The Bid podcast

Episode 16: Looks like a bond, trades like a stock

Once upon a time, investors could only buy and sell bonds in the over-the-counter market. The exchange traded fund took bonds and made them as easy to own as stock ETFs. Matt Tucker, Head of America’s Fixed Income Strategy, pioneered the bond ETF back in 2012. In this episode of The Bid, he explains how these low-cost vehicles have democratized investing and why he thinks they’re only going to get more interesting.

  • View transcript

    Elizabeth Koehler: Most investors have heard of the Exchange Traded Fund or the ETF. But the phrase ETF often invokes visions of stocks or the traditional style box. Now Matt Tucker, Head of America’s Systematic Fixed Income Strategy has a secret to share. Investors may want to pay attention to the stock ETF's lesser-known complement, the bond ETF. Bond ETFs have grown tremendously in recent years, and not just in global assets under management. On this episode of The Bid, Matt will talk about what makes bond ETFs unique and how they have changed the way that individuals, advisors and institutions invest. I’m your host Liz Koehler, we hope you enjoy.

    Matt, thank you so much for joining us today.

    Matt Tucker: Thanks for having me, Liz.

    Elizabeth Koehler: You have the distinction of being the creator and portfolio manager of the first bond ETF back in 2002, so tell us a little bit more about your process back then. What inspired you to create the first bond ETF and why wasn’t anyone doing this before?

    Matt Tucker: Yes, I was lucky enough to actually be on the team and develop and launch the first bond ETF as you mentioned back in July of 2002. And if you go back and think about what was happening then, you had equity ETFs had been introduced a couple years prior, and you’re seeing a real growth in usage. So investors were really discovering the benefits of being able to trade and invest in a portfolio of stocks that traded on the exchange. And we saw tremendous growth from this just as an investment vehicle, as a way to really empower investors out in the marketplace. And so we kind of thought about it and said, well what is going to be next? Well, fixed income ETFs, bond ETFs, probably have a role in a portfolio just like equity ETFs. Now, the challenge with bonds that a lot of folks don’t understand is that bonds don’t trade on an exchange; they trade over the counter. And what that means is that if you wanted to trade a bond you don’t go up and pull up your listing from your broker. You can actually pick up the phone usually and call someone, and say, I’m looking for a bond, can I get it at the right price? It’s a very manual process, and it means that there isn’t a lot of price information available. So you want to launch an ETF, you’ve got to be able to have a basket of securities that you can actually price throughout the day, that people in the market can trade throughout the day. And those types of mechanisms just weren’t available back then. So we had to do a lot of work to figure out just how to make the whole thing work, how to make the plumbing work to be able to support the trading of a basket of bonds throughout the trading day, which really had not been done before.

    Elizabeth Koehler: We recently heard from Martin Small about how ETFs have really changed the way investors participate in the markets. We know most investors are pretty familiar with stock ETFs, as you referenced, so what are bond ETFs exactly and how are they different?

    Matt Tucker: Well, if you think about the equity ETF, you basically have a bunch of stocks in a portfolio that is managed by a portfolio manager that trades on the exchange. And so as investors, we can all see that portfolio of stocks trading intraday, we can buy or sell that portfolio, much like we would an individual stock. And a bond ETF at that level is really the same thing. But what is really important is that that is very different from how most investors invest in the bond market. So if you want to trade bonds, you would have to go out and actually find a security, buy a security, the transaction costs can be very high. And it can be very difficult to actually find bonds and build diversification. And if you think about your options as an investor, you’re like well if I want to invest in the bond market, traditionally, I could try to buy these individual bonds which is kind of cumbersome. I could try and go out and buy a mutual fund, and that can work, but you don’t have the same level of control as an investor, you don’t have the same level of transparency into your investment. And so an ETF really empowered individuals by allowing them to see their investment better, see it trade throughout the day, and allowed them to really create their own custom portfolio to rebuild their own fixed income portfolio, that aligned with their investment objectives and their goals. So it allows people to really personalize and invest in a way they couldn’t do before the advent of the bond ETF.

    Elizabeth Koehler: That’s great. So it sounds like ETFs essentially take stocks and bonds from around the world, package them, and make them more accessible to everyone, and often times at lower cost. So with that context in mind, what are some of the potential benefits of bond ETFs in your mind, Matt? What do they offer that’s different from other vehicles like individual securities or even actively managed funds?

    Matt Tucker: I think you mentioned a couple of the benefits right there, and I think we just kind of think through them. This idea of intraday trading is very important to the bond market. Again, you simply don’t have the ability to trade bonds with a great deal of ease intraday if you are most investors. Institutional investors might have the ability to actually access bonds at inventory, but for most people, you can’t see it. And in fact, that is one of the other big benefits is that for most investors it makes the bond market visible for the first time. So intraday, everyone knows how to pull up an individual stock or the stock market and see what is happening, but if you think about it, most investors don’t know how to pull up an individual bond or the price of a bond, or bond trends. And so ETFs are providing actually visibility into these markets intraday to give people a better sense of what is happening in the financial markets. And of course you have the traditional benefits of generally lower management fees on ETFs, relative to other investment vehicles. And of course there is the tax efficiency that ETFs often benefit from as well in many markets where they often times will deliver lower capital gains distributions than traditional funds.

    Elizabeth Koehler: So Matt, you talk about how ETFs are able to invest intraday. Could that actually be seen as a bad thing if it’s encouraging short-term investor behavior?

    Matt Tucker: This is an interesting question that we get from time to time, and I think there is a misunderstanding of what intraday trading really means and what it enables people to do. So does it allow investors to trade more often if they want to? Of course. Is that generally a sound investment principle? For most people, not frankly. It’s very hard to time the market short term. The real benefit of intraday trading for ETFs is a couple things. So one is it does provide you with a view into what the market is doing. People know what the stock market did today, but what did the bond market do today? ETFs help answer that question. And the second thing is that ETFs allow you to trade when you need to trade. So it’s not the idea that you want to trade a lot but when you do want to rebalance your portfolio, when you do have new money to invest, when you do have some changing investment need that causes you to want to rebalance your portfolio, ETFs give you the ability to do that when you need to do that. And that again, that is such a critical feature in the bond market, where it can often be hard to trade individual bonds. So having an ETF that trades on the exchange, that is a collection of bonds, and still gives you the flexibility to trade when you need to trade, that is incredibly powerful.

