GLOBAL INVESTMENT OUTLOOK Q4 2018

Our latest market views

01-Okt-2018
By BlackRock Investment Institute

We see the steady global expansion rolling on, underpinned by above-trend US growth. Yet the range of potential economic outcomes is widening. Gradual increases in US rates are tightening financial conditions globally, and have contributed to bouts of volatility and sharply depreciating emerging market (EM) currencies. We also take a deep dive into the prospects for EMs after an unexpectedly drawn-out selloff.

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A solid near-term global growth outlook is clouded by persistent and elevated uncertainties. Above-trend US growth is underpinning G7 gross domestic product. US fiscal spending is picking up into year-end, keeping the risk of economic overheating on our radar. Trade tensions show few signs of abating. Tariffs have potential to disrupt corporate supply chains and dent business confidence.

Our base case … we still think global growth will be steady and will push forward through the rest of 2018.

- Terry Simpson, Multi-Asset Investment Strategist, BlackRock Investment Institute
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    Terry Simpson :

    For our first theme for Q4 outlook, we see wider range of growth outcomes. While we still see steady, above-trend global growth happening in 2018, really being led by United States, even in China, we should actually see stable resilient growth. However, we’ve had a rise in macro uncertainty. Now this rise in macro uncertainty is being driven by one, fears of an overheating US economy, given we are late in the economic cycle, but also secondarily, the rise of the trade conflict between the United States and other global peers. However, again our base case is we still think global growth will be steady and will push forward through the rest of 2018.

Gradually increasing US interest rates are tightening financial conditions globally. A stronger dollar – as a result – exacerbated the troubles of the most vulnerable EM economies. Higher US rates also add to EM stress by creating competition for capital. Investors can now receive decent returns in US short-term bonds without having to take major credit and duration risk. As a result, investors have reset their return expectations for riskier assets, especially EM assets and equities broadly.

Tighter financial conditions manifest themselves in three key areas in financial markets: higher interest rates, a higher risk premium, and a stronger dollar.

- Jeff Rosenberg, Chief Fixed Income Strategist, BlackRock Investment Institute
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    Jeff Rosenberg :

    Rising macro uncertainty and less easy monetary policy combined to form tighter financial conditions, the second of our key themes for the quarterly outlook for 2018. Tighter financial conditions manifest itself in three key areas in financial markets. The first is higher interest rates, the second is a higher risk premium, and the third is a stronger dollar. Most notably, the stronger dollar and tighter financial conditions showed up in the form of weakening prices and higher volatility in assets both debt and equity in emerging markets. The implications of tighter financial conditions is a theme for investors, show up mainly in the fixed income portfolio. Here, we see the restoration of value, interest rates above the level of inflation, restoring the risk and reward attraction of the short end of the yield curve. This is one area where we see some of the best risk adjusted returns for investors. Secondly the role of fixed income as ballast against our equity portfolios highlights the need and attraction of moving up in quality in the fixed income portfolio exposures. This helps to secure the role of ballast in fixed income against our more positive views on equity risk and our equity overweights.

The increased volatility in the market as a result of rising macro uncertainty and tighter financial conditions argues for a greater focus on portfolio resilience. US equities top our “like” list. We favour the momentum factor, but see a role for quality exposures as a buffer. In fixed income, we like short-term bonds in the US and take an up-in-quality stance in credit. We also like selected hard-currency EM debt over the local variety. Valuations are more attractive and we see better insulation from further currency depreciations.

We have decided to temper our risk stance … The way we’ve done this is try to focus on different segments of the markets that give us buffers to macro and potentially market shocks.

- Terry Simpson, Multi-Asset Investment Strategist, BlackRock Investment Institute
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    Terry Simpson :

    So how do you combine these first two themes, a wider range of growth outcomes as well as tighter financial conditions? From a portfolio construction exercise, this had led us to our third theme of greater portfolio resilience. When we think about our risk stance right now across portfolios from a BlackRock perspective, while we still think risk assets will benefit portfolios, we have decided to temper our risk stance down just a hair. And the way that we’ve done this is try to focus on different segments of the markets that really give us buffers in our portfolios to macro and potentially market shocks. So we still remain overweight US equities, we like the opportunities there, but we are also still overweight emerging market equities, particularly emerging market Asia. We think the correction in valuations has priced in some of the fears over trade conflicts, and so we’re actually remaining overweight emerging market equities. Also from a factor perspective, while we continue to be overweight momentum, which is a risk on factor, the other thing we try to do is balance out that from a diversification standpoint and still continue to recommend actually quality as a factor to offer another buffer for portfolios. From a fixed income perspective, we want to be up in quality across the credit spectrum, both in corporate, but as well even in emerging market debt. And then lastly, from a thematic perspective, we think investors should think about ESG investing, which has shown benefits for diversification but as well as alpha opportunities.

EM downdraft

This year’s EM troubles stem from a potent cocktail of negatives. And EM currencies have borne the brunt of the recent selloff. The biggest casualties: currencies of EM economies with the largest current account deficits and highest external debt burdens. See our BlackRock emerging markets marker for details. Volatility in EM currencies has spiked to higher levels than during the 2013 “taper tantrum” – when then Fed Chair Ben Bernanke signaled the beginning of the end of new asset purchases. Yet there has been no visible contagion to other global asset classes. See the Crisis as usual chart.

