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April 2018

Q2 2018 Outlook Implementation Guide

Key themes

Room to run: Equities currently look appealing amid a solid economic backdrop and earnings momentum supercharged by U.S. fiscal stimulus. We see this offsetting some valuation challenges: Investors are typically unwilling to bid up multiples when rising interest rates and inflation threaten to erode corporate margins.

Inflation comeback: Inflation is perking up, led by the U.S. Still, it will likely take some time for any economic overheating to challenge the Federal Reserve’s gradual pace of interest rate hikes. This, twinned with ongoing monetary accommodation by the European Central Bank and the Bank of Japan, is why we expect yields to potentially rise only gradually from here – and why we like shorter-maturity U.S. debt.

Reduced reward for risk: Last year was nearly nirvana for diversified portfolios. Returns were strong — and volatility was exceptionally low. Yet a mix of more muted returns and “normal” volatility challenge this dynamic. Another challenge: As rates rise, bonds may be less effective portfolio shock absorbers in risk-off periods, which means diversification may need a rethink.

Market views

We favor U.S. and emerging market (EM) equities but investors should consider bracing for choppier markets and potentially less-heady returns than last year. We prefer technology, financials and the momentum style factor. We are negative on government bonds overall but see short-maturity Treasuries now offering a compelling risk/reward proposition. We are neutral on credit amid tight spreads and increasing sensitivity to rate rises.

We’re not in 2017 anymore
Asset performance: full-year 2017 vs 2018 year to date

Asset performance: full-year 2017 vs 2018 year to date

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.

Sources: BlackRock Investment Institute, with data from Thomson Reuters, March 2018. Notes: 2018 data are through March 31st. The chart shows total returns in local currencies. Exceptions: emerging, global and momentum equities as well as commodities are in U.S. dollars. Volatility is measured by the standard deviation of the annualized daily returns. Indexes or prices used are, from top to bottom: MSCI Emerging Markets, copper spot price, MSCI World Momentum, MSCI World, Topix, S&P 500, Brent crude spot, MSCI Europe, Bank Of America Merrill Lynch Global High Yield, JP Morgan EMBI Global Composite, Bank Of America Merrill Lynch Global Broad Corporate, Datastream 10-Year Benchmark Government Bond (Italy, U.S. Germany) and U.S. Dollar DXY.


Risks

Trade: Rising U.S. protectionism is a key risk to the benign economic backdrop. We do expect bouts of market volatility as countries threaten retaliation, but do not anticipate trade wars for now.

Rising rates: The speedy rise in government bond yields this year has unnerved investors. We would be more concerned about a surge in rates unrelated to the growth outlook, such as one driven by market fears of central banks tightening too quickly. We believe risk assets may do well if yields are rising on the strong growth outlook.

Strategies and related funds

1. Room to run: Synchronized global growth provides a solid foundation for equities. Extraordinarily strong earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view on U.S stocks. We like equities elsewhere, especially emerging markets.

2. Inflation comeback: U.S. inflation is moving back toward the Fed’s target. We could see temporary overshoots, but likely not enough to suggest an overheating economy that would challenge the Fed’s gradual pace of rate increases. Shorter maturities and inflation linked securities may help buffer against rising rates and inflation.

3. Reduced reward for risk. We believe investors could still get compensated for taking risk in 2018, but we are unlikely to enjoy a repeat of the strong returns and low volatility of 2017. Rethinking your portfolio’s diversification may be one solution, by considering sector – we like the financial and technology sectors – as well as factor exposures. We like the momentum factor, as well as the value factor, home to cheap companies relative to fundamentals.

Christopher Dhanraj
Director
Head of ETF Investment Strategy