    Elizabeth Koehler: Thanks Matt, so let’s go back in time a little bit to the financial crisis. How has the evolution of the bond ETF market paralleled changes in the bond market itself since the crisis?

    Matt Tucker: I think it’s a very timely question, obviously, as we’re right now just about ten years since the depth of the financial crisis. If you think about the financial crisis broadly, it was a market where liquidity was challenging for a lot of asset classes, where a lot of investors had to really question their investments in different markets. But the really irony is that the financial crisis was actually a real boon for bond ETFs. If you take a look at the ETF market, around that time, what you saw was a number of different bond ETFs start to trade more readily and actually be utilized more as the financial crisis progressed. And what happened was, if you think about the financial crisis and in many ways, it was a bank and broker/dealer crisis. So, the intermediaries, the people that you actually would trade a bond with if you were to buy or sell a bond, many of those institutions either had gone out of business or were concerned they were going to go out of business. And so it became really hard for all investors, both individuals and financial advisors, even professional money managers, to actually buy and sell bonds. Liquidity became really challenging. And in that environment, many investors actually discovered the bond ETF. And they discovered it trading on the stock exchange, not in the traditional bond market. And so they suddenly found this alternate way to actually trade within the fixed income market and buy and sell baskets of fixed income securities. And so we saw for many bond ETFs an increase in usage, an increase in trading volume, and actually a growing number of investors as a result of the financial crisis.

    Elizabeth Koehler: So rather than needing to buy hundreds of bonds in an index, which I would imagine would take quite a long time and be pretty costly, investors found another way?

    Matt Tucker: That’s right. And I think what it led to is increasing usage by institutional investors, even today. I think a lot of people start with the assumption that a bond ETF works for an individual or financial advisor, but you really wouldn’t see a true institutional investor use a bond ETF. And in fact, the opposite is true. So very large, sophisticated institutions who have access to liquidity, to electronic trading platforms, to different derivative contracts like futures contracts, they will still use bond ETFs. Because ETFs have grown to be such a large and liquid market of the bond market that they provide liquidity and access to markets, and really convenience even for the largest most sophisticated investors in the marketplace.

    Elizabeth Koehler: So how might individual investors adopt some of those best practices that we’re seeing by these large institutions?

    Matt Tucker: I think if you’re an individual investor and you’re looking to build a bond portfolio, what ETFs allow you to do is really customize your bond investment for your unique investment needs. So if you’re an investor who is maybe in the later stages of retirement, you’re focused more on income, there are a range of different bond ETFs that can provide income in different forms, let you build an income portfolio that is customized to you. If you’re a younger investor and you’re looking for a portfolio more based around diversification, one that you’re looking to really balance out more risk investments whether those be stocks or real estate or something else, you can actually use a handful of ETFs to build a very diversifying portfolio that helps balance out your overall portfolio risk. So I think this is the real key about bond ETFs, and why it’s really changed how investors behave, because it’s democratized the bond market. And it’s now empowered really all investors, whether you’re individuals or financial institutions, to really invest in the bond market that really fits your specific investment objectives and needs, and really allow you to customize that exposure in a way you simply couldn’t do before ETFs were introduced.

    Elizabeth Koehler: Makes a ton of sense. Matt, if we could just move to rates for just a moment. So the Federal Reserve has hiked interest rates twice so far this year, and there are obviously expectations of two more potential hikes before the year is over. In this kind of a changing environment, how can investors be more thoughtful about cushioning their bond portfolios against risk?

    Matt Tucker: So I think this is a great example of this idea of empowerment that I spoke about a minute ago. So in the face of what some investors might view as changing market conditions, so in this case, the Federal Reserve has hiked rates. So in that cycle, you have short-term interest rates that are rising, and many investors become concerned if those rising interest rates will cause a drop in the value of their fixed income investments. And so there are a number of things investors can do to try to position themselves in that kind of market. So one is they can invest in shorter maturity ETFs, the shorter maturity part of the bond market that is less sensitive to interest rate movements, meaning that as rates rise, it’ll be less impacted in terms of price. We also have ETFs that have maturity dates. So you can actually go and buy a portfolio of bonds in ETF that actually matures on a future date. So in many ways, it’s similar to buying an individual bond, but instead of buying one bond, say to five years in the future, you’d actually buy 50 or 100 bonds that all mature five years in the future. So, you get some of the same benefits of having a known maturity date like you do for a bond and an income stream, which a fund is going to look to pay out just like other ETFs would. But the investor knows they’re getting diversification as well because they’re buying a collection of securities inside the ETF and not an individual bond. And then the last one I’ll mention, which has been a very interesting trade this year, has been the interest in floating rate notes that many people have, where the coupon rate on the bonds actually changes with changes in short-term interest rates. So as the Fed is hiking rates in the short end, the coupons, and therefore the income paid out by these ETFs actually is increasing. So floating rate notes have become a way for investors to actually participate in the Fed rate hikes and really turn the Fed hikes from being a concern about rising rates and impact on the portfolio to actually something that can cause an increase in the income they receive off their investment.

    Elizabeth Koehler: Okay. One last question: what are some developments you see going forward both in the types of bond ETFs that will be offered, but also in how investors will be using them?

    Matt Tucker: Well, if I sit here and look at where the market has come to, we’re about 16 years since the advent of the first fixed income ETF. The market is now over $800 billion dollars globally, so it’s grown to be very significant. There are fixed income ETF markets not just in the U.S., Europe, and Asia, but around the world. But in a lot of ways, we’re still at the early stages of this adoption, which I think is fascinating. So if you think about the new types of funds that might be out there, you can go and invest in many individual segments of the bond market through ETF. But there are new concepts like, say, factor investing that are just now coming into the fixed income market. And so I imagine you’ll be seeing more ways to invest in just different segments of the fixed income market, maybe more ways to invest outside the U.S. more in the global bond market. And at the same time, I think you’re going to see more investors continue to become aware of and adopt ETFs. The ETF market in fixed income is still very small relative to the mutual fund market or the individual bond market. So there is a lot more space for investors I think to discover the benefits of bond ETFs and find ways to take advantage of many of those characteristics we talked about, the ability to actually see and invest in the bond market throughout the day, the ability to create portfolios that are really customized to that individual investor’s needs in terms of the income profile or the diversification or whatever benefit the investor is looking to from their fixed income portfolio. So I still feel like there are so many investors discovering this market that we’re likely to see continued interest and growth as we move forward.

