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Pressure drop

Our reference to the classic Toots and the Maytals song comes as we see a de-escalation in trade tensions with China, diminishing risks of a no-deal Brexit and few signs that the record U.S. economic expansion is ending or reversing. Still, persistent trade uncertainty is denting business confidence and spending, particularly the longer-term risk of an unravelling of the global supply chain. Our take on the major investor themes for the weeks ahead.

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Investors have favored defensive sectors this year. While we do prefer less-cyclical exposures, we’re cautious on chasing rate-sensitive sectors from here given stretched positioning and instead prefer tech and healthcare amid a moderately pro-risk position within U.S. equities.

Sector steering

Defensive sectors have outperformed cyclicals this year against a backdrop of slowing growth and falling interest rates. However, we expect central bank easing could provide a floor for growth in the coming months. Among cyclicals, we remain constructive on technology, while we prefer less rate-sensitive sectors such as healthcare among defensives.

Key points

  • Defensive sectors’ moment. Defensive equity sectors have outperformed their cyclical counterparts this year as global growth continues to decelerate, central banks ease policy and interest rates fall in lockstep.
  • A consensus trade? However, equity market pricing, sentiment and positioning suggest these trends are largely baked in, while the prospect of a subsequent rebound in growth due to easier financial conditions remains modestly underpriced, in our view.
  • Easing provides a floor. We expect easier financial conditions to provide a floor under global growth in the coming months. Among cyclicals, we remain constructive on technology. Among defensives, we prefer less rate-sensitive sectors such as healthcare.

Market pulse

Interest rates are driving equities and sector leadership within those markets. As central banks eased policy in response to weaker global growth, U.S. equity market leadership has taken on a decidedly defensive and rate-sensitive tone this year. Lingering U.S.-China trade policy uncertainty has only amplified this trend. Not surprisingly, amid the slowdown, defensives have outperformed cyclicals, and global ETP flows across U.S. equity sectors suggest investors are highly positioned toward weaker growth and lower rates.

Yet we see 2019’s easier financial conditions laying the groundwork for a modest, subsequent growth rebound in the first quarter of 2020. We remain cautious on cyclicals overall given late-cycle concerns and geopolitical risks; however, we continue to favor tech amid unmatched and stable earnings growth. We’re also cautious on chasing rate-sensitive equity sectors, such as utilities, consumer staples and real estate, at current levels given heavy positioning and very dovish Federal Reserve pricing. Instead, we prefer less rate-sensitive defensive expressions, such as healthcare, a potential guard against a possible further slowdown with less sensitivity to rate movements.

A common theme across tech and healthcare is stronger organic earnings growth with less macro sensitivity—both to economic growth and rates. We expect tech to continue outperforming cyclicals, while we expect healthcare to recover from the weakness year-to-date (YTD) and outperform other defensive sectors as this year’s rapid decline in rates abates.

Figure 1: Tech climb continues, healthcare has cheapened versus other defensive exposures

Figure 1: Tech climb continues, healthcare has cheapened versus other defensive exposures

Source: Refinitiv Datastream, as of October 24, 2019. Note: Rate-sensitive, tech and healthcare total returns are shown relative to the S&P 500, based on the S&P 500 Consumer Staples Index, the S&P 500 Utilities Index, the S&P 500 Real Estate Index, the S&P 500 Technology Index and the S&P 500 Healthcare Index. Rate-sensitive is an equal-weighted average of the utilities, real estate, and consumer staples indexes. 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.

A tale of flows

Global ETP flows have exhibited a clear risk-off tone this year, with bonds outpacing equities and defensive leadership within both equities (i.e., defensives over cyclicals) and fixed income (i.e., rates over credit) as well. In the United States, flows are clearly skewed toward defensive exposures that benefit from lower interest rates.

Utilities, consumer staples and real estate are the only sectors to see positive ETP flows over the past year, each typically a strong beneficiary of lower rates. In contrast, global ETP flows to cyclical sectors are negative across the board, while financial sector ETP flows, the prime beneficiary of higher rates, are deeply negative.

Equity investors are expressing views on rates, and the trend in global ETP flows shows investors have been adding to these rate-sensitive expressions throughout the year. While we do prefer less cyclical exposures, we’re cautious on chasing rate-sensitive sectors from here given stretched positioning.

Figure 2: A preference for defensives

Figure 2: A preference for defensives

Source: BlackRock, Markit, as of October 24, 2019. Note: Chart measures all globally listed ETP flows to U.S. sector-focused ETPs over the past 12 months as a percent of AUM.

