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Spring fever

The term “spring fever” describes the contradictory emotions people have as the new season approaches: listlessness alongside energy, ennui next to excitement. It could also define the current mood in the markets: relief at the easing of trade frictions, expectations of an economic rebound and optimism around earnings, tempered by concerns surrounding the impact of the coronavirus and ongoing geopolitical tensions. Our take on the major investor themes for the weeks ahead.

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We prefer exposures reflecting structural trends over cyclicals, such as tech and healthcare, amid a moderately pro-risk position within U.S. equities.

The cyclical versus the structural

Although we expect a modest uptick in economic activity, cyclical sectors appear expensive as prices seem to have outrun the data. We would focus on sectors benefiting from secular trends, namely tech and healthcare. The low-yield environment suggests investors will still seek additional multi-asset carry to reach income goals.

Key points

  • A growth rebound. We expect a modest uptick in U.S. and global economic activity. However, after 2019’s valuation-driven rally, a successful handoff from easier financial conditions to better growth and a pickup in earnings is critical for sustained equity performance.
  • Cyclicals are fully priced. Equity markets appear to have outrun the data and are already pricing in a large growth rebound, marking a rather dramatic reversal in market expectations since our last publication.
  • Favor secular trends, while looking for carry. We remain constructive on tech and healthcare given strong secular trends. In a continued low-yield environment, investors may need to take more risk to reach income goals.

Market pulse

We believe economic growth will accelerate in the coming months, yet we have reduced our U.S. equity positioning to neutral in our 2020 outlook. More than 90% of last year’s rally was due to multiple expansions, but going forward, strong earnings growth will be necessary to justify valuations and sustain the rally.1 This is especially true given the stronger growth outlook U.S. assets have recently priced in.

Market-implied growth expectations now look quite elevated and returns are likely skewed toward the downside near term. Either economic data must catch up to the elevated market pricing or markets sell off to more realistically reflect the data.

Thus, we turn to long-term structural growth for guidance and reiterate our preference for technology and healthcare, two of the biggest R&D spenders.2 Each sector has strong organic growth, and we believe election fears regarding healthcare will continue to abate.

Figure 1: Global asset yields: Pre-crisis versus today

Figure 1: Global asset yields: Pre-crisis versus today

Source: BlackRock, Thomson Reuters, as of January 31, 2020. 1m LIBOR indexes used for cash, Datastream benchmark 10-year government bond indexes, Merrill Lynch corporate and high yield bond indexes, JP Morgan emerging market indexes for EM debt, Datastream total market equity indexes for equities. 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.

Meanwhile, in January, concerns first over geopolitical tensions and later potential pandemics helped drive interest rates lower, with the 10-year Treasury yield now hovering around 1.5%, as of January 31.3 As such, despite the anticipated growth rebound, investors may still need to consider taking on risk in seeking yield and consider dividend growers, preferreds and other multi-asset yield opportunities.

Figure 2: Lofty expectations: Markets have priced in a sizeable growth rebound

Figure 2: Lofty expectations: Markets have priced in a sizeable
growth rebound

Source: BlackRock, Bloomberg, as of January 24, 2020.
Note: Market-implied ISM is a statistical estimate of how markets are pricing U.S. growth expectations. We extract the first principal component (PC1) from the daily returns of growth-sensitive assets to capture the common (i.e., macro) variation across assets. To align units of measurement, PC1 is scaled to match the mean and standard deviation of the ISM. U.S. assets include S&P 500, S&P 500 cyclicals ex-tech vs. defensives and U.S. 10-year yield.

A tale of flows

Investor positioning is seldom a catalyst, but it can be a strong amplifier, particularly around key inflection points. The past several months represent a somewhat new market regime as the bond proxy trade faded, overall geopolitical risk abated, and a cyclical growth rebound took shape. Since equity investor positioning was muted and skewed toward defensive bond proxies, this created a scramble to add U.S. equity exposure and rotate into more cyclical areas.

Global ETF flows bear this out. Defensive bond proxy sectors such as consumer staples and utilities led global ETF flows when growth expectations and rates were still declining. But once growth expectations began to rise, they saw the largest outflows and cyclical sectors such as industrials and materials saw the largest increases, which further corroborates the notion that markets have priced in (and allocated to) a growth rebound.

Figure 3: Global ETF flows: Chasing upside exposure

Figure 3: Global ETF flows: Chasing upside exposure

Source: BlackRock, as of January 27, 2020.

Climate change is increasingly on the minds of businesses and investors, who are evaluating both the risks and the opportunities as demand for clean energy increases over the coming years and decades.