    Elizabeth Koehler: Matt, thank you so much for joining us today.

    Matt Tucker: Hey, thanks for having me Liz, I appreciate it.

    Elizabeth Koehler: And to our listeners, we’ll see you next time on The Bid.

Quarterly Investment Outlook
We see the overall environment as positive for risk assets, but expect more muted returns and higher volatility than in 2017.
Read more Read more

Episode 15: Resilience for a
changing regime

The market regime that brought outsized returns in 2017 has changed. Yet according to Kate Moore, opportunities abound, both within and outside of the U.S.

  • View transcript

    Dennis Lee: The market regime that brought outsized returns in 2017 has changed. Global trade disputes, rising rates and tensions in the eurozone all pose risks to market sentiment and growth. Against this backdrop, it may be time for investors to prepare portfolios. On the other hand, there may be opportunities that investors are overlooking.

    On this episode of The Bid, we turn to Global Chief Equity Strategist Kate Moore to uncover how investors can prepare for an uncertain world. I’m your host, Dennis Lee, we hope you enjoy.

    Kate, thank you so much for joining us today.

    Kate Moore: Yeah, thanks for having me.

    Dennis Lee: So the BlackRock Investment Institute kicked off the summer as it always does, with the Midyear Investment Forum. PMs from across the firm gathered to discuss the market outlook. An essential question that everyone was asked there was to think about, “Are we in a regime change?” What was the answer?

    Kate Moore: So first let me talk a little bit about the forum which is one of my favorite moments of the summer. In the summer we do the forum in London and in the fall in New York. But I liken it a little bit – for those of you guys who are science fiction fans – to Mad Max and Thunder dome. We enter in, we debate viciously and well, I’d like to tell you that only one idea comes out in the end, but a number of ideas came out from this regime change discussion. In fact, I would say there is not one conclusion. A lot depended on what asset class you sit in. So there were folks within the fixed income platform who were seeing a meaningful shift in their market dynamics, certainly the political and geopolitical watchers were observing that as well. And yet, there were quite a number of people who are bottoms up analysts both on the equity and credit side, who were observing that we were in a continuation of the current cycle of increasingly strong profit creation and actually hadn’t seen a meaningful shift in the dynamics of companies or their earnings trajectories yet.

    Dennis Lee: Kate, we’re recording this just before several companies release Q2 earnings. What are you watching out for this earnings season?

    Kate Moore: So the most important thing I think for earnings in the second half of 2018 I would say this is also true for the beginning of 2019, is not the actual numbers; because we know that earnings are going to be strong. We have enough data throughout the quarter to show us that that is the direction of travel. It’s not just about tax reform boosting earnings, but we have strong organic growth and demand from consumers and from other business. The big thing I’m watching this quarter and next quarter and probably the first quarter of 2019 is what companies are telling us in terms of their guidance. This is what really I think derailed some of the market performance after first quarter earnings, was lukewarm or cautious or nervous language in earnings calls. So I think to the extent that companies are able to reassure us that this exceptional bull market can continue, that they see strong earnings throughout the next few quarters, I think that is really going to propel prices higher.

    Dennis Lee: You mentioned some uncertainty especially at the start of the year when we saw some volatility hit in February. We were still, from a BlackRock standpoint, very much championing an optimistic view on the markets, that fundamentals look healthy, all the macro-economic signals look across the globe positive. How has that picture exactly changed and what can we expect from the next six months?

    Kate Moore: Yeah, so this has been a year of significant transition. I mentioned a moment ago that in our June Outlook Forum, we didn’t necessarily have a single view on whether or not we were undergoing regime change. But we are at a later stage in the cycle than we were six months ago, and there have been some pretty important developments. As we think about what has changed, I would say there are three things. Number one, instead of just saying that growth is going to be strong across the board, this synchronized sustained expansion that we discussed at the end of last year and the beginning of this year, we now see the range of potential outcomes for growth broadening out both on the upside and on the downside. Some of that is around trade, some of that is around stimulus. The second thing that is a little bit different is while we were seeing a bit of inflation percolating at the end of last year and beginning of this year, I think we can agree that inflation is in a pretty solid shape in the U.S., and that we’re more in a transition towards tighter financial conditions either from a modestly appreciating dollar or from higher rates. And that’s a bit of a different environment than we were in five months ago during that market selloff. And then the last thing I would say is at the end of last year, we were also focused on telling our investors and clients that they could expect less reward for the risk that they were taking. We are later in the cycle. And now we still believe that, we still believe equities are going to outperform, but we think you have to be a little bit more resilient in portfolios. And to structure both your risk assets as well as your total portfolio around a more resilience theme.

    Dennis Lee: So staying on the topic of resilience, I noticed that BII recently changed its asset class views to underweight European equities and neutral on Japanese equities. What is the reason for that shift?

    Kate Moore: As an equity investor, I always like to be a little bit more optimistic. As a friend of mine said, equity investors like to make money, fixed income investors like to sound smart. So here is what I will say. Yes, we downgraded Europe and Japan, but we also reiterated our overweight of the U.S. and emerging market equities, so that’s my positive spin on that. When it comes to non-U.S. developed markets, because we’re in a slightly later stage of the cycle, and because that first theme I mentioned about the uncertainty increasing, we see less market or index level opportunity for both of those regions. That’s not to say you should sell your European and Japanese equity exposure. I still own a lot. I would just say you need to be more selective and look at the types of quality companies that can continue to grow their earnings when you’re not getting a significant acceleration in global growth.

    Dennis Lee: Tell me a little bit more about your conviction in U.S. and emerging market equities. I know that you specifically champion emerging market equities at this firm and I want to get a little bit of a closer view into what that is.