Key insight
"Country-specific EM fragilities came home to roost this year — yet we don’t see these as a threat to global markets."
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Fund flows

We have seen a trickle of outflows from EM funds, but no signs of investor capitulation yet. This is playing out in both EM debt and equities, but with important differences: The current swoon follows a period of heavy inflows into EM debt strategies, as easy monetary policies depressed yields and pushed investors into riskier alternatives. By contract, flows into EM equities since 2016 have been more muted. See the Turning tide? chart.

Key insight
"We see room for renewed flows into EM assets — particularly in equities, where investors are lightly positioned."
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Fixed income

Hard-currency EM debt is gaining some appeal. Yields have risen to the top of their range this decade, erasing the usual gap with local currency yields. See the Hard currency preferred chart. Too soon to jump back in? Our analysis of the history of EM hard-currency debt selloffs since 1994 shows that each time after selloffs of the current magnitude, total returns were positive in the next 12 months. We are not quite there yet in local-currency debt, we found.

Key insight
"We prefer selected hard-currency EMD, and are mostly steering clear of the local-currency variety."
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Equities

It still pays to take risk in equities, we believe. Robust 2018 earnings estimates make the US our favoured region. A duller earnings outlook and looming political risks have us less enthusiastic about Europe, while Japanese equities lack a clear catalyst to propel performance. We haven’t lost confidence in EMs, where economic strength is starting to translate into sustained strong earnings growth for the first time in a decade. The recent selloff has restored a lot of value, and EMs are now trading at a large discount to DM equities. See the On sale chart.

Key insight
"The 2018 selloff has restored value in EM, one of our favoured regions."
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Asset class views

Tactical views on assets, October 2018

 

Asset Class View Comments
Equities US icon-up Strong earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view. We like the momentum factor and see a role for quality exposures amid steady global growth but rising uncertainty around the outlook. Technology tops our list of favoured sectors.
Europe icon-down Relatively muted earnings growth, weak economic momentum and political risks are challenges. A value bias makes Europe less attractive without a clear catalyst for value outperformance. We prefer higher-quality, globally-oriented names.
Japan The market’s value orientation is a challenge without a clear growth catalyst. Yen appreciation is another risk. Positives include shareholder-friendly corporate behaviour, solid company earnings and support from Bank of Japan stock buying.
EM icon-up Attractive valuations, along with a backdrop of economic reforms and robust earnings growth, support the case for EM stocks. We view financial contagion risks as low. Uncertainty around trade is likely to persist, though a lot of it has been priced in. We see the greatest opportunities in EM Asia on the back of strong fundamentals.
Asia ex Japan icon-up The economic and earnings backdrop is encouraging, with near-term resilience in China despite slower credit growth. We like selected Southeast Asian markets but recognise a worse-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.
Fixed Income US government bonds icon-down We see rates rising moderately amid economic expansion and Fed normalisation. Longer maturities are vulnerable to yield curve steepening but should offer portfolio ballast amid any growth scares. We favour shorter-duration and inflation-linked debt as buffers against rising rates and inflation. We prefer 15-year mortgages over their 30-year counterparts and versus short-term corporates.
US municipals Solid retail investor demand and muted supply are supportive, but rising rates could weigh on absolute performance. We prefer a neutral duration stance and up-in-quality bias in the near term. We favour a barbell approach focused on two- and 20-year maturities.
US credit Sustained growth supports credit, but high valuations limit upside. We favour investment grade (IG) credit as ballast to equity risk. We believe higher-quality floating rate debt and shorter maturities look well positioned for rising rates.
European sovereigns icon-down The ECB’s negative interest rate policy has made yields unattractive and vulnerable to the improving growth outlook. We expect core eurozone yields to rise. Valuations in the periphery appear tight. The exception is Italy, where spreads are reflecting simmering political risks. The upcoming end to the ECB’s net asset purchases could dampen appetite for the asset class.
European credit icon-down Increased issuance and political risks have widened spreads and created some value. Negative rates have crimped yields — but rate differentials make currency-hedged positions attractive for US-dollar investors. We are cautious on subordinated financial debt despite cheaper valuations.
EM debt We prefer hard-currency over local-currency debt and developed market corporate bonds. Slowing supply and broadly strong EM fundamentals add to the relative appeal of hard-currency EM debt. Trade conflicts and a tightening of global financial conditions call for a selective approach.
Asia fixed income Stable fundamentals, cheapening valuations and slowing issuance are supportive. China’s representation in the region’s bond universe is rising. Higher-quality growth and a focus on financial sector reform are long-term positives, but a sharp China growth slowdown would be a challenge.
Other Commodities and currencies * A healthy inventory balance underpins oil prices. Trade tensions add downside risk to industrial metal prices. We are neutral on the US dollar. Rising global uncertainty and a widening US yield differential with other economies provide support, but an elevated valuation may constrain further gains.

icon-up Overweight Neutral icon-down Underweight

* Note: Views are from a US dollar perspective as of September 2018. *Given the breadth of this category, we do not offer a consolidated view.

Global Chief Investment Strategist, BlackRock Investment Institute
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active ...
Head of Economic and Markets Research
Chief Multi-Asset Strategist
Chief Equity Strategist
Chief Fixed Income Strategist

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