A narrow path

We refresh our 2019 investment themes and take a deep dive on China. We see a narrow path ahead for risk assets to move higher. Yet rising risks could knock markets off this track. This calls for carefully balancing risk and reward in portfolios.

How do markets typically perform in “late-cycle” phases of the economy – where we are right now? We looked at performance across asset classes in 28 quarters that fell into “late-cycle” periods since 1988. The result: Global equities produced quarterly returns above the full-cycle historical average, edging out fixed income. Yet there was wide dispersion and pronounced downside around these averages, particularly in EM equities. Within fixed income, U.S. Treasuries modestly outperformed riskier credit sectors. See the Late-cycle returns chart.

Late cycle returns
Selected quarterly asset performance during U.S. late-cycle periods, 1988–2019

Services revival
BlackRock China economy MCD tracker and its key components, 2015–2019

China plays a pivotal role in our views on the global economy, markets and geopolitics. We see China’s growth-friendly policies supporting an economic turnaround from the current quarter onward, giving a boost to global growth. The turnaround is already visible in the services sector, our new tool for tracking turning points in the Chinese economy shows. This “months to cyclical dominance” (MCD) indicator allows us to track how many indicators have crossed the threshold between growth and contraction. China’s key services sector passed this turning point in late 2018. See the chart. Other key sectoral drivers of our MCD, international trade and manufacturing, have yet to show improvement. We see the overall MCD reading (see the chart’s inset) picking up in coming months.

Income is king
Return sources of selected fixed income markets, 2001–2019

Coupon income historically has contributed the lion’s share of total returns across global fixed income markets, as the chart shows. The recent decline in yields may have temporarily elevated the role of capital appreciation in generating returns. Price appreciation made up roughly three-quarters of U.S. Treasury returns this year to date, we estimate. We see income, or carry, taking back the reins in the quarters ahead.

Unsustainable momentum
Key equity metrics today vs. December 2018

Equity markets face crosscurrents entering the second quarter. An ongoing global economic expansion, low inflation and supportive policy are positives. Yet equity fundamentals and valuations face bigger hurdles than at the start of 2019. We see a combination of weaker earnings revisions, higher prices and low volatility, shown in the chart, as unlikely to hold. We remain moderately pro-risk, but favor tempering allocations to equity markets amid rising valuations and falling earnings momentum. Our preferred regions remain the U.S. and emerging markets. We favor quality equities in sectors that can sustain earnings growth even in a slower economy, such as selected health care and tech firms.

Tactical views on selected assets, April 2019

Asset Class		View	Comments
Equities	U.S.		A slowing but still growing economy underlies our positive view. We prefer quality companies with strong balance sheets in a late-cycle environment. Health care and technology are among our favored sectors.
	Europe		Weak economic momentum and political risks are challenges to earnings growth. A value bias makes Europe less attractive without a clear catalyst for value outperformance. We prefer higher-quality, globally oriented firms.
	Japan		Cheap valuations are supportive, along with shareholder-friendly corporate behavior, central bank stock buying and political stability. Earnings uncertainty is a key risk.
	EM		Economic reforms and policy stimulus support EM stocks. Improved consumption and economic activity from Chinese stimulus could help offset any trade-related weakness. We see the greatest opportunities in EM Asia.
	Asia ex Japan		The economic backdrop is encouraging, with near-term resilience in China and solid corporate earnings. We like selected Southeast Asian markets but recognize a worse-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.
Fixed Income	U.S. government bonds		We are cautious on U.S. Treasury valuations after the recent rally, but still see them as portfolio diversifiers given their negative correlation with equities. We expect a gradual steepening of the yield curve, driven by still-solid U.S. growth, a Fed willing to tolerate inflation overshoots — and a potential shift in the Fed’s balance sheet toward shorter-term maturities. This supports two- to five-year maturities and inflation-protected securities.
	U.S. municipals		We see coupon-like returns amid a benign interest rate backdrop and favorable supply-demand dynamics. New issuance is lagging the total amount of debt that is called, refunded or matures. The tax overhaul has made munis’ tax-exempt status more attractive in many U.S. states, driving inflows.
	U.S. credit		A still-growing economy, reduced macro volatility and a decline in issuance support credit markets. Conservative corporate behavior — including lower mergers and acquisitions volume and a focus on balance sheet strength — also help. We favor BBBs and prefer bonds over loans in high yield.
	European sovereigns		Low yields, European political risks, and the potential for a market reassessment of easy ECB policy or pessimistic euro area growth expectations all make us wary on European sovereigns, particularly peripherals. Yet any further deterioration in U.S.-European trade tensions could push yields lower.
	European credit		“Low for longer” ECB policy should reduce market volatility and support credit as a source of income. European bank balance sheets have improved after years of repair, underpinning fundamentals. Yet valuations are rich after a dramatic rally. We prefer high yield credits, supported by muted issuance and strong inflows.
	EM debt		Prospects for a Chinese growth turnaround and a pause in U.S. dollar strength support both local- and hard-currency markets. Valuations are attractive despite the recent rally, with limited issuance adding to positives. Risks include worsening U.S.-China relations and slower global growth.
	Asia fixed income		A focus on quality is prudent in credit. We favor investment grade in India, China and parts of the Middle East, and high yield in Indonesia. We are cautious on Chinese government debt despite its inclusion in global indexes from April. We see rising funding needs outstripping foreign inflows.
Other	Commodities and currencies	*	A reversal of recent oversupply is likely to underpin oil prices. Any relaxation in trade tensions could boost industrial metal prices. We are neutral on the U.S. dollar. It has perceived “safe-haven” appeal but gains could be limited by a high valuation and a narrowing growth gap with the rest of the world.

Overweight     Neutral     Underweight

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