Trade uncertainties and slowing growth have taken a toll on developed world ex-U.S. stocks. But not all DMs are created equal; those with less exposure to trade with China have enjoyed stronger flows and returns than those with relatively high exposure. We are neutral on Europe and underweight Japan.

Winter of our discontent?

Trade uncertainties and slowing growth have taken a toll on developed world stocks outside the United States. But not all DMs are created equal, and there are signs that the global growth slowdown has hit bottom, while central bank easing could help. We are neutral on Europe and underweight Japan.

Key points

  • Under pressure. Developed world (DM) ex-U.S. stocks have come under pressure in 2019 amid rising protectionism and slowing growth. However, not all DMs are created equal.
  • We upgraded European equities to neutral this year. The accommodative shift by the European Central Bank (ECB) should support the region amid its challenging macro backdrop. Trade disputes and a slowdown in China pose downside risks.
  • However, we downgraded Japanese equities to underweight. We believe they are particularly vulnerable to a Chinese slowdown with a Bank of Japan that is still accommodative but policy constrained. Other challenges include a consumption tax increase.

Market pulse

DM economies have exhibited synchronized deceleration throughout 2019. Figure 3 identifies how the Markit DM composite PMI is teetering on the brink of contraction. In several pockets of the DM universe, economies are exhibiting outright recessionary characteristics, too. For example, Germany’s September manufacturing PMI fell to the worst reading in more than a decade and the eurozone manufacturing PMI is at a seven-year low. Alongside this weakness, the BlackRock G7 growth GPS—a proprietary measure of where the GDP-weighted G7 12-month consensus GDP forecast may stand in three months’ time—has moved lower.

Figure 3: BlackRock G7 growth expectations have fallen YTD

Figure 3: BlackRock G7 growth expectations have fallen YTD

Source: BlackRock, Thomson Reuters, as of October 31, 2019.

The key question: Has the global economy struck bottom? Financial conditions would suggest so. The historical relationship between financial conditions and our GPS points to potential for a growth pickup in the coming six months. An effort by global central banks to stretch the cycle is a key tailwind. For example, the European Central Bank announced its highly anticipated economic stimulus package, which included a rate cut, the resumption of quantitative easing (QE), and a two-tier excess liquidity system for banks.

However, protectionism continues to haunt markets. While a perceived easing in U.S.-China trade tensions has boosted sensitive equities, including beaten-down Japanese stocks, we do not see this rotation having staying power. We maintain our underweight on Japanese equities: They are particularly vulnerable to a growth slowdown in China, and we see no sustained letup in the protectionist push. Yet the recent rally offers a preview of the potential upside in Japanese equities if trade tensions were to fade substantively and growth to reaccelerate.

A tale of flows

Flows of ETPs have generally reflected slowing growth and heightened global trade tensions. Cumulative ETP flows into DM equity focused products remained in negative territory throughout most of the year. As of the end of October, ETP flows into DM (ex-U.S.) equity focused products are on pace for the worst year since 2016.1

Figure 4: Rebound in DM?

Figure 4: Rebound in DM?

Source: BlackRock, as of October 24, 2019. Shows U.S.-listed flows into DM ex-U.S. ETFs.

Within individual country focused ETFs, there is notable dispersion. Japanese, Hong Kong, and German products saw the most outflows through the year, while Canada-, France- and U.K.-focused products gathered the most inflows.

Figure 5: DM country ETF flows impacted by economic exposure to China and performance in 2019

Figure 5: DM country ETF flows impacted by economic exposure to China and performance in 2019

Source: BlackRock, Thomson Reuters, as of October 24, 2019. Note: Country return information is based on the respective MSCI index for each country. Flows are for U.S.-listed ETFs.

Through there are many differences among these individual countries, two points are particularly noteworthy with respect to their overall YTD popularity. First, the specter of trade wars and a reduction in economic activity in China weighed on economies with a high exposure to the region. The bottom three flow-gathering countries had an average trade with China as a percent of total trade of 28%; the top-three average was 9%. Second, the year-to-date performance differential of the top three flow-gatherers outpaced the bottom three by nearly 6%, on average.

Although a trade truce is welcome, China’s growth slowdown is a risk. We are neutral EM equities overall, and prefer EM debt.

China’s mixed outlook

A temporary trade truce with the United States provided some optimism around China over the last month. However, China’s growth slowdown has become more pronounced. Investors may want to consider EM ex-China exposures to hedge out the risks associated with a Chinese slowdown and any potential negative trade news.