    Kate Moore: So let me say on the U.S., U.S. is an outstanding quality investment. We know that. But there are a couple other things that lend to continuing to own the U.S. despite its outperformance and leadership and one of them has to do with market composition. Frankly, the companies that make up the U.S. market are just phenomenally strong. And the other is, the balance sheets and corporate health is really above and beyond the other U.S./developed market peers. On emerging markets though, you’re right. I have been a champion here at BlackRock of having a healthy allocation there. Understanding that EM equities are more volatile and understanding that there are lots of political and geopolitical and other asset forces that can affect the price levels. But emerging market equities I think offer some of the best opportunities for long term compounding of returns. It’s not just the domestic growth, it’s the gearing to global growth. I’ve been super-encouraged over the last couple years to see significant structural reform and corporate governance reform championed by governments. Many of these companies have strong profitability, their margins are on par with their U.S. counterparts and actually we’re seeing a broadening of these markets as more companies become public and there is just an interesting opportunity set. I think what has happened so far this year, where emerging market equities have sold off, is not reflective of fundamentals. That actually not only will earnings be strong but much broader than the leadership in EM would suggest right now.

    Dennis Lee: One hesitation we’ve heard in the field for emerging market equities specifically is that U.S./China relations are heating up and specifically on trade, we’ve had several announcements of tariffs. How do you think about emerging market equities as it relates to some of the trade uncertainties we’re seeing?

    Kate Moore: So let me be clear, I think if we have a huge escalation further than what has already happened so far in 2018 on trade, it’s not just EM equities that will take a beating; I think it’s the whole global supply chain and I think the potential impact whether it’s through inflation or risk aversion on U.S. equities, will be non-zero. That’s like my joking way of saying we’ve got to be careful. So I understand concern, but I would say that quite a lot of the bad news around trade and tariffs is already getting priced into EM equities and it’s almost impossible for us to forecast exactly company by company what the impact will be both in the U.S. and in China. All I can tell you is, our analysts from BlackRock on the ground in China right now, are reporting really good news. Strong domestic demand, company management teams are upbeat. They see a lot of positive momentum in the future and increasingly, especially if you’re thinking more medium term about investing in China and EM Asia, the companies you’re investing in are more domestically oriented. There is one last thing I will say having done my graduate work on China and having it be a focus for me for the better part of the last two decades. People who doubt Chinese political will are making a poor bet in my view. And the amount of capital and the amount policy coordination and the amount of desire, an effort that we put behind supporting both the Chinese economy and asset markets in the event of a full blown trade war I think cannot be discounted.

    Dennis Lee: Kate, we’ve been talking about uncertainties in the markets, both to the upside and the downside, and one of the key themes for the remainder of 2018 is building portfolio resilience. What can equity investors do to prepare for the second half of the year?

    Kate Moore: Yeah, so when I think about portfolio resilience here, I’m not just thinking about the second half of the year, Dennis, I’m also thinking about over the next few years, as we continue to progress into this later stage of the cycle. I think there is a real tendency for investors to want to go back to a playbook that they’ve used before and in that case it would be to revert to defensive sectors, more bond proxy sectors if they want more protection in their portfolios. If they believe what we’re saying, that the uncertainties around the economic and growth outlook are greater, they may say, I want to buy staples and telecom and utilities, those sectors that have been a great portfolio ballast for me in the past. But I would argue that a lot of those sectors which are more sensitive to rising interest rates, won’t provide that kind of ballast, and in fact, the way to think about building portfolio resilience within equities is to focus on quality companies, thinking about balance sheets that are strong, that are less sensitive to rising rates, and thinking about companies that have sustained and sustainable earnings growth. A few of these safe haven sectors that I’ve been talking about actually are in the midst of massive disruption. And I think this is an important theme is that not only are they going to be more sensitive to rising interest rates, but they’re also facing increasing challenges to their business models. I think investors need to ask themselves, are these the same companies and do they offer the same potential protection that they have in the past?

    Dennis Lee: What do you see from an investment standpoint in terms of capital expenditures? And what sectors are you seeing companies really invest back into their business?

    Kate Moore: Let me just say I’ve been a little bit skeptical of how companies were going to be spending based on tax reform or tax cuts. When we first started discussing this the beginning part of 2017, I was scratching my head a little bit and I said, it’s not as if companies have had trouble accessing capital, the credit markets have been open, rates are at historic lows, U.S. corporate profitability is at an all-time high, companies have excellent balance sheets. So I wasn’t quite sure that a tax code would change things. And this year, I think there is a lot of optimism that the tax code and the tax cuts will really inspire huge spending. But actually the companies that are spending are those that are in outstanding shape already. Particularly tech companies that have a lot of cash, that are growing their businesses, that want to invest and make acquisitions for the future; we’ve also seen healthcare companies that are repatriating some of their foreign cash increase their expenditure, but largely across the board, we’re not seeing a step change in terms of capex and investment. So I would say look for beneficiaries of regular strong growth instead of trying to game the system based on the tax cuts.

    Dennis Lee: So I smiled a little bit when you mentioned tech because behind, “Where we are in the market cycle?” and, “What about the flattening yield curve?” tech is the most frequent question we get, which is, “How long can this tech bull market run?” Give us a little bit more reason behind why tech is positioned for growth over the long term?

    Kate Moore: I’m going to be honest and tell you it makes me a little bit uncomfortable that I am still recommending technology stocks after their significant outperformance. In a former job, I was told to stop being such a contrarian and that I was arguing against the market too much. Here, technology is actually putting up great numbers, and it’s not just a few technology stocks. A theme we’ve been highlighting with regards to the sector has been the breadth, that you’re getting strong earnings growth from multiple different industries. And actually, to go back to the point we were talking about a moment ago in terms of capex and investment, enterprise technology is a great beneficiary of incremental spend, especially for companies that have a little bit more cash in their pockets post the tax cut. Now here is what I will say also about tech: when we get excited about tech, it’s not just the U.S., it’s also global tech companies, which really are centered a lot in EM Asia and a reason why we continue to like emerging market stocks. These companies are growing their user base, they are innovating, they are disrupting themselves, and we would recommend investors looking for tech exposure to think just outside the U.S. in addition to some of our big mega caps.

