Buying time to build resilience

BlackRock Investment Institute |08.07.2019

The key change in our outlook is that we now see trade and geopolitical frictions as the principal driver of the global economy and markets. This leads us to downgrade our growth outlook further and take a modestly more defensive
investing stance.


In and out of favor
Major changes to BII six-to 12-month asset views, July 2019

In and out of favor


Sources:BlackRock Investment Institute, July 2019. Notes: The table shows major upgrades and downgrades to BlackRock Investment Institute’s six-to 12-month asset views. See page 15 of our midyear investment outlook for full details of our asset views.

A significant shift by central banks toward monetary easing should extend the long expansion and support risk assets, we believe, and buys investors time to build portfolio resilience. The US economy has only recently hit full capacity, as the chart below shows, entering the “late” stage of the cycle that can often run for an extended period.

Stretching the cycle
Output gap and stages of the US business cycle, 1965-2019

Stretching the cycle


Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, as of July 2019.Notes: This chart shows an estimate of the US output gap (that is, GDP as a percentage of potential GDP). We have classified different time periods as belonging to certain stages of the business cycle. The classification of the stage is done via a 'cluster analysis' that groups together time periods where economic series have behaved in similar ways.

We remain positive on US equities against a backdrop of reasonable valuations. Coupon income is key in a low-yield world, and we upgrade emerging market (EM) debt as a result. We believe markets are overly optimistic about China’s efforts to boost growth, however, leading us to downgrade China-linked EM and Japanese equities.

The European Central Bank (ECB) has put stimulus tools back on the table, while the Federal Reserve is poised to cut interest rates as insurance against a downturn. We expect the ECB to deliver on stimulus expectations. We close our underweight in European equities and upgrade the region’s bonds as a result. By contrast, we view the degree of Fed easing that markets are pricing in as excessive, given that we see limited near-term risks of recession. We could see yields snap back. This leads us to downgrade US Treasuries in the short run.

The US and China have entered into a strategic competition that we see as structural and persistent. The fallout is a potential rollback of decades-long globalization trends that gradually lowered inflation and expanded corporate profit margins. Could this eventually result in a supply shock that pushes down trend growth and ends disinflation? This is a scenario that markets are not prepared for –and could lead to negative returns in both equities and bonds. We prefer to dial down overall risk by raising some cash but still see an important role for long-term government bonds as portfolio stabilizers, especially on a medium-term horizon.

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We introduce three new 2019 investment themes as trade disputes and geopolitical tensions come to the fore.

Protectionist push

We are downgrading our global growth outlook as trade disputes and broader geopolitical tensions stoke greater macro uncertainty. The range of potential economic and market outcomes further ahead has widened. We see a lull in China’s growth due to the fallout of US tariffs.

Implication: We favor reducing risk amid rising protectionism, including raising some cash.

Stretching the cycle

The decisively dovish shift by central banks has depressed long-term yields and should help extend the long expansion. This makes for a benign near-term environment for risk assets, in our view, although uncertainty around the outlook has risen.

Implication: We stay positive on US equities and like EM debt’s income potential in a low-yield world.

Raising resilience

We believe portfolio resilience is crucial at a time of elevated macro uncertainty. We define resilience as the ability of a portfolio to withstand a variety of adverse conditions — both on a tactically defensive basis and strategically across cycles.

Implication: Government bonds play an important role in building portfolio resilience — even at low yield levels.

Our June 12-13 Outlook Forum in London brought together roughly 100 BlackRock investment professionals to debate the prospects of the global economy, policy and markets. These debates included the prospects for inflation in a deglobalizing world, the significance of US-China competition, and policy challenges facing central banks.

Lowflation regime
US inflation shocks and the government bond-equity correlation, 1965-2019

Lowflation regime


Sources: BlackRock Investment Institute, US Bureau of Economic Analysis and US Bureau of Labor Statistics, with data from Haver Analytics and Refinitiv Datastream, July 2019. Notes: The top chart shows US inflation misses (actual inflation minus inflation expectations). We use a statistical model to estimate inflation expectations back to 1965, drawing on the relationship between the actual US Consumer Price Index (CPI), GDP and policy interest rates over trailing three-year periods. We use these regressions to estimate the expected annual inflation rate in three months' time. We show the difference between the actual and expected CPI outcome. The bottom chart shows the correlation of the US 10-year Treasury and the S&P 500 Index over rolling three-year periods based on monthly readings. A correlation reading of 1 suggests the two move in lockstep, and a reading of -1 suggests their movements are completely opposite.

Investors have become used a world where inflation is low – and inflation surprises are almost always to the downside. Our gauge of inflation shocks in the top chart above shows how inflation has mostly come in below expectations since the 1980s. This has arisen in an environment largely devoid of macro supply shocks – such as the oil shocks of the 1970s – that push growth lower and inflation higher. And growth disappointments have tended to come with lower inflation – characteristic of demand shocks.

As a result, bonds have tended to cushion portfolios during equity selloffs in this period. The bottom chart shows the negative correlation between stock and bond returns during a period of low inflation. The risk? Trade protectionism and deglobalization could unwind some these benefits over time and serve as a negative supply shock that raises prices, slows productivity growth and lowers economic output — an outcome investors haven’t had to worry about for decades.

Other key debates featured in our midyear outlook publication: the significance of US-China competition, the prospects for China’s economy and what “low-for-longer” bond yields mean for investors.

