iSHARES AUTUMN 2023 INVESTMENT DIRECTIONS

As the fastest rate rise since the early 1980s approaches its conclusion, signs of distress have become evident in weak and poorly run areas of the global financial sector. While we strongly believe there is enough systemic liquidity and capital in the U.S. and European banking systems, fear can trump facts in markets.

Policymakers will closely monitor incoming data to determine just how much the banking shock will adversely impact financial conditions via tighter lending standards, wider credit spreads and greater caution in hiring, consumption, and capital expenditures. U.S. Federal Reserve Chair Jerome Powell made it clear that he views the resulting tighter credit conditions as equivalent to additional policy tightening. In Australia too, the central bank paused for the first time in 11 meetings this month to assess the state of the economy and the outlook, in an environment of considerable uncertainty.

For investors, we believe it is more important understand the broad implications than to quantify the precise impact of the shock on financial conditions. The International Monetary Fund has trimmed1 its 2023 and 2024 global growth forecast by 0.1 percentage points to 2.8% and 3% respectively as higher interest rates cool activity. It also warned that a severe flare-up of financial system turmoil could slash output to near recessionary levels. Australia will not be immune, the IMF said. While the Australian economy expanded 3.7%2 in 2022, the IMF estimates the pace to show to 1.6% this year and to 1.7% in 2024.

Slower growth and tighter financial conditions could mean a lower terminal rate globally. It could also bring forward the timing of the first rate cut though we still expect rates to be in higher for longer on persistent inflation and don’t think central banks especially the Fed will be in a position to cut rates this year. That belief shapes our outlook for the Q2 2023. 

  1. Our highest conviction allocation remains fixed income. We still see the yields on offer in short-dated Treasuries as compelling. We also see benefit in opportunistically adding to duration for ballast in the potential coming recession. Persistent inflation and falling real rates could benefit Treasury Inflation-Protected Securities (TIPS), and local currency emerging market (EM) debt also looks attractive.
  2. In US equities we end our preference for value and instead shift to exposures with quality characteristics to lead in a slowing economy. We also introduce a framework for identifying growth at a reasonable price, a screen that favors global tech and global energy.
  3. Our tactical overweight to EM equities is fueled by China’s reopening, a weaker dollar, and the potential for looser monetary policy in the region, though in the long run we see demographic challenges to growth and geopolitical tensions as a headwind.
  4. Both volatility and correlations in traditional asset classes have risen. Commodities can be instrumental in choppy markets characterized by high volatility and low visibility. We see tactical opportunities to help hedge portfolios using gold.

Video 01:55

REMAINING NIMBLE WILL BE KEY FOR THIS INVESTMENT REGIME

If 2021 was the year of the inflation shock and 2022 the year of the rate shock, 2023 so far has been the year of the volatility shock. Given mounting recession risks, we think investors may consider shifting their portfolios to a more defensive stance, seeking quality in both their fixed income and equity allocation.

With high quality fixed income like highly rated Investment Grade credit and Treasuries yielding the same today that “junk bonds,” or poorly rated bonds, did just a year ago, we see a generational opportunity to allocate to fixed income.3 While short duration still offers attractive yields, we also believe investors may want to consider taking advantage of any back up in rates to start moving back into intermediate duration fixed income, which can provide ballast in the coming recession.

FRONT-END FOR YIELD

The RBA may yet deliver more rate hikes, but the dovish messaging they delivered at the April meeting reinforces our view on owning the front end of fixed income markets. We still see an opportunity in short and ultra-short duration exposures given the inversion across the front half of the Australian yield curve. And, while front end yields have declined in recent weeks, they are still near multi-decade highs and may remain here as the RBA trades off controlling inflation versus delivering a recession. We believe the recent drop in two-year and other medium-term Australian government bond yields may reverse when it becomes clear central banks will not aggressively ease in 2023. However, we view any meaningful reversal in yields as an opportunity to add to fixed income allocations. 

DURATION FOR BALLAST

We believe investors could use any moves higher in yields to begin stepping into longer duration Australian bond exposures, with yields on the 10-year Australian Commonwealth Government Bond above 3.6% seen as buying opportunities to own duration. The Bloomberg AusBond Composite 0+ Year Index provides investors with exposure to multiple high-quality Australian denominated fixed rate sectors such as Australian Commonwealth government bonds (ACGBs), state government bonds, supra-national and corporate bonds. The current yield to maturity on the AusBond Composite provides a greater yield cushion than in the past: because more of the expected total returns are attributed to coupon income, exposure to the AusBond Composite could generate positive returns even if yields move modestly higher.

CORPORATE BONDS FOR INCOME

A third alternative that looks very attractive right now are investment grade corporate bonds. The Australian credit market, as measured by the AusBond Corporate Bond 0+ Year Index, consists of high quality investment grade issuers and currently has a yield to maturity of around 4% to 4.5%, with just over three years of duration. This provides investors with higher yields and more income, while also providing a modest level of duration to serve as a ballast in the event yields fall or if the RBA decide to cut rates.