A climate turning point

Gauging the impact of climate change risks is now an increasing priority for the private sector, in businesses’ strategic objectives and capital allocation decisions. But the shift to renewable energy production and the emergence of technological innovations, like electric cars, present significant potential as long-term investment opportunities.

Key points

  • A heating world. Scientists now estimate that global temperatures could increase by three degrees Celsius by the end of the century,4 raising risks to human health, food supply and economic growth.
  • Measuring the risks. Gauging the impact of climate change risks is an increasing priority for businesses’ strategic objectives and capital allocation decisions.
  • A shift to renewable energy. Bloomberg New Energy Finance (BNEF) estimates that two-thirds of electrical energy production will come from renewable resources by 2050, particularly wind and solar. The likely growth in demand underscores their potential as investment opportunities.

Market pulse

The average global temperature has increased approximately 1.4 degrees Fahrenheit (less than one degree Celsius) since the early 20th century, according to the National Oceanic and Atmospheric Administration.5 And while the degree of future change is unknown and estimates vary, current broad consensus is that the world could warm by roughly three degrees Celsius by 2100.6 Even just 1.5 degrees Celsius of warming could increase risks to health, food supply and economic growth, according to the most recent report by the UN Intergovernmental Panel on Climate Change.7

Assessing the potential impact of this climate change has become an evergrowing priority for companies’ strategic and capital allocation decisionmaking processes. Furthermore, central bankers, consulting firms and Wall Street have all started to evaluate the risk of climate crisis, similar to how they have historically looked at financial crisis risk. We believe this will help drive investments in renewable energy as people demand sustainable sources of growth.

According to BNEF, solar and wind power will be the main renewable resources by 2050. Although burning fossil fuels represents roughly two-thirds of total electrical energy production today, this will shift to two-thirds renewable resources in 30 years. This is key as energy demand is expected to increase by 62% over this same time period.8

In short, we believe we are at an important turning point in evaluating climate change and resource scarcity. January’s World Economic Forum, where the theme was “Stakeholders for a Cohesive and Sustainable World,” is just one example of climate change conversations gaining momentum on a global stage, a trend we expect will continue.

A tale of flows

Sustainable investing is gaining in popularity globally with record inflows into Environmental, Social, and Governance (ESG) focused funds in 2019. U.S.- listed sustainable funds saw a major uptick in flows in 2019 compared to previous years: 2019 net inflows to ESG funds totaled $8.5 billion compared to $2.3 billion in 2018.

As global investors start to pay more attention to the impact of climate-related risks, sustainable strategies with a distinct focus on investing in clean energy resources, such as solar and water, and renewable energy technology have grown at an extremely rapid pace. Flows into U.S.-listed clean energy themed ETFs increased from $190 million in 2018 to $890 million in 2019 (Figure 4). With increasing demand for sustainable investing and a shift in global power generation from two-thirds fossil fuels to two-thirds renewables in the next 30 years, investors may seek more opportunities in the clean energy space to catch up with the trend.

Figure 4: U.S.-listed flows into clean energy themed ETPs

Figure 4: U.S.-listed flows into clean energy themed ETPs

Source: Markit, as of December 31, 2019. Annual flows into U.S.-listed ETPs that focus on clean energy investments.

An uptick in global manufacturing and trade activity favors a tactical tilt into more cyclical exposures, including EM and Japanese equities.

Looking east

Given the unknowable fallout from the coronavirus in China, investors will likely remain cautious. However, we see potential for other cyclically oriented countries such as Japan and emerging market (EM) equities to outperform. A weaker U.S. dollar should help those regions.

Key points

  • Global growth rebound. We see potential for cyclical assets such as Japanese and emerging market (EM) equities to outperform as manufacturing and global trade recover.
  • Expect stable to weaker USD. Higher international growth and a reprieve in U.S./ China tensions should reduce perceived safe-haven demand for U.S. dollars, weakening the dollar and supporting international equities and EM currencies.
  • Europe expensive, Asia cheap. We prefer cyclical exposure in Japanese and EM equities over European equities given higher sensitivity to global manufacturing and cheaper valuations.

Market pulse

The potential for a global trade and manufacturing rebound augurs well for both European and Asian assets. Although European manufacturing looks poised for an uptick as new orders improve and the inventory cycle turns, we prefer to take our cyclical exposure in Japanese and EM assets.

Japanese and EM equities both have a higher sensitivity to global manufacturing and cheaper valuations than their European counterparts (See Figure 5). Similar to U.S. equities, European stocks appear to have already priced in a growth rebound while EM and Japanese equities appear comparatively cheaper. In other words, Europe would need to grow into current market pricing while no such growth rebound appears priced into EM and Japanese equities.

