Skip to content
Our Company and Sites

Autumn breezes: Change in seasons — and markets

The return of fall offers cooler temperatures—but a shifting market environment. Dovish central bank policies may extend the long economic expansion, but against a backdrop of rising geopolitical tensions and trade disputes contributing to slower growth. Investors are responding by seeking to boost portfolio resilience to withstand volatility. Our take on the major investor themes for the weeks ahead.

Paragraph-2,Featured Funds-1
Paragraph-3,Featured Funds-2
Paragraph-4,Bio-3,Featured Funds-3
Paragraph-5,Featured Funds-4
Paragraph-6,Featured Funds-5
Paragraph-7

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

Technology: The cyclical versus the secular

With the economy in the late stages of the business cycle, we continue to favor a moderately pro-risk posture in U.S. equities. Technology remains one of our preferred sectors, but it is important to recognize that some sectors are more tied to the business cycle (like semiconductors), while others may benefit from long-term tailwinds (like software).

Key points

  • We continue to favor a moderately pro-risk posture in U.S. equities, and believe the economy is in the late stages of the business cycle.
  • While one of our preferred sectors is technology, we note that some industries within the sector are more tied to the business cycle than others.
  • Software and semis. Software could benefit from long-term tailwinds that will likely prevail through cycles, while semiconductors are more interwoven with the business cycle.

Market pulse

With the U.S. economy in what appears to be the final stage of the business cycle, the decade’s darlings—technology stocks—are increasingly at the forefront of investor worries. The sector has provided investors 10 years of 17% annualized growth, three percentage points more than the S&P 500, thereby stretching valuations, particularly in the more “growth” orientated industries of the sector.1 For example, the S&P North American Expanded Technology Software Index is now trading at 126% of its five-year average while the S&P 500 is at 102%.2

While we advocate a cautiously pro-risk approach to equities at this stage of the cycle, we note that some industries within the technology sector are more tied to the business cycle than others. For example, the software industry’s high valuations may make it vulnerable to profit-taking, but it benefits from tailwinds (i.e., adoption of the cloud, data analytics, digital media and cyber security) that will likely prevail through market cycles. This may help explain why software companies tend to have a lower “beta” to the market than the broad tech sector and semiconductors, although software companies are also more “asset-light” than their semiconductor counterparts (Figure 1).

Figure 1: Software companies tend to be more asset-light than their semiconductor counterparts, on average

Figure 1: Software companies tend to be more asset-light than
their semiconductor counterparts, on average

Source: Bloomberg, as of June 17, 2019.
Notes: The bars represent the average ratios of companies in the Philadelphia Semiconductor Index (semis) and the S&P North American Expanded Technology Software Index (software). PPE stands for Property, Plant and Equipment.

Conversely, semiconductors, the backbone of information technology, are increasingly interwoven into the business cycle as their usage is deeply engrained in manufacturing systems, etc. The strength of their earnings largely depends on order flow supply chain management, which makes them quite susceptible to U.S.-China economic tensions. If economic growth rebounds from its recent slowdown and trade tensions moderate, semiconductors may enjoy a “relief rally.”

Figure 2: Semiconductor sales have declined—have we reached the bottom?

Figure 2: Semiconductor sales have declined—have we reached the bottom?

Source: Semiconductor Industry Association (SIA) global semiconductor sales data, as of May 31, 2019.

A tale of flows

Overall in the United States, as interest rate moves priced in by the market turned significantly lower over the past six months, rate-sensitive sectors rallied and drew investor interest. In the United States, flows into real estate and utilities exchange traded products (ETPs) surged in the first half of 2019 on lower rate expectations. Telecommunications remains a front-runner in sector flows year-to-date, with more than $3 billion of net inflows gathered. Within the information technology sector, hardware-focused exposures saw the largest amount of inflows, collecting more than $500 million, followed by software and services.

Amid the rising market uncertainty, quality and minimum volatility factors continued to lead flows in factor funds. Min-vol exposures took in nearly $13 billion of inflows year-to-date. Quality saw more than $3 billion, while value experienced slight outflows.

Figure 3: Year-to-date flows most pronounced in safe havens and dividend-proxy U.S. sector ETFs

Figure 3: Year-to-date flows most pronounced in safe havens and dividend-proxy U.S. sector ETFs

Source: BlackRock, Markit, as of July 23, 2019.

The expectation of fresh monetary stimulus from the ECB could provide a lift to European stocks. We prefer quality companies that display higher profitability, stable earnings and lower leverage.