    Dennis Lee: So we’ve been focused on where we see growth over the long term and building portfolios to capture some of that growth. On the fixed income side, what does building resilience mean?

    Kate Moore: So this is a tough one because we still expect rates to continue to grind up from here. We had a bit of a pause in terms of the rate cycle as the market was looking to digest the growth implications of trade and tariffs and conflict. But the truth of the matter is that there are large parts of fixed income that are not going to produce the types of returns that many investors had gotten used to; it’s a theme we’ve been talking about for a while. Within fixed income, I think you need to be focused, just as within equity, on quality and it’s a reason why we like investment-grade debt over some of the lower in quality corporate credit. I would also say that there is still opportunity in emerging market debt even though between emerging market debt and emerging market equity, our preference is for the equity.

    Dennis Lee: So to sum up our conversation, it seems that we’re expecting positive but muted return and we’re turning our attention to more quality exposures. Looking ahead in your view, what will be the main driver of growth in the long term? I know we talked about tech for a little bit, but if investors want to position for excess returns in addition to building resilience, where might they look?

    Kate Moore: So I think technology is interesting, I think it’s going to be quite interesting for us to watch over the next five or ten years whether the same tech companies are the leaders then as they are today. I expect we’re going to have more disruption and so you want to have a broader exposure to the sector. Emerging markets is something to continue to focus on I think over the medium and longer term. We still believe in the growth of the emerging market consumer, we still believe that there is a lot more to gain from investing in the equity market because of the broadening out, a new number of companies, more domestically oriented, less part of the global supply chain, and in better corporate governance and more thoughtful shareholder return. And I would also say pay close attention to the evolution of consumption, because consumer companies both in the U.S. as well as the rest of the world are undergoing a seismic shift. You were either a have or have not, a product people want or a product people are rotating away from, a technology that allows you to deliver that product in a quick and efficient manner to consumers, or perhaps behind in using old systems. There is going to be great, in my view, bifurcation within that sector but some really incredible opportunities.

    Dennis Lee: Great. Kate, thank you so much for joining us today; it was great having you.

    Kate Moore: Thanks Dennis, happy trading everyone.

Episode 14: The big impact of
big data

2.5 quintillion bytes of data are generated every day, but IBM estimates that 90% of this data has actually been created in just the past two years. In particular, big data is making headlines in a big way. Rich Mathieson discusses how big data is transforming the way we think about investing.

  • View transcript

    Liz Koehler: The world is awash in data. With 2.5 quintillion bytes generated every day, IBM estimates that 90% of the data in the world today has actually been created in just the past two years. It’s no surprise, then, that every day generates some new promise of how we can use this big data to change the world. In this episode of The Bid, we speak to the expert on how big data is transforming the way we think about investing. Rich Mathieson is a portfolio manager for global equity strategies, and a member of the Systematic Active Equity division within blackrock’s Active Equities Group.

    Rich, thanks so much for joining us today. Take us back just a few years ago: what was investing like before the worldwide commercialization of the internet, before smart phones, before social media? What opportunities do you think might have been missed because they maybe lacked some of today’s technology?

    Rich Mathieson: Hi Liz. I will take it back further than a few years. The Systematic Active Equity Team at blackrock have been combining data and technology with traditional investment insight for as long ago as 30 plus years. And I think really through a lot of that period, the big constraint we had to generating alpha in client portfolios was data. Today that is no longer the case. Think of something you would want to measure electronically and the chances are somebody in the world is already doing that. So today the constraint on alpha isn’t necessarily data availability, it’s the ideas that you have and how to use that data to forecast outcomes in financial markets.

    Liz Koehler: That’s great. It’s fascinating, I was just reading an article this morning that was talking about how farmers themselves in Australia are even using big data to change their industry and to improve their own crops. So it’s amazing how prevalent it is today. So as we talk about today, what do we mean – we hear it all over the news – what do we really mean by “big data” and how new is it really?

    Rich Mathieson: Yes. I think we first started thinking about the idea—at the time we called it unstructured data or alternative data back in 2010 and that was really when we first started to realize that there was this growing amount of information available to investors that didn’t come in traditional, prepackaged databases of rows and columns of numeric information. And it required a lot of work to turn it into useful information but we felt if we could do that we would have a real edge in terms of investing.

    Liz Koehler: That’s great. And speaking of all of that data, last year in 2017, your team trailed over 70 new datasets. That’s pretty impressive. What kinds of data does the Systematic Active Equity Team really look at, and then how does your team analyze those massive amounts of data to really gain those investment insights that you referenced?

    Rich Mathieson: We have a general philosophy that there is no such thing as bad data. We want to look at as much data and information as possible to ultimately try and answer the traditional questions that any investor would ask of the securities or stocks that they invest in. Examples where we’ve had a lot of success would be interpreting textual information that used to simply be words on a hard copy of an analyst report or a broker note or a company earnings call transcript. Today that information is electronic. We can capture it, we can use it to measure how well securities and companies are doing. Information from social media, information from internet search—think about the way we all use the internet today. If you’re going to spend a lot of money in something, chances are you start doing your research online before you engage in the transaction. Geolocation data that helps us analyze consumer aggregate behavior in terms of actual physical location, in and out of retail locations, such as shops and stores. These are just some of the many examples of how we’re using this alternative data to again answer very traditional investment questions.

    Liz Koehler: There has been a lot of publicity around tech firms recently that have access to personal data of their customers. How does your team think about that in the data that you touch?

    Rich Mathieson: Yeah. And it’s a great question and a very, very topical one. I think that the big differentiation of it highly is what we are interested in compared to what a lot of technology firms might be interested in. We aren’t interested in any way shape or form in anyone’s personal information; it doesn’t help us make better forecasts for the companies and securities that we invest in. What we are really interested in, is aggregate consumer behavior or aggregate behavior of individuals and how that behavior maps on to companies’ prospects. So we’re not interested in individual, we are interested in how individuals as a group are behaving and what that means for companies. When we’re looking to bring some of this alternative data into the building, we make sure very clearly from a legal and compliance standpoint that at no point in time will that include any personal identifiable information.

