EBITDA rise since 2021 to around $80bn. Area chart showing the free cashflow yield rise to around 8% this year.


Furthermore, the Russia-Ukraine conflict has reemphasized the necessary role energy companies play during the transition to net-zero emissions. The long-term trend away from carbon fuels dissuade substantial investment in new oil and gas projects, helping to keep energy prices higher for longer. However, this also makes green energy alternatives more cost competitive, encouraging investment in the net-zero transition. Transition essentials like wind turbine farms and electric vehicles also require staggering amounts of iron ore, copper, lithium and other metals to match fossil fuel generated power sources’ outputs.

 

Although not as readily transparent, global food inflation has proven to be just as important as rising oil prices (Figure 2). Disruptions to this season’s growing cycle — due to export restrictions, higher fertilizer costs, and climate change effects — look to only continue. To combat the uncertainty, we believe countries and their farmers will refocus on generating sustainable crop yields through technological investment. Capital expenditures in U.S. farms during much of the past decade have been below depreciation values, pointing to structural underinvestment and aging machinery.10 The next generation of farm technology will look to enable farms to operate more efficiently in face of these needs.

 

Despite agriculture making up 4% of global GDP (and more than 25% in many emerging markets), many investors remain under-allocated to this part of the real economy.11 Valuations within the agriculture producer space are attractive relative to the broader S&P 500 (12.2 versus 19.6 P/E ratio), while earnings growth has accelerated (three-month EPS percent change: 19%, S&P 500: 1.1%).12 With these attractive valuations and growth in expected earnings, we see the agriculture commodity sector as ripe for investment.

 

While we see near term opportunities in energy and agriculture, investors with a longer-term focus may also want to consider structural solutions captured in thematic exposures like clean energy and the future of food.

Figure 2. Commodities on the rise

Line charts showing prices, rebased to 100 as of January 01, 2018 for oil, wheat, soybeans, and corn.

Source: BlackRock, Bloomberg, chart by iShares Investment Strategy. Reference indices are the generic futures contract for WTI Oil, Corn, Wheat, and Soybeans. Rebased at 100 on January 01, 2018. As of June 24, 2022.

Chart description: Line charts showing prices, rebased to 100 as of January 01, 2018 for oil, wheat, soybeans, and corn. Prices have for all of these commodities have risen consistently since 2021 and are remaining at elevated levels.


Gargi Pal Chaudhuri

Gargi Pal Chaudhuri

Head of iShares Investment Strategy Americas at BlackRock

Kristy Akullian

Investment Strategist

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Jon Angel

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Jasmine Fan, CFA

Investment Strategist

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David Jones

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Arjun Kapur

Investment Strategist

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Nick Morales

Investment Strategist

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