Upgrading Europe

We are upgrading the region from underweight to neutral. The European Central Bank’s fresh monetary stimulus could provide a tailwind for equities. We believe the negative sentiment toward the region may be overdone (while recognizing obvious risks) when comparing Europe’s risk to emerging markets and its valuations to U.S. equities.

Key points

  • The tide could be turning for European risk assets. We have upgraded European stocks to neutral on the expectation of fresh monetary stimulus from the European Central Bank (ECB), which is focused on lifting stubbornly low inflation.
  • Despite a strong recovery this year, investor positioning in European equities is bearish. We believe the negative sentiment may be overdone when comparing risk premia to EM equities and valuations to U.S. equities.
  • Investors should still consider persistent risks in the region. These include exposure to Chinese growth and global trade disputes. A preference for quality is warranted, in our view.

Market pulse

The environment for European equities appears to be changing. Although financial conditions have eased and imply stabilizing growth (see Figure 4), the ECB signaled an interest rate cut and indicated that more action is needed to counter persistently below-target inflation. We believe that the bank is set to announce new stimulus measures that could exceed current market expectations, potentially including further cuts to already negative deposit rates and new rounds of asset purchases. In this context, we have upgraded our underweight to European equities to neutral.

Figure 4: BlackRock financial conditions indicator for eurozone, 2010-2019

Figure 4: BlackRock financial conditions indicator for eurozone,
2010-2019

Sources: BlackRock Investment Institute and Bloomberg, July 2019. Notes: The line shows the rate of gross domestic product growth implied by our financial conditions indicator (FCI) for the eurozone, based on its historical relationship with our Growth GPS. The BlackRock Growth GPS shows where the 12-month forward consensus GDP forecast may stand in three months’ time. The FCI inputs include policy rates, bond yields, corporate bond spreads, equity market valuations and exchange rates. Forward-looking estimates may not come to pass.

Investors appear to be underinvested in European stocks (see “A tale of flows” below). Sentiment may be too bearish: Earnings expectations have priced in risks of slow growth, and European equity risk premia (the expected return advantage of holding equities over government bonds) are similar to those of riskier emerging markets. Meanwhile, European stocks trade at an approximate 20% discount to U.S. equities—near the widest since 2010 (see Figure 5).

Figure 5: Equity valuations: Europe relative to U.S., 2010-2019

Figure 5: Equity valuations: Europe relative to U.S., 2010-2019

Source: Bloomberg, as of July 24, 2019.

To be clear, European stocks are still exposed to any lulls in Chinese growth, global trade disputes and political risks. We are wary of the region’s heavy exposure to financials grappling with negative interest rates. Therefore, we prefer the quality factor and companies that display higher profitability, stable earnings and lower leverage, such as pharmaceuticals, and companies with sustainably high dividend yields.

A tale of flows

Despite a strong recovery of European stock markets in the first half of 2019, persistent outflows point to weak investor conviction in the region. Broad European-focused ETPs continued to see outflows totaling more than $1.1 billion year-to-date. While the price momentum brought positive flows to the United Kingdom in the first four months, sentiment turned again in May, as Brexit uncertainty intensified to cloud the country’s outlook. France was among the few bright spots, with consistent inflows in 2019 totaling more than $470 million.

Among other developed markets, Japan experienced notable outflows in 2019, as investors become increasingly concerned with the negative impact of trade sentiment and upcoming tax increases. Japan-focused exposures registered more than $5.2 billion of outflows year-to-date.

Figure 6: European 2019 ETP flows

Figure 6: European 2019 ETP flows

Source: BlackRock, as of July 23, 2019.

We have downgraded EM equities from overweight to neutral, but within EM we see opportunities in Latin America.

Latin America in focus

We have downgraded emerging markets to neutral, but we see opportunities in Latin America. Valuations are attractive for many of the region’s economies compared to other emerging markets, particularly with respect to earnings expectations. We are not sanguine about the risk of trade tensions but note that easing financial conditions and progress on political reform have already helped drive asset prices this year.

Key points

  • We see opportunities within Latin America. Although we recently downgraded emerging market (EM) equities to neutral, we are keeping an eye on Latin America.
  • Attractive valuations. Many of the region’s economies have lower valuations relative to forward earnings expectations than other EMs.
  • Looser financial conditions and political reform are key. Both have helped drive asset prices this year.
  • Key risks remain. Although U.S.-Mexico trade tensions have eased, the potential for further turmoil remains.

