The BlackRock Investment Institute

Midyear investment outlook

Jul 10, 2017

The global economy has settled into a steady growth rate slightly above the post-crisis trend. In fact, our BlackRock GPS suggests G7 growth over the coming year is set to comfortably exceed current consensus forecasts. Investors may want to embrace the implications of a durable economic expansion and favor risk assets like stocks over bonds.

Three themes to consider

Sustained expansion
We believe the current cycle won’t die of old age any time soon. The economy still has slack for the recovery to
chug on.
Rethinking risk
Low volatility is no cause for alarm in and of itself. Placid markets are the norm when the economic backdrop
is benign.
Rethinking returns
Long-term bond yields are likely to remain low. This suggests stock valuations may not snap back to historical averages.

1. Sustained expansion

The current U.S. economic cycle has been unusually long, sparking fears that it may die of old age. We have a different take. Looking at the quantity of recovery rather than the time it has taken reveals an economy with ample slack to power on. Its remaining lifespan may be clocked in years, not quarters.

Room to run
Comparison of U.S. economic cycles from peaks to troughs, 1953-2017

U.S. economic cycles comparison chart

Sources: BlackRock Investment Institute, with data from U.S. BEA, Congressional Budget Office, National Bureau of Economic Research (NBER), July 2017. Notes: This chart compares real U.S. GDP with other cycles. Each line begins with the previous cycle’s peak, as determined by the NBER. We align the cycles based on their peaks, troughs and the point when potential output is reached. For details, see our interactive graphic at blackrockblog.com/cycles-in-context.

If growth persists for some time and valuations on stocks are more reasonable than historical averages suggest, the biggest danger investors face may be a premature flight to safety. Indeed, we believe the old adage holds: make hay while the sun is shining.

Take action: Stick to your guns in stocks

A sharp earnings recovery is supporting equities globally. We favor markets outside the U.S. and the momentum style factor.

BGF Global Allocation
BGF Global Equity Income
iShares Edge MSCI USA Momentum Factor ETF

2. Rethinking risk

Much noise has been made around recent lows plumbed by volatility measures such as the VIX for the S&P 500 and MOVE for U.S. Treasuries. For some, this calm is causing consternation: Surely markets must obey the principle of mean reversion and volatility should march back to more “normal” levels? However, this popular line of reasoning features a flaw: Markets are typically docile when the economic backdrop is benign.

Low volatility ... with a long tail
Distribution of realized monthly U.S. equity volatility, 1872-2017

monthly U.S. equity volatility chart

Sources: BlackRock Investment Institute, with data from Robert Shiller, June 2017. Notes: Realized volatility is calculated as the annualized standard deviation of monthly changes in U.S. equities over a rolling 12-month period. Bars show the number of months at each level of volatility. Each bar represents a bucket of two percentage points in realized volatility. For example, the bar marked 10–12 shows that volatility was between 10% and 12% for 369 months.

This isn’t to suggest complacency is warranted. Spikes in volatility happen with some frequency and present real risk for flightier investors. However, a sustained shift into a high volatility state may require a real growth scare or systemic financial threat. As neither looks imminent (at least as we parse the signals), dialing down risk in portfolios today may leave investors tilting at windmills.

Take action: Keep calm but hedge on

Pairing stocks and bonds remains a prudent risk management play. More flexible, actively-managed strategies may help investors navigate fixed income markets in flux.

BGF US Dollar Core Bond Fund
BGF Global Multi-Asset Income Fund
BGF Fixed Income Global Opportunities Fund

3. Rethinking returns

Expectations in the U.S. of imminent fiscal stimulus and infrastructure spending sent the 10-year Treasury yield soaring in early 2017 only to fall back over the course of the year. While we still believe bond yields will march higher over time, structural factors such as aging populations and high debt levels should cap any yield rise to levels well below pre-crisis norms. Naturally, it could be a bumpy road along the way.

Low yields matter
Developed market real rates, neutral rates and trend growth, 1992-2017

developed market rates chart

Sources: BlackRock Investment Institute, with data from the Federal Reserve, U.S. BEA, Eurostat, Statistics Canada and Japan Cabinet Office, July 2017. Notes: This chart shows the GDP-weighted averages of 1 estimates of the neutral rate, called r*; 2 estimates of trend GDP growth rates, and; 3 the real short-term rate for the U.S., Japan, eurozone, UK and Canada. Data are through February 2017. For more details, see our Global macro outlook of November 2016 at blackrock.com/corporate/en-us/literature/whitepaper/bii-global-macro-outlook-november-2016.pdf.

This has an important equity market corollary. If, as we believe, bond yields remain low, financial logic suggests valuations on stocks could remain elevated for some time: A lower discount rate applied to future earnings will simply elevate their present value. And earnings momentum is strong across the world. This means stocks can sustain seemingly lofty multiples for longer than expected as long as bond yields are held down.