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Investors are challenged by powerful cross-currents in the near term. On the one hand, macro uncertainty is rising and asset prices have run up a lot this year. On the other hand, monetary policy has pivoted toward easing and valuations of many risk assets still look reasonable. The leads us to a modestly more defensive stance while still favoring risk assets with attractive risk/reward ratios. Here are our detailed asset views:

Asset class views

Tactical views on selected assets, June 2019


Asset Class View Comments
Equities US icon-up A supportive policy mix and the prospect of an extended cycle underpin our positive view. Valuations still appear reasonable against this backdrop. From a factor perspective we like momentum and min-vol, but have turned neutral on quality due to elevated valuations.
Europe icon-neutral We have upgraded European equities to neutral. We find European risk assets modestly overpriced versus the macro backdrop, yet the dovish shift by the European Central Bank (ECB) should provide an offset. Trade disputes, a slowing China and political risks are key challenges.
Japan icon-down We have downgraded Japanese equities to underweight. We believe they are particularly vulnerable to a Chinese slowdown with a Bank of Japan that is still accommodative but policy-constrained. Other challenges include slowing global growth and an upcoming consumption tax increase.
EM icon-neutral We have downgraded EM equities to neutral amid what we see as overly optimistic market expectations for Chinese stimulus. We see the greatest opportunities in Latin America, such as in Mexico and Brazil, where valuations are attractive and the macro backdrop is stable. An accommodative Fed offers support across the board, particularly for EM countries with large external debt loads.
Asia ex Japan icon-down We have downgraded Asia ex-Japan equities to underweight due to the region’s China exposure. A worse-than-expected Chinese slowdown or disruptions in global trade would pose downside risks. We prefer to take risk in the region’s debt instruments instead.
Fixed Income US government bonds icon-down We have downgraded US Treasuries to underweight from neutral. Market expectations of Fed easing seem excessive, leaving us cautious on Treasury valuations, particularly in shorter maturities. Yet we still see long-term government bonds as an effective ballast against risk asset selloffs.
US municipals bonds icon-up Muni valuations are on the high side, but the asset class has lagged the US Treasuries rally. Favorable supply dynamics, seasonal demand and broadly improved fundamentals should drive muni outperformance. The tax overhaul has also made munis’ tax-exempt status more attractive.
US credit icon-neutral We are neutral on US credit after strong performance in the first half of 2019 sent yields to two-year lows. Easier monetary policy that may prolong this cycle, constrained new issuance and conservative corporate behavior support credit markets. High-yield and investment-grade credit remain key part of our income thesis.
European sovereigns icon-up We have upgraded European government bonds to overweight because we expect the ECB to deliver — or even exceed — stimulus expectations. Yields look attractive for hedged US dollar-based investors thanks to the hefty US-euro interest rate differential. A relatively steep yield curve is a plus for eurozone investors.
European credit icon-neutral We have upgraded European credit to neutral. Fresh ECB policy easing should include corporate bond purchases. The ECB’s “lower for even longer” rate shift should help limit market volatility. European banks are much better capitalized after years of balance sheet repair. Even with tighter spreads, credit should offer attractive income to both European investors and global investors on a currency-hedged basis.
EM debt icon-up We have upgraded EM bonds to overweight on their income potential. The Fed’s dovish shift has spurred local rates to rally and helped local currencies recover versus the US dollar. We believe local-currency markets have further to run and prefer them over hard-currency markets. We see opportunities in Latin America and in countries not directly exposed to US-China trade tensions.
Asia fixed income icon-neutral The dovish pivot by the Fed and ECB gives Asian central banks room to ease. Currency stability is another positive. Valuations have become richer after a strong rally, however, and we see geopolitical risks increasing . We have reduced overall risk and moved up in quality across credit as a result.

icon-up Overweight     icon-neutral Neutral     icon-down Underweight

*Note: Views are from a US dollar perspective as of June 2019 and are subject to change at any time due to changes in market or economic conditions. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as research or investment advice regarding any specific fund, strategy or security.

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Philipp Hildebrand
Vice Chairman
Philipp Hildebrand, Vice Chairman of BlackRock, is a member of the firm's Global Executive Committee.
Elga Bartsch
Head of Macro Research, BlackRock Investment Institute
Jean Boivin
Head of BlackRock Investment Institute
Mike Pyle
Chief Investment Strategist, BlackRock Investment Institute.
Scott Thiel
Chief Fixed Income Strategist, BlackRock Investment Institute
Scott Thiel, Managing Director, is BlackRock's Chief Fixed Income Strategist with responsibilities in developing BlackRock's strategic and tactical views.
Elga Bartsch
Head of Macro Research, BlackRock Investment Institute
Elga Bartsch, PhD, Managing Director, heads up economic and markets research at the Blackrock Investment Institute (BII).
Mike Pyle
Chief Investment Strategist, BlackRock Investment Institute
Mike Pyle, CFA, Managing Director, is Global Chief Investment Strategist for BlackRock, leading the Investment Strategy function within the BlackRock Investment
Scott Thiel
Chief Fixed Income Strategist, BlackRock Investment Institute
Scott Thiel, Managing Director, is Chief Fixed Income Strategist for BlackRock and a member of the BlackRock Investment Institute (BII).
Thomas Donilon
Chairman of the BlackRock Investment Institute
Thomas E. Donilon is Chairman of the BlackRock Investment Institute. He served as National Security Advisor to President Barack Obama.
Elga Bartsch
Head of Macro Research, BlackRock Investment Institute
Vivek Paul
Senior Portfolio Strategist, BlackRock Investment Institute
Ben Powell
Chief Investment Strategist for APAC, BlackRock Investment Institute
Mike Pyle
Chief Investment Strategist, BlackRock Investment Institute
Mike Pyle, CFA, Managing Director, is Global Chief Investment Strategist for BlackRock, leading the Investment Strategy function within the BlackRock Investment
Scott Thiel
Chief Fixed Income Strategist, BlackRock Investment Institute
Scott Thiel, Managing Director, is Chief Fixed Income Strategist for BlackRock and a member of the BlackRock Investment Institute (BII).

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