Moreover, a stronger U.S. dollar has weighed on international markets recently, yet many of its drivers appear poised to reverse as global growth firms, rate differentials converge, and perceived safe-haven demand for the U.S. dollar declines. This particularly underpins our preference for EM equities.

As of this writing, fallout from the coronavirus in China is unknown and difficult to predict. Recent Chinese manufacturing and trade data came in better than expected and Japanese growth has rebounded after the consumption tax. For clients looking to stay in EM but wary of China-related risks, EM ex-China exposures may provide a useful international building block.

Figure 5: Sensitivity to global manufacturing

Figure 5: Sensitivity to global manufacturing

Sources: BlackRock Investment Institute, with data from Refinitiv, MSCI, the Netherlands Bureau for Economic Policy Analysis, and the National Bureau of Economic Research, January 2020. Notes: Each region’s equity market is represented by the respective MSCI index. Sensitivity to global industrial production is calculated by comparing the changes in 12-month forward earnings estimates and equity market total return to the changes in global industrial production on a rolling three-month basis. We used the world industrial production data from the Netherlands Bureau for Economic Policy Analysis and forward earnings based on I/B/E/S estimates in this study, from the start of 2000 to October 2019 excluding recessions.

A tale of flows

Despite the improving global backdrop, global ETF flows to Japanese and EM equities remain somewhat muted. Flows picked up at year-end, but the pace quickly fell to start this year.

One of the more interesting flow trends has been the disconnect between EM equity returns and flows. Typically, ETF flows track returns, yet EM equity flows remained surprisingly strong as returns suffered. And as performance recovered, global ETF flows to EM equities tapered off. Perhaps more noteworthy have been the inflows to EM equity ETFs used for asset allocation, while financial instrument ETFs–typically a cleaner read on market sentiment–have seen outflows.

Figure 6: EM equity ETF flows

Figure 6: EM equity ETF flows

Source: BlackRock, Refinitiv, as of January 27, 2020. 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.

We would favor high yield bonds based on expectations of supportive monetary policy and stronger growth. We would also consider agency MBS for the potential yield above Treasuries. Meanwhile, we believe that inflation risks may be underpriced and would consider short-duration TIPS.

The virtues of carry and quality

We favor high yield bonds based on expectations of supportive monetary policy and the prospect of stronger growth, along with agency mortgage-backed securities (MBS) exposures that may provide the potential for additional yield above Treasuries. Short-duration TIPS can help serve as a potential inflation hedge while limiting exposure to interest rate risk.

Key points

  • Focus on the coupon. We are overweight high yield bonds based on expectations of supportive monetary policy and the prospect of a growth inflection.
  • High quality and potential additional yield. With policymakers on hold and a stable interest rate environment on the horizon, agency mortgagebacked securities (MBS) exposures provide the potential for additional yield above Treasuries.
  • Inflation risk underappreciated. Although there are no immediate signs of overheating in the U.S. economy, we believe that inflation risks may be underpriced. Short-duration TIPS provide the potential for hedging inflation risk while limiting exposure to interest rate risk.

Market pulse

Periodic market volatility aside, the current environment appears to be one of sustainable economic growth, a patient Federal Reserve and constrained inflation and interest rates. Such an environment bodes well for risk assets such as equities and high yield. While we view high yield as being fully valued, there is still merit in the carry if you believe this environment will persist.

That said, there is also need for portfolio ballast given tight valuations and vulnerability to exogenous risk-off shocks (e.g., pandemic fears). For this reason, we continue to like agency MBS and shorter-duration TIPS as U.S. Treasury surrogates. Agency MBS are less fully valued than corporate bonds and historically outperform Treasuries in a relatively stable rate environment from a carry standpoint.

Figure 7: MBS valuations look attractive relative to other sectors

Figure 7: MBS valuations look attractive relative to other sectors

Source: BlackRock, Bloomberg, as of December 31, 2019.

In addition, almost by definition, there is some risk of increasing inflation. We remain at historically low levels of unemployment, wage growth is picking up, and there has been some strength in commodity prices. These factors all pose a risk for an unexpected increase in inflation, currently underpriced by the market, in our opinion. Given the Fed’s response function, increasing inflation could lead to rising real rates if the Fed were to resume tightening. For this reason, we prefer shorter-duration TIPS, which will hedge investors against higher realized inflation while limiting duration exposure to rising real interest rates.