Key points

  • Trade tensions pause. A temporary trade truce with the United States has helped mitigate near-term economic uncertainty in China.
  • Growth grinding down. China’s growth slowdown has become more pronounced. Policymakers are likely to provide stability with cautious and measured monetary easing.
  • Managing the exposure. Investors could consider EM ex-China exposures to hedge out downside risks associated with a Chinese slowdown and negative trade headlines.

Market pulse

A temporary trade truce with the United States has helped mitigate some of the near-term uncertainty on the economy.

The phase one trade deal, if finalized, could eliminate a tariff hike from 25% to 30% on $250 billion of goods planned for mid-October in exchange for China’s purchases of U.S. agricultural products and additional commitments on currency policy, intellectual property protection and financial market reforms.

Although the lack of discussion on Huawei left investors questioning the extent of progress on trade, the world’s second largest economy has more to worry about than the trade war. China’s economic growth has been grinding down to the slowest pace in nearly three decades, with third-quarter GDP at 6% year-over- year. Companies face lower earnings growth prospects as negative PPI continued to exert pressure on industrial profits (Figure 6).

Figure 6: China’s consumer prices and producer prices show divergence

Figure 6: China’s consumer prices and producer prices
show divergence

Source: Revinitiv DataStream, October 23, 2019.

However, Chinese policymakers are becoming more cautious on fiscal and monetary stimulus compared to earlier this year. Chinese officials now cite the broad-based cooldown as a “natural stage of development” and focus on cushioning the negative impact with measured easing instead of aggressive stimulus. In addition, elevated inflation, driven primarily by a sharp surge in pork prices this year, is likely to cap the extent of monetary policy in the next few months.

A tale of flows

Despite consistent inflows earlier this year, investors have pulled more than $3.5 billion from China-focused U.S.-listed ETPs in the past few months due to the uncertainty after the deterioration of the U.S.-China trade relationship.

Dedicated China ETP flows still dominate the emerging markets (EM) single-country universe, as China alone has seen more inflows or outflows in absolute numbers than all other EM single countries combined each month. The increasing weight of China in the MSCI EM Index also speaks to the importance of taking a separate view on China. Broad EM ex-China exposures offer investors a unique way to decouple China from the other EM regions while still providing access to the unique growth potential of EM economies.

Figure 7: China-focused ETP flows vs. aggregated EM single-country ex-China ETP flows

Figure 7: China-focused ETP flows vs. aggregated EM singlecountry
ex-China ETP flows

Source: Markit, as of October 20, 2019, based on U.S.-listed ETP flows.

We remain underweight U.S. Treasuries, but recognize the important role they play as potential ballast in a portfolio. We are neutral on U.S. credit after this year’s strong performance, but high yield and investment grade remain key parts of our income thesis. We are overweight emerging market debt.

Seeking defense in credit

U.S. government bond yields have responded to geopolitical risks over the past few months both ways, which underscores bonds’ important role as a diversifier. Meanwhile, investment grade credit continues to lead sectoral performance, supported by easing financial conditions, a still-growing domestic backdrop and investors seeking high-quality yield. An up-in-quality approach may allay fears over potential downgrades.

Key points

  • Lower rates, tighter spreads, persistent income needs. U.S. government bond yields have moved both ways in response to geopolitical risks over the past few months. Investment grade credit continues to lead sectoral performance, supported by easing financial conditions, a still-growing domestic backdrop and investors seeking high-quality yield.
  • BBBurgeoning. Record BBB-rated issuance has changed the composition of investment grade markets and has given some investors pause with respect to potential downgrades. Though we don’t share this concern to the same degree, we suggest an up-in-quality approach may allay fears.
  • How to play a reversal? Longer-dated government bonds have played their part in offsetting equity risk. Investors fearing a reversal in rates may consider shortening duration.

Market pulse

Bond markets have continued their impressive year-to-date performance over the past quarter. Demand for so-called “safe havens” compressed U.S. 10-year Treasury yields to near-record lows, hitting 1.45% in early September as trade tensions escalated.2 They have since risen on hopes of a partial U.S.-China trade deal. Investment grade corporates have outperformed, posting returns in excess of 16%, with EM debt (+12.6%) and high yield (+11.3%) the other top performers.3

The amount of U.S.-related BBB corporate debt has grown 2.2 times to $2.5 trillion over the past decade, representing $1.2 trillion of net new issuance and $745 billion of downgrades from a higher credit quality.4 Credit spreads, or the additional yield investors receive above Treasuries, have not widened, even as more debt has been issued (widening spreads point to increased risk expectations). We think the action is underpinned by a global thirst for yield. We consider downgrade fears to be somewhat overdone but note that concerned investors can target higher-quality credit through products focused exclusively on AAA- to A-rated bonds.