    Liz Koehler: Makes sense. It’s a whole lot more about the trends and the aggregated data that the team is looking to glean insights from. So Rich, the asset management industry as a whole is embracing Big Data, that’s clear, to make investment decisions. But it seems that some of these managers could easily buy some of this data or the technologies in order to analyze it off the shelf. Is that really all that’s required?

    Rich Mathieson: No, absolutely not. And I think you hit the nail in the head earlier, SAE researchers last year trialed around about 70 different datasets. Many of those will be publicly available, anybody could get hold of it, anybody could buy it. It’s very, very difficult for a lot of asset managers to look at 70 datasets. One of the things we’ve learned over that ten year period in which we’ve been looking at this type of information is that bringing as much data as possible to bear on the same investment question for example, what our next quarter sales are likely to be better or worse than expected for a given company, bring as much data as possible to answer that question is very, very important. And only firms with an ability to leverage a technology platform and they can accelerate as much data as possible over that platform, will be able to answer those types of questions successfully. So size and scale is important in this game. The second point I would make is again, this data even when you acquire it from an often third party vendor, is messy, noisy, unstructured, a lot of work is required to refine and curate that data and ultimately map it onto an easily tradeable security for you to actually build that information into a client portfolio. It’s not easy. And we have a lot of years of skill and experience and the talent required in order to make that transformation.

    Liz Koehler: Rich, the Systematic Active Equity Team has been analyzing Big Data to enhance its investment outcomes with technologies like machine learning for almost a decade. What are some of the necessary ingredients that you think asset managers need to ensure they are actually using this Big Data most effectively?

    Rich Mathieson: The first I highlighted earlier is size and scale is important and an ability to bring as much differentiated data to bear on the same investment question as possible. For an example, if you’re looking to forecast whether next quarter sales for a company are going to surprise for the upside or downside. There is a tradeoff between the forecasting horizon of the information and the accuracy that you’re likely to get. So for example, I talked about internet search earlier is giving you a very nice early warning of an intention across large groups of consumers towards particular brands and products. The problem being there that I think that gives you just an intention rather than get you close to hard transaction activity. So if you take it to the other end, if you look at things like geolocation, or aggregated transaction data from bank statement and credit card statements, you’re getting closer and closer to hard transaction activity and ultimately book sales. Any one of these datasets might not necessarily give you the right answer, but when you bring them all together and they corroborate one another, that’s when you can get something clearly powerful in terms of forecasting ability and an ability to accurately get ahead of improving company fundamentals. Second point I would note, when you bring in a new dataset, when you build an initial model, it’s very rarely the best possible model that you can build. And what we’ve found is the best results come from years of innovation, of layering incremental innovation on top of the same insight or same idea as new data, information, techniques for looking at the data become available. One of the best examples I think we have of that is the way that abilities in natural language processing have evolved over the last eight to ten years. Original algorithms that we ran to build models that essentially enabled us to read text which is very rigid preprogrammed dictionaries of words. For example, words like growth, exciting, opportunity or threat, deterioration, competition, these would be words that the investment team would select and then the program or algorithm would look for those words within the text of a broker report or a company earnings call or regulatory filing. The second iteration of that insight would start to then look at different features of the text. So the company using lots of numerical data, we tend to find that good companies talk a lot about numbers. We would compare the sentiment in the text across different sources, so for example, different parts of the call Q&A section when management teams are more likely to be or less likely I should say to be reading from prepared remarks, we found that particularly useful. And then I guess bringing up to date the most recent innovation in that insight actually brings in the concept of machine learning and combines that with natural language processing where we’ve built an algorithm that essentially learns from analyzing the relationship of words versus stock returns, what the important words are. Rather than individuals preprogramming the words to look for, the algorithm is actually learning for itself and it’s doing that on an individual security level and a very adaptive and dynamic way. So those are just two of the examples of lessons that we’ve learned, continual innovation and bringing as much data as possible to answer a traditional investment question.

    Liz Koehler: Wow, that’s fascinating work. On top of it, I get to tell my husband tonight that all of my online shopping is not a bad thing, I just am contributing to the important Big Data cause here. But no, thank you, those examples are really great. Broadening this out to our listeners, how might investors really see this come to life in their own investments?

    Rich Mathieson: Yeah. So I think whilst the ideas and the data we’ve been able to analyze to model those ideas have changed a lot over the last decade, the way that we build those ideas into client portfolios has remained very, very consistent throughout our 30 year history. The process starts with traditional investment question, how am I going to forecast whether the stock will beat expectations in terms of next quarter earnings or sales or whether this stock is going to see an improvement in expectations for future earnings over the next six months, or a change in profitability over the next 12 to 18 months? These are the same types of investment questions that any investor would be interested in knowing the answer to for a given security. But what we then do is try and bring as much data as possible to bear to answer those questions, and we want to measure the exposure of pretty much every stock in an underlying investible universe to that data, to that information with a view to maximizing the breadth of the opportunity set, we can get exposure to in portfolios. And then as we go from that measurement of exposure to the idea, we then build as many of those views as possible into very, very diversified portfolios where essentially we’re going to be long or overweight all of the stocks that we think have positive exposure to the idea or short or underweight all the stocks that we think have negative exposure to the idea as measured by the stock’s exposure to the underlying data we have identified enables us to model that idea. So what you end up with is a very broad portfolio of assets. We tend to hold large numbers of securities, we control risk very, very tightly so you are diversifying away the element of that stock’s risk that isn’t explained by this exposure to your investment idea and getting a nice, clean pure exposure to that information set, to that investment idea in the portfolio.

    Liz Koehler: It seems that all over the media today, you hear about machines being poised to take over the world, and in this particular case, even investing. Is the human touch still instrumental in all of this?