Figure 1: Yield to Maturity on the Bloomberg U.S. Aggregate Index near highest since 2008

Line chart displaying yield to maturity. The line shows a spike in 2008, and then gradually decreases.

Source: BlackRock, Bloomberg, chart by iShares Investment Strategy. As of April 12, 2023. 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.

Chart description: Line chart displaying yield to maturity. The line shows a spike in 2008, and then gradually decreases. However, the line slopes positively starting in 2020, reaching a peak in 2022.


REAL RATES FOR STICKY INFLATION

The need for inflation protection is especially salient in a scenario where inflation remains firm, but the Fed backs off from an aggressive rate hiking cycle. This is consistent with the market anticipating real rates continuing to fall in the months ahead, which could benefit inflation linked bonds.4

Current valuations for TIPS also look attractive, especially since we believe that structural forces such as the transition to net zero, a re-wiring of global supply chains, and aging demographics can all contribute to inflation remaining well above the pre-pandemic levels in the medium term.

In the Australian context, ILBs look also attractive and have recently enjoyed their strongest quarter of performance since 1993 and we see continued medium term outperformance as we approach the terminal rate and inflation persists.

EM DEBT FOR EXTRA YIELD

We also favor owning local currency emerging market debt, particularly if the path of the USD stabilizes from the straight line higher we saw in 2022. If there is a growth slowdown in the months to come, as we expect, emerging markets could be in a better position to cut interest rates than their developed markets (DM) counterparts, as inflation has remained more contained in many EM markets.

FLOWS TO FOLLOW - UNWINDING THE UNDERWEIGHT IN FIXED INCOME

Over the last 12 months, financial professionals have been under allocated to their fixed income investments and many pension funds have funded rations in excess of 100%. 5 This means many types of investors may find fixed income investment opportunities attractive. While short-term US Treasury ETFs still dominate the fixed income flow landscape with $20bn of net inflows year-to-date, investors have gradually added more than $7bn into longer-term Treasury ETFs as they unwind an underweight to duration that many investors have held since last year.6

FEATURED FUNDS

iSHARES AUSTRALIA FUNDS

DM EQUITIES

For equity investors, slowing growth and still-high interest rates means difficult decisions within a broadly underweight allocation to stocks. Value-style stocks may not perform as well as we earlier anticipated, as this style of equity can struggle when rates start to fall and growth starts to slow. That said, since we do not anticipate the Fed will cut rates aggressively this year, we also don’t like highly speculative growth stocks or non-earning frontier technology.

We think investors pursuing strong relative performance may want to consider companies with quality earnings. This includes companies with high returns on capital, margin stability and solid balance sheets with reasonable valuations. But also - since we believe rates and the U.S. dollar likely came to a cycle peak in Q4 2022 — we favor quality-tilted growth stocks and companies with sales exposure outside the United States.7 In short, we are looking for Growth At Reasonable Prices (GARP), particularly companies with a global exposure.

Applying a strictly quantitative framework that optimizes for both Growth and Quality (see chart below), we observe a distinct preference for established technology and energy companies, both of which boast low use of leverage, and high free cash flow. Our qualitative overlay further prefers global companies over U.S., and established names selling conventional products over companies developing new products in energy or technology.

We believe the current environment argues for quality and defensiveness in equities. Investors can look to the Quality and Minimum Volatility factors to help provide exposure to these attributes across the broad equity market. Investors who prefer a more granular approach can consider tailoring this view via a barbell of global technology and global energy. Those who believe the U.S. economy is headed for a sharp slowdown and rate cuts may prefer a larger allocation towards global technology. For those who believe the U.S. will experience only a shallow downturn or a period of sluggish growth, a heavier allocation towards global energy could potentially be beneficial.

Figure 2: Growth at Reasonable Prices (GARP) means tech and energy

Scatterplot showing Growth at Reasonable Prices (GARP) scores, with growth scores across the X-axis, and quality scores on the Y-axis.

Source: BlackRock, Bloomberg, as of March 28, 2023. Pink markers represent the iShares Investment Strategy's favored segments (Oil & Gas Exploration, Global Energy Producers, Global Energy, Global Tech, US Tech, US Energy, while green markers represent other indexed segments that scored relatively lower on growth and/or quality metrics. Global Energy producers represented by M1WDSEPI Index; Oil & Gas Exploration represented by M1WDSGPI Index; Global Energy represented by SPG12CEN Index; U.S. Energy represented by RIYECTR Index; Global Tech represented by SPG12CTN Index; U.S. Tech represented by RIYWCTR Index.

 

Note: Growth metrics are based on an equal-weighted ranking of Compounded Annual Growth Rates of operating earnings per share, current price per sales and the PE/G ratio. PE/G ratio is a company's price/earnings ratio divided by its earnings growth rate over the next business cycle, adjusting the traditional P/E ratio to take future growth rate into account. Quality metrics are based on an equal-weighted ranking of trailing free cash flow to price, return on common equity, total assets divided by total equity and earnings variation (the standard deviation of long-term EPS growth estimates).

