Rethinking risks and returns

BlackRock |10-Jul-2017

The global expansion is chugging along; deflation fears and near-term political risks look to have faded; and financial market volatility is subdued. We believe this provides fertile ground for modest gains in risk assets such as equities.


We think structurally lower bond yields mean there is a need to rethink asset valuations. Take equities. The earnings yield of U.S. equities (earnings per share divided by the share price, or the inverse of the price-to-earnings ratio) gauges the attractiveness of equities versus bond yields. This measure puts U.S. equity valuations in the richest quartile of their history. Yet the earnings yield still looks attractive versus bond yields. Also we see less reason to expect equity valuation metrics to fall back to historical means in a world of lower rates. See the chart below.

Eye of the beholder
U.S. equity valuation, 1988-2017

Eye of the beholder

Sources: BlackRock Investment Institute, with data from MSCI and Thomson Reuters, June 2017.
Notes: U.S. equities are represented by the MSCI U.S. Equity Index. Absolute valuation is based on earnings yield (the inverse of 12-month forward price/earnings ratio. Valuation relative to bonds is based on earnings yield minus U.S. real bond yield (10-year U.S. Treasury yield minus U.S. core CPI inflation). Valuations are shown in percentiles. For example, the current U.S. absolute earnings yield is in the 18th percentile. This means the earnings yield has been equal to or lower than that level 18% of the time since 1988.

Outlook debate

At a mid-June gathering of some 90 BlackRock portfolio managers, we had vigorous debates on the drivers of low volatility, how to think about valuations and the outlook for monetary policy and markets. We dissected key risks such as a snapback in government bond yields, discussed how poor trading liquidity could aggravate any sell-offs in frothy pockets of credit markets, and concluded that worries over a China slowdown are overstated in the near term.


We see the world in a synchronized and sustained economic expansion that is slower than previous cycles. We believe structurally lower growth and interest rates mean that comparing valuation metrics to past levels may not be a good guide to the future. We see low market volatility as a normal feature of the benign economic backdrop — and not as a warning sign in itself. Taken together, this could mean equities are cheaper than they look — and investors may run the risk of being under-risked.

Market views

We prefer equities over fixed income, and credit over government bonds. In equities we generally prefer European, Japanese and emerging market (EM) stocks over their more expensive U.S. counterparts. We see room for the momentum style factor and the technology sector to outperform further, albeit with potential for swift reversals. We also like selected value shares and financials. In fixed income, we like higher-quality credit and generally prefer inflation-linked bonds over nominal ones. We also see opportunities in selected EM debt.

Elga Bartsch
Head of Macro Research
Scott Thiel
Chief Fixed Income Strategist, BlackRock Investment Institute