Forum debate

The focus of the BlackRock Investment Institute’s virtual Midyear Outlook Forum in early June was decisively on longer-term trends. The Covid-19 shock has pushed the world harder against four key shifts we identified at our November forum: inequality, globalization, macro policy and sustainability. This event brought together some 100 BlackRock investment professionals and kicks off a series of discussions that we leverage to anchor our views. Below we give a flavor of some of the key takeaways.

Geopolitics

The pandemic has added fuel to geopolitical dynamics already underway. The post-coronavirus world is likely to be characterized by four key themes: First, the world is increasingly becoming bifurcated, with the U.S. and China at opposite poles. Intense rivalry looks set to affect nearly every dimension of the U.S.-China relationship — regardless of the U.S. election outcome. Other countries will increasingly be pushed to choose sides. Decoupling is focused on – but not limited to – the technology sector. This means investors need exposure to both markets, especially as the center of gravity of global growth is moving to Asia.

Second, the pandemic is poised to accelerate deglobalization as it magnifies nationalist and protectionist trends. The crisis adds to existing pressures such as global trade tensions and rising populism and protectionism. This is upending the web of global supply chains at the expense of efficiency. It includes onshoring the production of strategic goods.

Third, government intervention in economies is likely to become more entrenched. Unprecedented policy support comes with strings attached – including curbs on share buybacks and dividend payouts – and companies increasingly will need a social license to operate. Lastly, the pandemic exacerbates inequalities within and across countries. It has hit hard emerging economies with more limited institutional capacity.

Domestic polarization is on the rise too, with the U.S. presidential election set to take place against the most tumultuous domestic backdrop since 1968. The two parties are as far apart on policy as they have ever been, making the result consequential for markets.

Emerging markets

Many emerging markets entered the crisis in stronger financial shape than in the past and – unlike in previous crises – let their currencies depreciate as a release valve.

Many have weak public health systems, however, and the pandemic has not yet peaked. Activity remains frozen in many EMs, debt levels are on the rise, and some have limited ability to cushion the virus shock. This poses challenges to long-standing pillars of EM investing: strong growth, strong balance sheets and fiscal conservatism. Yet the size of the economic shock – and the ability to withstand it – varies greatly across EM countries.

We divide EM economies into three columns. First: those with relatively strong balance sheets and the policy space to weather the downturn. Many northern Asian economies, including China and South Korea, fit this bill. Second is a group of troubled economies with high external imbalances and rising indebtedness that face financial distress. The third group includes large EM economies such as Mexico, India and Russia, which face large economic shocks but likely have the tools to weather them. Our Emerging markets marker shows the diversity.

Bottom line: We downgrade broad EM equities and debt to tactical underweights, and see country and security selection as key.

The role of bonds

The traditional approach to building financial resilience in multi-asset portfolios has been to rely on nominal government bonds as a cushion against risk asset selloffs. One consequence of the policy revolution – bond yields tethered by central bank intervention – challenges this and forces investors to seek out alternatives.

We expect negative returns across developed market government bonds on a five-year horizon given low to negative yields today. Also, the inverse correlation between bonds and stocks decreases as yields near perceived lower bounds, compromising bonds’ ballast role. The underperformance of German and Japanese bonds in recent equity selloffs illustrates this. Both these effects cause us to favor reduced allocations to government bonds. If yield curve control were to capyields as well as provide a floor for them, returns may be less punitive, resulting in a higher allocation than with a floor alone.

No one asset can directly replace the ballast role of nominal government bonds, but we believe inflation-linked bonds offer an increasingly attractive alternative. Inflationary pressures could build up once the initial deflationary shock from the sizeable demand shortfall dissipates. Deglobalization, re-regulation and deficits are possible catalysts. And central banks will likely tolerate temporary overshoots above inflation targets.

Bottom line: Investors need to re-evaluate nominal government bond exposures in an environment of increased deglobalization, lower-for-longer yields and unprecedented policy action. We favor alternatives such as inflation-linked securities.

Diversification

Globalization led to growing cross-border flows and integrated consumer markets, with differences between companies, countries and regions dissipating. Now, the world is becoming more fragmented, with the U.S. and China at opposite poles.

We see return dispersion growing across regions as a result. This creates more diversification potential – as in the rapidly decoupling U.S. and Chinese tech industries. Investors will likely need strategic exposure to both markets, as we see two main but separate engines of global growth ahead.

State intervention in economies and policy will vary greatly by country. The pandemic is exacerbating inequalities within and across countries, and magnifying protectionist trends. This puts in question the usefulness of broad asset classes, such as EM, and makes “real resilience” critical, through considered diversification across countries and sectors. Most portfolios have yet to embrace this new normal, as investors are traditionally focused on using broad asset classes to diversify.

Mainstays of portfolio diversification – such as U.S. Treasuries – may be less effective in this role going forward. By contrast, geopolitical bifurcation and higher inflation could raise the diversification potential of assets such as Chinese government bonds and inflation-protected securities over time. We also see a bigger role for private markets, both for diversification and exposure to real-economy trends.

Bottom line: We believe asset class diversification alone is not going to work anymore. Granular analysis at the country and sector level is crucial to understanding exposure to the structural limits that will be tested in the post-Covid-19 world.

Sustainability

The pandemic has supercharged a shift toward sustainability. Assets at environmental, social and governance (ESG)-mandated funds in the U.S. exceeded last year’s record levels at the end of April, even as markets had sold off. These flows are in their early stages, and the sustainability wave will likely unfold over years and decades, in our view. Importantly, we believe a return advantage can be gained during the transition to a more sustainable world. See Sustainability: the tectonic shift transforming investing

We also believe markets still under-appreciate the potential economic damage caused by climate change as well as related opportunities, such as the rise in renewable energy. Extreme weather and other climate events are not yet reflected in valuations, as shown in Getting physical of April 2019. There have been setbacks in sustainability-related trends such as the “circular economy” – the crisis has led some governments to pause efforts to curb plastics use.

We believe these setbacks are temporary. We see the “S” (social) in ESG capturing greater attention as the pandemic spotlights issues such as employee safety and satisfaction and forces companies to reconsider their social purpose. In fact, we see sustainability rising beyond the mere labels of environmental, social and governance. What matters is the resilience of companies to shocks, and we see sustainability becoming a core part of the investment process as a result.

Bottom line: The shift toward sustainability is not just poised to give sustainable assets a potential return advantage for years to come, but we also see it altering all other return drivers and creating entirely new sources of returns.