Market pulse

We recently downgraded emerging market (EM) equities to neutral from overweight, but we do see opportunities within Latin America. The region has exhibited characteristics of a different economic cycle than what much of the world experienced over the last several years. Many of Latin America’s largest economies teetered in and out of recession for much of the past decade while their EM counterparts grew at a steady pace. This leaves many markets within the region at the lower end of the valuation spectrum versus other MSCI EM constituents, which when juxtaposed with forward earnings expectations looks attractive (Figure 7).

Figure 7: LatAm countries look fairly valued relative to expected earnings growth

Figure 7: LatAm countries look fairly valued relative to expected
earnings growth

Source: BlackRock, Thomson Reuters, as of July 23, 2019.

Still, economic headwinds remain significant as growth has disappointed throughout the year, prompting the IMF to reduce its July 2019 GDP forecast for the region to 0.6% from 1.4% in April. However, stable employment conditions in Brazil and Mexico (representing 53% of the region’s GDP) and moderate inflation pressure create an environment supportive of consumption and interest rate cuts, which may help boost growth. Indeed, a driver of asset prices this year has been looser financial conditions, as well as improving political risk and fiscal reforms in some countries. For example, in Brazil, the recent passage of pension reform by the country’s lower house is a positive, market-friendly development.

Additionally, although Mexican-U.S. trade tensions look manageable for the foreseeable future, the unexpected departure of Mexico’s finance minister in early July is another source of uncertainty. Elsewhere, we see risks in the spillover effects of a protracted crisis in Venezuela.

A tale of flows

U.S.-listed ETP flows into Brazilian equities stalled in May despite a continued rally in the secondary market. Brazil-focused ETPs shed more than $500 million in June, erasing the $400 million of net inflows the funds gathered in the first four months of 2019. This came after a series of strong net inflows in 2018 totaling more than $1 billion. The U.S. dollar’s rally against EM currencies in May sparked outflows in the rest of Latin America. Mexico exposures lost more than $240 million in May while broad Latin America-focused ETPs experienced $235 million of outflows in May and June before seeing inflows again in July.

Figure 8: Latin American ETF positioning has softened along with the growth outlook

Figure 8: Latin American ETF positioning has softened along with
the growth outlook

Source: BlackRock, Markit, as of July 23, 2019.

Bonds play an important role as potential ballast in a portfolio. Investors may want to consider high-quality fixed income assets like investment grade corporate bonds and agency MBS.

Navigating the fall in rates

The Federal Reserve’s 180-degree pivot from rate hikes to rate cuts has had a significant impact on fixed income markets. Still, we believe this is an important time to strengthen the ballast in one’s portfolio through quality fixed income investments, namely investment grade bonds and agency mortgage-backed securities.

Key points

  • The big pivot. The Fed’s 180-degree pivot from December 2018 to today has meaningfully impacted fixed income markets. This is particularly true at the intermediate to longer end of the yield curve, where rates have fallen by more than 100 basis points (bps, or 1 percentage point) since their near-term peak last November.
  • The return of carry. While year-to-date fixed income returns have been driven by price appreciation through falling rates and tightening spreads, we believe that carry will resume its place as the dominant return contributor going forward.
  • Looking for ballast. We believe this is an important time to maintain ballast in one’s portfolio through quality fixed income investments, specifically high-quality investment grade and agency MBS. Over the long term, a diversified portfolio may help generate higher returns and provides investors with reduced volatility.

Market pulse

What a difference eight months can make. In December 2018, the Federal Reserve raised rates to the highest level since early 2008, with its median forecast calling for two more hikes in 2019. Fast forward to August 2019, and interest rates, particularly at the intermediate to longer end of the yield curve, have dropped meaningfully. Specifically, the yield on both 2- and 10-year U.S. Treasuries declined more than 60 bps year-to-date through August 1st. As a result, year-to-date returns through July 31st on fixed income products have been impressive: Agency MBS +4.6%, Investment Grade corporates +12.2%, High Yield +10.1%, 2-year U.S. Treasury bonds +0.9% and 10-year U.S. Treasury bonds+6.2%.3

Given the market dynamics of falling rates and tightening spreads (driven by a loosening in financial conditions), price appreciation has dominated fixed income total returns. Approximately 75% of year-to-date returns have come from price appreciation with the balance coming from yield, i.e., carry. This attribution differs significantly compared to the previous 18 years when more than 80% of returns came from carry (see Figure 9).

Despite the unexpected drop in yields and resulting positive returns, we believe that it is important to maintain ballast through fixed income exposure in the overall portfolio going forward, particularly through allocations to high-quality investment grade and agency mortgage-backed securities.