    Rich Mathieson: Yeah. Very much so and I think there is a couple of key elements there. First is that certainly the robots aren’t in complete control yet. For any algorithm we deploy, for any piece of data that we bring in and analyze, there is still a very, very large interaction with the investment team, with human beings, with the algorithm and underlying data. A lot of the algorithms that we have used for example in the machine learning space, they weren’t originally designed for analyzing time series of financial information with a view to building an investment model. And quite often, we have to bring a lot of investment insight that we have built up over 30 years of primary research into what matters for stock returns to bear on defining and refining the model in order to enable it to think and behave like an investor. The second point I would note is that culture is very important and the idea of building a very open, collaborative culture where experts in the field of data science and individuals who have talent in knowing how to extract useful information from these very large messy, unstructured datasets are working in a very, very collaborative way with again, individuals who might not necessarily be data scientists but have again, years of experience in understanding what really matters for stock returns. And I think if an investment manager doesn’t have that open, collaborative culture and isn’t able to fully integrate these two elements into the investment process, then I think a lot of what we’ve been discussing today will struggle to become a reality.

    Liz Koehler: Rich, thank you so much for joining us today; it really was a pleasure having you.

    Rich Mathieson: Thank you. My pleasure to be here.

Episode 13: Disruptors in the
sweet spot

We all like to think we know which disruptive companies will float to the top, or at least we wish we did. Lawrence Kemp and Phil Ruvinsky discuss how more often than not, disruptors lie in the goldilocks of growth stocks: not too big, not too small, but right in the middle.

  • View transcript

    Dennis Lee: At some point, you may have thought to yourself, if only I had invested in Intel when it was at $5 dollars, or I knew it. I should have bought Amazon in the 1990s. We all like to think we know which disruptors will float to the top, or at least we wish we did. And while there isn’t a magic formula, one team at BlackRock has a unique approach to come up with ideas every day. On this episode of The Bid, we speak with Lawrence Kemp and Phil Ruvinsky, Portfolio Managers for the Mid-cap Growth Equity Fund. Because as it turns out, a lot of these disruptors lie in the goldilocks of growth stocks, not too big, not too small, but in the sometimes forgotten middle. I’m your host, Dennis Lee. We hope you enjoy.

    Lawrence, Phil, thank you so much for joining us today.

    Lawrence Kemp: Our pleasure.

    Phil Ruvinsky: Thanks for having us.

    Dennis Lee: Phil, let’s get right into it then: why do you think mid-cap growth stocks are often overlooked by investors?

    Phil Ruvinsky: We definitely agree that they’re overlooked. The states are that 20 to 25 percent of US market cap is actually mid-cap companies, and yet, only 10 to 13 percent of US fund portfolios are in mid-caps. And a lot of that is actually belied by style drift. So I think it’s just investors don’t have the familiarity with mid-caps that they have with large caps. People don’t really understand the business models as well; they’re not household names. And so when they add equity exposure, they just go with the S&P or other large cap indices.

    Dennis Lee: How do we familiarize it? How can it fit into a portfolio and why should it?

    Phil Ruvinsky: Well, we think it should play a significant part. Over the last 20 years, mid-caps have had higher absolute and risk adjusted returns than small or large caps. And the time is essentially ripe for mid-caps in a low return environment. There are so many disruptive exciting companies that can compound at higher rates than market expectations. And in all sectors. We’re constantly surprised to discover more of them as we go along, and we’ve been doing it for a long time. After all, we originally bought Amazon and Netflix when they were mid-cap.

    Dennis Lee: Lawrence, disruptor is a term I’m hearing quite a bit in Phil’s answer. And that term has been popularized in recent years to companies that have tremendous potential for growth. How do you think about disruption in your portfolios and how do you find those opportunities?

    Lawrence Kemp: Disruption has been occurring for over 100 years. We have seen this impact industries as varied as transportation, TV viewership, cell phones, software, and now EVs. It’s important to—when we think about disruption today, because of the tools which are being developed, in an AI world, in a Cloud based world, that this speed of disruption is accelerating. I think in today’s world, it’s really Cloud based applications. And the extraordinary success of a variety of SAS companies, which is Software as a Service. These business models continue to—and they key is they almost built a platform of solutions and they get maybe one regarding cost management, then they come up with a marketing impactful tool. And these products are just so amazing since they’re digital, the cost of actually selling them is much lower, it’s much easier. You can constantly upgrade them, and then of course it means that basically the user has to embrace the Cloud which means you have lower operating cost, lower cap-ex cost. It’s almost a virtual cycle where everyone wins. The impact of this is resulting in loss of traffic, price deflation, and really creating new competitive threats in almost every sector. It’s important to remember that with all the talk about AI, so far AI machine learning has really only commercially impacted online advertising. There are so many areas that are ripe to be disrupted.

    Dennis Lee: Are technology companies a big part of your growth strategy and how do you think about the tech space today?

    Lawrence Kemp: Technology has been a huge part of growth investors forever, and obviously it’s true for us in large cap. When we think about technology today, there is a big debate ongoing regarding the cyclical nature of tech versus the past. Our job is to identify those business models that we expect to continue to take share in a global economy. This includes online advertising, it includes payments, Cloud based software, which improve customer outcomes, and semicap equipment where the cost for bit keeps increasing. And I think just as importantly, or more importantly, these tools are basically being used as a backbone for many of the leading mid-cap companies where they’re basically doing very well.

    Dennis Lee: Phil, you mentioned Amazon and Netflix earlier. To us today, the investors and the average consumer, it seems almost obvious that those companies would do well. Can you help explain what made those companies an obvious bet for you earlier and what can we learn from that sort of analysis when it wasn’t obvious to everyone that Amazon and Netflix would do so well?

    Phil Ruvinsky: Amazon is the first company I covered when I first started with Lawrence. At that time, the question was not whether it would be dominant in all these sectors that we’re talking about today, but the question was whether the company would survive. Taking on debt in order to grow its business in the early days, and there was free cash flow negative back then. And so it took a lot of imagination to think about it being the company that it is today. And never in our wildest dreams would we have thought back in 2002 that it would be what it is today. But the fact was we thought that hey, we’re getting the world’s e-commerce leader for $5 billion dollars back then when we first invested. And the ultimate prize is what kept us in the stock. It’s similar to Netflix where we had a clear picture of the end state that it could become this bull case scenario. And that is part of our process for all of our analysts is to think big and to have a bull case scenario that we won’t say will definitely happen, but assign some probability that it will happen. In that end state, Netflix looks like a much, much bigger company than it even is today, which is multiples of where we originally bought it, same as for Amazon.

    Dennis Lee: Turning to you Phil, what are some mistakes that investors might make in trying to invest in mid-cap growth on their own?