After three rate cuts, the U.S. Federal Reserve signaled a pause in further cuts. Moving out to 2020, it is important to note the important role long-term government bonds still play in diversifying equity risk. How would we react to a reversal of rates in the event of unexpected geopolitical upside? Shift to shorter to intermediate duration.

Figure 8: BBB share of global investment grade corporate market

Figure 8: BBB share of global investment grade corporate market

Source: Barclays Indices, based on the Bloomberg Barclays Global Aggregate Corporate Bond Index, as of September 17, 2019.

A tale of flows

Fixed income ETP inflows have remained strong this year, with more than $110 billion of inflows, driven mostly by flows into Treasuries, compared to $74 billion into equities. Interestingly, flows into short- and intermediate-term Treasury ETPs have outpaced those into long durations.

Reflecting the ongoing desire among investors for yield, investment grade inflows have picked up, collecting $25 billion. High yield ETPs have also seen considerable interest this year, attracting $12.2 billion of inflows, but this stalled recently. We have also seen solid inflows into mortgage-backed securities ETFs, with $6.2 billion YTD.

Figure 9: 2019 fixed income ETP flows by sector

Figure 9: 2019 fixed income ETP flows by sector

Source: BlackRock, as of October 24, 2019.

Our outlooks for minimum volatility and quality have improved with a firm overweight for the former and a moderate overweight for the latter. We are underweight size and have also upgraded value to neutral.

Q4 factor outlook

We remain in an unfavorable environment for value, given slower growth and the return of “lower-for-longer” interest rates. Still, our outlook for value has improved and now stands at a neutral position as relative valuations appear quite cheap. Our outlooks for minimum volatility and quality have similarly improved.

Outlook views

  • Firm overweight on min vol. Our outlook for minimum volatility has decidedly improved from neutral, based on improvement in its relative strength, which appears quite attractive compared to other factors.
  • Moderate overweight on quality. Our outlook has improved from a neutral position this quarter. Forward-looking valuations have cheapened and quality tends to perform best in periods of moderating growth, and the slowdown regime continues to favor this factor.
  • Firm underweight on momentum. Our outlook has markedly deteriorated from a moderate overweight last quarter to a firm underweight position. While valuations have marginally improved, they remain relatively expensive.
  • Other factors. We are underweight size and, as discussed below, we have upgraded value to neutral.

Value, the comeback king?

The value factor has been in a protracted drawdown since the end of 2017, a victim of the outperformance of expensive stocks as those companies smashed earnings estimates, as well as the low interest rate, late-cycle regime in which value does poorly.

We saw a dramatic reversal in value in September on the back of sharply rallying interest rates. We see September’s rotation away from high-glamour momentum stocks and into value as a classic unwinding of a crowded trade, where investors have been long momentum and short value for months. In terms of the economic environment and structural landscape, nothing has changed, in our view.

Figure 10: Keeping track

Excess returns for value and 2-year U.S. Treasury yields

Figure 10: Keeping track

Source: BlackRock, as of September 20, 2019. Value is represented by the MSCI USA Enhanced Value Index. Value returns are in excess of the MSCI USA Index.

We remain in an unfavorable environment for value, one of slowing growth and “lower-for-longer” interest rates. Still, our outlook for value has improved and now stands at a neutral position as relative valuations appear quite cheap. We have also down-weighted momentum on sharply deteriorating relative strength, continued richness and staleness.

Notes from the field

The BlackRock Portfolio Solutions team analyzed 13,784 models provided by advisors from throughout the industry over the past 12 months. Three main takeaways:

  • Most advisors indicate they want their alternative investments to diversify. In practice, we find advisors’ alternative products have meaningful amounts of plain-vanilla equity beta, which may limit diversification of the core exposures in a portfolio.
  • The emerging market challenge. Emerging market stocks have been a challenging holding over the past few years, but there is still a case to be made for the asset class and fine-tuning your emerging markets stock exposure.
  • The tide is flowing back to the United States. Earlier in the year, we pointed out a trend of advisors slowly decreasing their U.S. equity allocations. We now see the trend reversing as advisor portfolios contain the highest U.S. weightings since September 2017.

Our View and Outlook

Portfolio trends: Our view and outlook

Christopher Dhanraj
Director
Head of iShares Investment Strategy
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