Figure 9: Return sources of select fixed income markets

2019 year-to-date

Figure 9: 2019 year-to-date

2001-2018

Figure 9: Return sources of select fixed income markets, 2001-2018

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. Source: BlackRock, Bloomberg, as of July 2019. Notes: Figure shows the ratio of price returns to coupon returns for 2019 year-to-date in the upper chart, and from January 2001 to December 2018 in the lower chart. Bloomberg Barclays indexes used from left to right are: U.S. Treasury Index, Euro Government Bond Index, Global Aggregate Corporate Index, Global High Yield Index, EM USD Aggregate Index. U.S. Treasury and EM USD Aggregate returns shown in USD, Euro Government returns shown in EUR, global index returns shown in USD hedged terms.

A tale of flows

Fixed income ETP inflows remained strong in the first half of 2019, totaling more than $76 billion across investment exposures amid favorable rate moves. On June 3, the global bond ETF market surpassed $1 trillion in assets under management and is on pace to grow at 22% annually. Treasury ETPs have gathered $18 billion in inflows year-to-date, led by more than $6 billion into intermediate-term exposures and $5 billion into longer-term exposures.

Investment grade bonds have outperformed most other fixed income assets this year and continue to draw strong investor interest, attracting nearly $25 billion in flows year-to-date. U.S.-listed fixed income flows this year also speak to investors’ search for income in a low-yield environment, with high yield exposures gaining $10 billion of net inflows.

Figure 10: 2019 fixed income ETP flows by sector

Figure 10: 2019 fixed income ETP flows by sector

Source: BlackRock, as of July 17, 2019.

Both momentum and minimum volatility have been on an upward trend since late April; however, valuations appear stretched for min vol and supportive of momentum. Given that, we maintain a preference for momentum.

Q3 outlook: Min vol goes viral

After a challenging start to the year, both minimum volatility and momentum stocks outperformed the broader market in the second quarter. This reinforces how investors are looking to build resilience in their portfolios, while not missing out on market rallies. Min vol valuations appear stretched at this point, while momentum valuations are supportive.

Outlook views

  • Upgrade to momentum. After down weighting momentum for two consecutive quarters, our outlook for the factor has improved from neutral to moderately overweight this quarter. Strong recent performance has boosted its relative strength and reasonable valuations further support our up weight.
  • Neutral on minimum volatility. We maintain a neutral stance toward minimum volatility. The slowing economic environment favors this more defensive factor; however, cash flow-based valuations appear quite stretched. The factor rallied in the second quarter and its relative strength has improved, reinforcing our neutral outlook.
  • Other factors. We are neutral toward quality, and moderately underweight both size and value.

Market pulse: Min vol rallies

After a challenging start to the year, low-risk stocks (i.e., those showing less volatility than the market at large) outperformed their riskier counterparts in a choppier second quarter, and minimum volatility sharply rallied past the broad market, ending on par year-to-date. Interestingly, momentum followed an eerily similar path, tracking min vol’s underperformance in the first quarter and strong rebound in May. Sure enough, the excess return correlation between momentum and min vol has been steadily rising since fourth quarter 2018 and has hovered around +85% for most of 2019.4

As global central banks now appear committed to additional stimulus, riskier assets have returned to the forefront. Indeed, the semiannual May rebalance of the MSCI USA Momentum Index saw a pivot from more defensive health care and consumer staples exposures toward trending technology shares. Investors are looking to build more resilience in their portfolios but also to participate in market rallies during this late-cycle environment dotted with trade and geopolitical frictions. While a slowing economic regime favors more defensive factors like quality and min vol over the medium term, our forward-looking views also incorporate more near-term influences like the valuations and recent trends of each factor. Both momentum and min vol have been on an upward trend since late April; however, valuations appear stretched for min vol and supportive of momentum, reinforcing our preference for the latter.

Notes from the field

The BlackRock Portfolio Solutions team analyzed 12,697 models provided by advisors from throughout the industry over the past 12 months. Three main takeaways:

  • Many portfolios lack meaningful tilts to rewarded risk factors like value, momentum and quality. Equity sleeves look a lot like the broad market benchmarks and could benefit from more intentional targeting of rewarded exposures associated with higher potential returns.
  • Building an income portfolio: It is important to prioritize among the competing preferences of maintaining stability, generating income and creating overall total return.
  • Durations have ticked down, exposing more credit risk: Therefore, many bond portfolios are less effective hedges against equity risk than they were a year ago, exposing models to greater potential downside if equities fall.

Our View and Outlook

Portfolio trends: Our view and outlook

Christopher Dhanraj
Director
Head of iShares Investment Strategy
Read more