Figure 8: Markets have recently underappreciated the risk of inflation

Figure 8: Markets have recently underappreciated the risk
of inflation

Source: BlackRock, Bloomberg, as of January 31, 2020.

A tale of flows

Demand for fixed income ETFs continued to grow in the second half of 2019. Total net inflows into U.S.-domiciled fixed income ETFs reached $149.5 billion in 2019, easily surpassing the $142 billion into equity ETFs. As more investors look for quality in fixed income assets, U.S.-listed investment grade exposures experienced more than $35 billion of inflows while high yield bonds saw ETF inflows of $17.5 billion throughout 2019. Inflation-focused ETFs had $1.8 billion of inflows, concentrated at the short-end of the curve.

As the Fed cut rates three times throughout 2019, U.S.-listed Treasury ETFs saw tremendous inflows into the long-end of the curve—$10.3 billion and $37 billion into U.S.-listed intermediate and long-term U.S. Treasury ETFs, respectively—while short-term exposures only experienced $0.23 billion of inflows (Figure 9). However, this trend is likely to reverse as the Fed signaled a hold in policy rates in the upcoming months.

Figure 9: 2019 fixed income ETP flows by sector

Figure 8: Markets have recently underappreciated the risk
of inflation

Source: Markit, as of December 31, 2019. Flows are subject to change.

Our outlooks for value and momentum have improved, while we remain moderately overweight quality. We remain cautious on value for the longer term, but recent trends appear supportive.

Q1 factor outlook

We have upgraded value to a moderate overweight. Value’s relative strength has rallied from the depressed levels seen last year, while valuation measures like forward-looking earnings and cash flow-to-price support our view. But we believe a longer-run catalyst is needed for our model to move to a high-conviction overweight.

Outlook views

  • Moderate overweight on value. As discussed below, value’s valuations have cheapened and relative strength has improved, driving our upgrade from neutral.
  • Maintain moderate overweight on quality. Its relative strength has improved. This more defensive factor continues to be favored in the current slowdown regime and reinforces our positive outlook.
  • Neutral on min vol.Our outlook for minimum volatility has decidedly declined back to neutral. Relative to other factors, valuations overall appear expensive.
  • Moderate underweight on momentum. Our outlook has mildly improved from a firm underweight last quarter. Its relative strength has slightly weakened while valuations remain expensive.
  • Firm underweight on size. We move from a moderate to firm underweight on size, as its relative strength has deteriorated and appears quite weak.

Market pulse

Our factor-tilting model has been underweight to neutral on value for the past 18 months, due to an unattractive outlook across multiple metrics, particularly an unsupportive economic regime of slowing growth. Historically, value stocks tend to underperform in the late stages of an economic cycle because those companies tend to have large amounts of fixed capital that make them more inflexible when adjusting to an economic slowdown. Our negative outlook relative to other factors proved beneficial; our underweight to value was the model’s best-performing position in 2019.

After a recent bounce in performance that began with an impressive September 2019, we have started to see trends building for the factor and have upgraded our view to a moderate overweight. Value’s relative strength has rallied from the depressed levels seen at the start of 2019 and into the summer. Continued cheapness across both cash flow and forward-looking valuation measures also supports our view.

While our outlook has improved, we remain cautious toward value in the continued slowdown regime. We believe a longer-run catalyst is needed for our model to move to a high-conviction overweight. For now, we take a measured tilt toward value in the short run as recent trends and valuations appear supportive.

Figure 10: Turning trends

Valuation & relative strength scores for value

Figure 10: Turning trends

Source: BlackRock, as of December 31, 2019. Value is represented by the MSCI USA Enhanced Value Index. Z-scores measure values’ strength relative to their means. A Z-score greater than 0 indicates “cheap” while a Z-score less than 0 indicates “expensive.” Relative strength is a measure of price momentum.

Notes from the field

The BlackRock Portfolio Solutions team analyzed 16,581 models provided by advisors from throughout the industry over the past 12 months. Three main takeaways:

  • The old debate of “active versus passive” should evolve to a framework of blending index, alpha and factors. We found 35% of advisor models are already combining index, factor and actively managed products.
  • It’s key to use factors effectively.Factors can be tools for building resilience into portfolios, either by attempting to reduce volatility during the market cycle or by adding persistent sources of alpha over the long run.
  • Average fees break the 50 bp barrier. The average fee on advisor portfolios has dropped to 49 basis points (bps, or 0.49% points). At the end of 2016, the figure was 56 bps.

Our View and Outlook

Portfolio trends: Our view and outlook

Christopher Dhanraj
Director
Head of iShares Investment Strategy
Read more