Chart description: Scatterplot showing Growth at Reasonable Prices (GARP) scores, with growth scores across the X-axis, and quality scores on the Y-axis. The plots show Global Tech and US Tech scoring high on growth scores, while Global Energy Producers, Global Energy, and US Energy ranking high on quality metrics.


EM EQUITIES

Our tactical overweight in Emerging Markets is driven by three near-term catalysts: the economic restart in China, a weaker U.S. dollar, and loosening monetary policies in the region. We do note, however, that challenging demographic dynamics and mounting geopolitical tensions leave us neutral on China over a longer term horizon, causing us to prefer a modular approach to EM investing that allows us to dial up or down tactical China exposures according to current opportunities.

The lifting of Covid restrictions in China last December has led to a meaningful rebound in economic activity. New home completions growth turned positive in January and February rising to 8.0% year over year after contracting -6.6% YoY in December.8 A restart of economic activities doesn’t happen overnight, and domestic consumption — which currently makes up nearly 54% of GDP — may continue to grow.9 More importantly, China’s reopening not only benefits the domestic Chinese economy, but also boosts the broad EM region with a strong pick up in travel and consumption abroad.

Secondly, the dollar’s strength has faded since October last year, falling more than 12% from last year’s two-decade highs.10 Historically, a weak U.S. dollar is associated with strong equity performance for EM assets like equities and local currency debt. While stronger local currencies could benefit investors who are taking risk with foreign currency exposures, a weak dollar can also relieve pressure for emerging markets with high external debt obligations, as most sovereign debts are U.S. dollar denominated. A weaker U.S. dollar also rewards emerging market countries with more purchasing power, making foreign imports and commodities less expensive as a result.

Lastly, inflation in most EM regions remains contained relative to DM, allowing local policy makers to provide accommodative monetary support. For example, China announced a surprise reserve requirement ratio (RRR) cut in March to enhance the ability of banks to lend more money. Estimates show that 500 billion to 600 billion yuan ($72.6 billion to $87.2 billion) of liquidity will be unleashed into the market as a result.11

Figure 3: EM performance & China imports rise after falling the last two years

Line and area chart depicting China imports and MSCI Emerging Market Index performance.

Source: Bloomberg, Refinitiv as of March 24, 2023. EM performance represented by MSCI Emerging Markets Index (MXEF Index).

 

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.

Chart description: Line and area chart depicting China imports and MSCI Emerging Market Index performance. The line chart shows positive relationship between the two lines - imports and EM performance are positively correlated. The line chart shows imports beginning to pick up in 2023.


Global investors have turned more constructive on emerging market exposures this year. Broad EM ETFs have seen over $13 billion of inflows since the beginning of 2023, with an additional $2 billion of inflows into single country focused ETFs, as investors take advantage of tactical opportunities around the globe.12 Investors have also increasingly taken a modular approach when it comes to adding EM allocations, breaking EM into China and EM ex-China. As we expect U.S.-China tensions to remain persistent, likely attaching an increased geopolitical risk premium to Chinese assets, a dedicated EM ex-China approach allows investors to stay nimble in international investing.

FEATURED FUNDS

iSHARES AUSTRALIA FUNDS

Growth and inflation risks have thrown a blanket of uncertainty over markets. From tighter lending standards to five straight months of contractionary manufacturing PMIs, economic upside feels constrained.13

Figure 4: Volatility elevated across bonds and equities

Line chart displaying equity and rate volatility since 2006, showing spikes in 2022, higher than one standard deviation over the previous decade.

Source: BlackRock, Bloomberg. Equity volatility represented by Chicago Board Options Exchange’s CBOE Volatility Index. Rate Volatility represented by Merrill Lynch Option Volatility Estimate Index. As of March 24, 2023. Standard deviation measures how dispersed returns are around the average. A higher standard deviation indicates that returns are spread out over a larger range of values and thus, more volatile.

Chart description: Line chart displaying equity and rate volatility since 2006, showing spikes in 2022, higher than one standard deviation over the previous decade.


Volatility across equities and bonds has been meaningfully higher this year compared to the past decade on average (see chart above). Amidst the instability, portfolio diversification has reemerged as top of mind for many investors. However, positive correlations between equities and bonds have made it harder to find portfolio ballast. The diversified nature of some commodities has therefore been instrumental in choppy markets characterized by high volatility and low visibility.

March saw the stress in the U.S. banking system force policymakers to intervene, echoing the financial stability measures of 2008. Given the historical context, it’s not surprising investors turned to gold as a relative “safe-haven” during the volatility: gold prices have risen over 9% year-to-date.14 Although the Federal Reserve intervened quickly and forcefully, investors became acutely aware of the risks to the U.S. economy that stemmed from tightening monetary policy. There may be more destabilizing surprises out there.

We believe the presence of ‘fear’ in the market — whether that be of contagion or recession — supports gold prices from here. Although gold is a non-yielding asset, a tactical allocation may make sense for some investors looking to help reduce downside risk ahead of possible subsequent events.