Downgrading Europe and Japan

Jul 9, 2018

Key points

  • We like equities but favor cutting risk exposure as uncertainty rises. We have downgraded our lowest-conviction equity views: Europe and Japan.
  • Global equity funds posted a third straight week of net outflows. Global equities stabilized. Defensive sectors outperformed. Asian stocks fell.
  • U.S. core CPI data this this week are expected to show inflation edging up, supporting the Fed’s path of gradual normalization.

Financial markets are in an uneasy equilibrium. Strong U.S. growth is leading the global expansion and powering corporate earnings, but uncertainty around the outlook is rising and financial conditions are tightening. We favor equities over fixed income, but prefer to reduce some portfolio risk. We focus on our highest-conviction equity markets – and have downgraded Europe and Japan.

European equity fund flows and European fragmentation risk BGRI, 2017-2018

Rising macro uncertainty– primarily tied to global trade disputes and their potential impact on growth – and tighter financial conditions magnify the importance of portfolio resilience. This is a major theme in our 2018 Mid-year global investment outlook. We see European equities as vulnerable to risks – both global and local. Sentiment already has turned. Investors have yanked money out of European equity funds for 17 straight weeks. See the chart above. Our BlackRock Geopolitical Risk Indicator suggests markets may still not be paying enough attention to the risk of European fragmentation.

Getting selective

Sustained U.S.-led global economic growth is our base case – supported by our BlackRock GPS. Yet the range of possibilities for the economic outlook has widened: On the upside, U.S. fiscal stimulus could lift capital expenditures and potential growth. On the downside, trade wars and overheating risks. We do not see trade disputes derailing the global expansion for now, but tensions are likely to get worse before they get better. This could hit investor sentiment and business confidence, prompting companies to defer or cancel investments. There are also home-grown risks in Europe. An anti-establishment, euro-skeptic Italian government and renewed tensions over immigration have raised long-run risks for the European Union (EU)’s future. A non-committal outcome at the most recent summit of EU leaders gives us little confidence that a crisis would be handled well. In Japan, ongoing improvements in corporate governance and profitability are encouraging, but we see no near-term catalyst to propel relative equity outperformance.

Our call for portfolio resilience leads us to prefer U.S. equities – with unmatched earnings growth – over other regions. We still like EM equities, especially EM Asia – but are becoming more selective amid rising trade risks, tightening financial conditions and a stronger dollar. We see valuations in EM stocks as compelling after the recent selloff. EM earnings growth is still supported by global expansion, sustained growth in China and a well-telegraphed path of Federal Reserve tightening.

Globally, we look to quality companies – those able to generate and grow free cash flow – as a way to build the right defense in equities. We now prefer quality to value, and also like the momentum factor. In a portfolio context, we favor reallocating some funds to U.S. equities, and (for U.S. dollar investors) shifting some equity risk to short-duration U.S. Treasuries and investment grade credit. These exposures may also look attractive to global investors (such as euro-based ones) with a favorable view on the U.S. dollar.


July 10 Germany ZEW Indicator of Economic Sentiment; China Consumer Price Index (CPI) and Producer Price Index (PPI)
July 11 U.S. PPI; Bank of Canada interest rate decision; North Atlantic Treaty Organization (NATO) summit starts
July 12 U.S. CPI; NATO summit ends; eurozone industrial production (IP)
July 13 U.S. University of Michigan Surveys of Consumers

Consensus estimates for the U.S. core CPI reading this week point to inflation edging up to a year-on-year pace of 2.3% in June. We see this trend lending support to the Fed staying on its path of gradual policy normalization, despite rising trade risks. Our proprietary BlackRock Inflation GPS sees U.S. core inflation creeping up to 2.4% in six months’ time. The University of Michigan survey this week may serve as a gauge on whether trade disputes have started to affect consumer confidence.

  • Global equity mutual funds and exchange-traded funds posted net outflows for a third straight week. Global equities tread water. Asian stocks weakened. European stocks rose on hopes for progress in auto tariff talks. Defensive sectors, such as telecom and utilities, outperformed. Copper and zinc both slid to their lowest levels since mid-2017.
  • The Chinese yuan’s official onshore exchange rate stayed near an 11-month low against the U.S. dollar hit earlier this week. The People’s Bank of China governor indicated that China wouldn’t use the currency as a weapon in a trade war, keeping at bay fears of a steep yuan depreciation. The dollar index softened slightly.
  • U.S. nonfarm payrolls grew more than expected in June on the back of strong hiring activity in the manufacturing sector. Moderate wage growth is likely to keep the Fed on a path of gradual interest rate increases.

