Building greater resilience into portfolios

Jul 9, 2018

We see strong U.S. growth extending positive spillover effects to the rest of the world, sustaining the global economic expansion. Yet the range of possibilities for the economic outlook has widened. On the downside: trade war and overheating risks. On the upside: U.S. stimulus-fueled surprises. This greater uncertainty − along with rising interest rates − has contributed to tightening financial conditions and argues for building greater resilience into portfolios.

Setting the scene

Market sentiment has shifted markedly. 2017 was a year of upside growth surprises and muted inflation — and unusually low volatility. That set the stage for outsized risk-adjusted returns across markets. Fast forward to 2018: Sentiment on many of these key market drivers has shifted. The Market moods graphic tells the story. The growth picture is still bright overall. Inflation risks look more two-way, and financial conditions are tightening as U.S. rates rise. The big change in 2018: a rise in macro uncertainty. How dark is the mood? Not nearly as bad as 2015, as the graphic seeks to capture.

Main themes in global economy, 2015-2018


1. Wider range of growth outcomes

We see steady global growth ahead — but global growth is becoming uneven and has a broader set of possible outcomes. The U.S. is the growth engine, propelled by fiscal stimulus. We see positive spillover effects, especially to emerging markets (EM). Economic growth boosts corporate earnings. Yet the risks are two-sided: U.S. stimulus could accelerate capex and lift potential growth — or trade wars and/or inflation driven overheating could incite a downshift. The market’s adjustment to these higher levels of uncertainty will be a key theme for the remainder of 2018, we believe, and is already being mirrored in higher risk premia across asset classes.

A key theme for markets going into the second half of the year is more uncertain growth outcomes.

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    Isabelle Mateos y Lago

    A key theme for markets going into the second half of the year is more uncertain growth outcomes. 

    The baseline is still a constructive one, of steady growth across the world, with the U.S. firmly in the lead across developed markets, and China still growing steadily despite signs of recent slowdown.

    But risks have increased and they have increased on both sides. On the upside, we could so the spillovers from the U.S. fiscal stimulus being stronger than expected, and we could also see growth reaccelerating if uncertainty linked to trade tensions were to lift.

    But on the downside, we now also have the possibility of a global trade war which could be very destabilising for the growth outcome.

    We also have the possibility of the U.S. economy overheating which would lead the Fed to step on the breaks and possibly bring this expansion to an end. 

    And we also have the return of the risk of fragmentation in Europe, as a result of the election of an entire establishment and Eurosceptic government in Italy.

    So what to do in portfolios? We think it is still time to remain risk-on, so equities over fixed income, but time also to start building resilience, with a focus on quality assets, stronger balance sheets as well as a bias towards liquidity.

2. Tighter financial conditions

Rising interest rates, less-easy monetary policy and a strengthening U.S. dollar are tightening financial conditions, with ripple effects across markets. Tighter funding conditions have played a role in this year’s EM hardships − including Argentina and Turkey, countries with big external financing needs. Further gains in the U.S. dollar could cause more pain, including for global banks that rely on dollar funding. Higher U.S. short-term rates mean renewed competition for capital and less need to stretch for yield when (dollar-based) investors can get above-inflation returns in short-term “risk-free” debt.

Market returns have been volatile and mostly disappointing so far this year, and we believe a key driver for that has been tighter financial conditions.

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    Isabelle Mateos y Lago

    Market returns have been volatile and mostly disappointing so far this year, and we believe a key driver for that has been tightening financial conditions – a key theme that we expect will persist into the second half of the year.

    This tightening has come in three forms. The first one has been tighter monetary policy in the United States, which is set to continue and will be less and less offset by other central banks, most notably the ECB.

    The second source of tightening has been a stronger US dollar which has hit emerging market assets particularly hard. We do not expect this to go much further, unless a massive risk-off shock hits the global economy, but it could persist and so that is something to watch out for.

    And the third form of the tightening has been a higher risk premium demanded by investors to hold risky assets, notably a derating of equities multiples and wider credit spreads across the board.

    Assuming this credit tightening persists through the rest of the year, what to do in portfolios? We like emerging market hard currency debt, which has reprised significantly and we see good value there now, and we also like issuers of equities or credit with strong balance sheets and strong earnings.

3. Greater portfolio resilience

Bouts of volatility this year underscore the need for portfolio resilience. Think of the VIX tantrum in February, 2018 tied to leveraged short positions in equity volatility, the explosive selloff in Italian government bonds, and the tech sector suffering a brief shake-out of popular long positions. How to make portfolios more resilient? We advocate shortening duration in fixed income, going up-in-quality across equities and credit, and increasing diversification.

One of our key themes for the second half of 2018 is the need for greater resilience in portfolios.

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    Richard Turnill

    One of our key themes for the second half of 2018 is the need for greater resilience in portfolios. 

    We see a wider range of economic outcomes and tightening financial conditions leading to more volatility events going into the second half of this year.

    While our base case continues to be for equities to outperform fixed income, we think investors should look to protect their portfolios from this potential higher volatility.

    In equities this means focussing on the U.S. market, where we see strong earnings growth and higher quality balance sheets. Within emerging markets, this means focussing on Asia, where we see still strong growth coming out of China, and interest rates rising only gradually in the U.S.

    And then in fixed income, this means focusing on upping quality on investment grade credit where see attractive opportunities today, following some spread widening and focusing on the short end of the yield curve where we see asymmetric risk with limited downside risk and attractive real returns for the first time since the global financial crisis.

Outlook debate

The market regime that brought outsized risk-adjusted returns in 2017 is changing. Rising leverage in pockets of the credit markets is a concern, but we see no flashing red lights yet − and view liquidity as a greater risk. Global trade disputes pose risks to market sentiment and growth. A populist Italian government and immigration tensions have raised the risk of European fragmentation, but we expect the eurozone to muddle through this year. We see China’s economy as steady in the near term, even as deleveraging poses slowdown risks.

Market views

We remain pro-risk but have tempered that stance given the uneasy equilibrium we see between rising macro uncertainty and strong earnings. We prefer U.S. equities over other regions. We still see momentum equities outperforming, and prefer quality exposures over value. In fixed income, we favor short-term bonds in the U.S. and take an up-in-quality stance in credit. Rising risk premia have created value in some EM assets. We like selected private credit and real assets for diversification. We see sustainable investing adding long-term resilience to portfolios.

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Richard Turnill
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 ...
Jean Boivin
Head of Economic and Markets Research
Jean Boivin, PhD, Managing Director, is Global Head of Research for the Blackrock Investment Institute and is a member of the EMEA Executive Committee.   His ...
Isabelle Mateos y Lago
Chief Multi-Asset Strategist
Kate Moore
Chief Equity Strategist
Jeffrey Rosenberg
Chief Fixed Income Strategist