Global snapshot

Weekly and 12-month performance of selected assets


EquitiesWeekYTD12 MonthsDiv. Yield
U.S. Large Caps 1.6% 3.2% 14.5% 2.0%
U.S. Small Caps 3.1% 11.0% 22.5% 1.2%
Non-U.S. World 0.3% -3.5% 7.6% 3.2%
Non-U.S. Developed 0.6% -2.2% 7.5% 3.4%
Japan -1.6% -3.6% 9.2% 2.3%
Emerging -0.7% -7.3% 7.7% 2.9%
Asia ex-Japan -1.5% -6.2% 8.6% 2.7%
BondsWeekYTD12 MonthsYield
U.S. Treasuries 0.2% -0.9% -0.1% 2.8%
U.S. TIPS 0.4% 0.4% 2.8% 3.0%
U.S. Investment Grade 0.5% -2.8% -0.1% 4.0%
U.S. High Yield 0.0% 0.2% 2.7% 6.5%
U.S. Municipals 0.1% -0.1% 1.8% 2.7%
Non-U.S. Developed 0.7% -0.7% 4.2% 0.9%
Emerging Market $ Bonds 1.4% -3.9% 0.5% 6.3%
CommoditiesWeekYTD12 MonthsLevel
Brent Crude Oil -2.9% 15.3% 60.3% $77.11
Gold 0.2% -3.6% 2.5% $1,255
Copper -5.2% -13.3% 7.4% $6,282
CurrenciesWeekYTD12 MonthsLevel
Euro/USD 0.5% -2.2% 2.8% 1.17
USD/Yen -0.3% -2.0% -2.4% 110.47
Pound/USD 0.6% -1.7% 2.4% 1.33

Source: Bloomberg. As of July 6, 2018
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon


Asset Class View Comments
Equities U.S. icon-up Unmatched earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view. We like momentum. We prefer quality over value amid steady global growth but rising uncertainty around the outlook. Financials and technology are our favored sectors.
Europe icon-down Relatively muted earnings growth, weak economic momentum and heightened political risks are challenges. A market dominated by value sectors also makes the region less attractive in the absence of a growth upswing.
Japan The market’s value orientation is a challenge without a clear growth catalyst. Yen appreciation is another risk. Positives include shareholder-friendly corporate behavior, solid company earnings and support from Bank of Japan stock buying.
EM icon-up Economic reforms, improving corporate fundamentals and reasonable valuations support EM stocks. Above-trend expansion in the developed world is another positive. Risks such as a rising U.S. dollar, trade tensions and elections argue for selectivity. We see the greatest opportunities in EM Asia.
Asia ex Japan icon-up 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 icon-down We see rates rising moderately amid economic expansion and Fed normalization. Longer maturities are vulnerable to yield curve steepening but should offer portfolio ballast amid any growth scares. We favor shorter-duration and inflation-linked debt as buffers against rising rates and inflation. We prefer 15-year mortgages over their 30-year counterparts and versus short-term corporates.
U.S. municipals Solid retail investor demand and muted supply are supportive, but rising rates could weigh on absolute performance. We prefer a neutral duration stance and up-in-quality bias in the near term. We favor a barbell approach focused on two- and 20-year maturities.
U.S. credit Sustained growth supports credit, but high valuations limit upside. We favor investment grade (IG) credit as ballast to equity risk. A temporary surge in M&A-related issuance has cheapened IG valuations. Higher-quality floating rate debt and shorter maturities look well positioned for rising rates.
European sovereigns icon-down The ECB’s negative interest rate policy has made yields unattractive and vulnerable to the improving growth outlook. We expect core eurozone yields to rise. We are cautious on peripherals given tight valuations, political risks in Italy and the upcoming end to the ECB's net asset purchases.
European credit icon-down Increased issuance and political risks have widened spreads and created some value. Negative rates have crimped yields — but rate differentials make currency-hedged positions attractive for U.S.-dollar investors. We are cautious on subordinated financial debt despite cheaper valuations.
EM debt Valuations of hard-currency debt have become more attractive relative to local-currency bonds and developed market corporates. Further valuation support comes from slowing supply and strong EM fundamentals. Trade disputes and a tightening of global financial conditions are downside risks.
Asia fixed income Stable fundamentals, cheapening valuations and slowing issuance are supportive. China’s representation in the region’s bond universe is rising. Higher-quality growth and a focus on financial sector reform are long-term positives, but a sharp China growth slowdown would be a challenge.
Other Commodities and currencies * Declining global crude inventories underpin oil prices, with geopolitical tensions providing further support. We are neutral on the U.S. dollar. Rising global uncertainty and a widening U.S. yield differential with other economies provide support, but an elevated valuation may constrain further gains.

icon-up Overweight     Neutral     icon-down Underweight

* Given the breadth of this category, we do not offer a consolidated view.

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