    Phil Ruvinsky: Yeah. So I definitely would not recommend that investors do this on their own. Not only are these not household names in a lot of cases, but also just the concept of high growth and high profitability attracting competition entry. And that is our job is to make sure that the competitors don’t drive down our company’s returns. The team works really hard on that one question. How sustainable are these earnings streams? Is there pricing power? Are margins going to go up? For this to do this on your own would be next to impossible. We constantly meet with management teams and industry experts, and competitors, et cetera, to ensure that our companies earnings streams are safe and that the businesses are sustainable.

    Dennis Lee: I wanted to end with one final question. You both spend your time thinking about the future, so where do you see the next three to five years playing out? What’s on the horizon now?

    Phil Ruvinsky: Well, I would point to automation as a huge growth sector, both domestically and globally. Most automation today happens in the auto sector. It’s like 85 percent of robotic instances are in the auto sector. We think every sector is going to adopt automation to some extent. And we have some things in the portfolio that we like there. We think home services is ripe for disruption as well, as we just discussed. There is a lot of friction to be taken out there, so we like that sector. Latin America as an e-commerce and fintech marketplace we think has a lot of opportunities there. So those are some.

    Lawrence Kemp: E-commerce continues to be a huge opportunity and we’re seeing significant investment in voice automation finally beginning to come true, and it’s very exciting to think about being able to order items on a regular basis by just speaking if you will in the kitchen. And in the meantime, there are business models which are really true digital platforms, that not only are leaders in gaming, but also in social media as well as payments. And they continue to offer exciting new products to a very highly engaged customer base.

    Dennis Lee: Lawrence, Phil, thank you so much for speaking with us today. It was a pleasure having you.

    Lawrence Kemp: Thanks much for the discussion, we really enjoyed it.

Episode 12: The $5 trillion technology powering your portfolio

Many portfolios today harbor a technology that’s changing the way we look at investing. It’s called the exchange traded fund, and in this episode of The BidMartin Small explores the ins and outs of its rapid rise.

  • View transcript

    David Brodnick: Call to your mind the image of the financier: what do you see? Is it some pin-striped suited man reading a ticker tape, or maybe a Gordon Gekko type screaming into a brick shaped cell phone? In this scenario, one thing is probably true: the tech they’re using is hopelessly lame. Now Martin Small, Head of U.S. and Canada’s iShares business, has a secret to share. Things have changed. In fact, many portfolios today, maybe even your own, harbor a technology with a collective market value more than double that of the FANG stocks: Facebook, Amazon, Netflix and Google parent Alphabet combined. It’s called the exchange traded fund, and in this episode of The Bid, we’ll learn what it is, what it does and how it’s transforming finance for investors of all sizes. I’m your host David Brodnick, we hope you enjoy.

    Martin, thank you so much for joining us today.

    Martin Small: Thanks for having me, it’s great to be here.

    David Brodnick: So we’ll get into what an ETF is, but first I just want to step back to the early-90s for a second. Can you explain to us what it actually took to build a diversified portfolio 25 years ago?

    Martin Small: Well, I really think of two things on this front. I think of Nobel laureates and I think of shipping containers. And I know it doesn’t seem like those things go together, but they do. And I think putting those together gives you a better sense of why the exchange traded fund was actually invented and brought to market. So in the 50s and 60s, we had Nobel laureates, we had Markowitz, we had Sharpe, and they wrote about the market portfolio and being able to own stocks and bonds at their market weight all around the world. However, if you really went out to try to do that, it would be so unaffordable, so impossible that just the transaction costs alone would make it impossible. Fast forward to shipping containers. In 1956, Malcolm McLean invented the shipping container; it used to be the case that if you were moving goods from Japan to the east coast of the United States, it would cost $5.86 a ton. Today it costs about $0.16 a ton, and the reason for that is we standardized shipping, we made them metal boxes. You can put everything in a metal box and you can move it off a train, to a truck, onto a ship, on a train, to a truck again. And basically we reduced all the friction. So put those two things together. We took stocks and bonds from all around the world, packaged them up in exchange traded funds, standardized their pricing and made them accessible for everyone. Basically, we now have an industry that has standardized shipping so that you can trade on the ideas from the 50s and 60s, the truly powered portfolio, which are Nobel laureate ideas about indexation. So think of the ETF as two things, right? It is a traditional, boring, open-end index mutual fund, regulated under the Investment Company Act of 1940, but it’s also just like a stock, right. It can be bought or sold on exchange. You can go to your Fidelity brokerage account and buy it the same way you might buy shares of Apple, IBM, Netflix, Google, whatever you fancy. And it’s that simplicity of basically being an investment security, that can be bought or sold at low cost on exchange that has really I think transformed the way that people are able to access markets all over the world.

    David Brodnick: So I think you’re getting at something very foundational, and it’s not a misconception about the ETF but it’s a very simplistic view of the ETF, which is that it is a financial product that goes in an investor’s portfolio and that’s the beginning and middle and end of it. But there is the more philosophical way of viewing the ETF, which is as a market exposure on demand. It’s instantaneous and providing you very low cost efficient beta to pretty much any single individual market that you could want. And that is something that is incredibly valuable for many of the clients we work with beyond just the traditional individual investors. Can you talk to us about how some of the financial intermediaries and more sophisticated clients we’re working with are harnessing that property of the ETF?

    Martin Small: So imagine that you’re an emerging markets debt manager and you are managing bonds all over the world in your emerging markets debt strategy. You are a highly sophisticated asset manager. All of a sudden, you have a new inflow of cash from an excellent and awesome client and you say, I would like to go out and buy the 400 bonds that might be in an emerging markets bond index. You would say, that might take me a month. It might take me two months. However, I can probably buy an emerging markets debt ETF on exchange and buy into that portfolio today. And that’s what you’d see some of the most sophisticated institutions doing in high yield, you’d see them doing it in investment grade corporate bonds, you’d see it in the global aggregate. And so the most sophisticated institutions are thinking through where they spend all those transaction costs, where are they best spent in order to keep as much money as possible in their investors’ pockets and generate higher returns? They’re leveraging 50 plus years, two generations of research about what really powers portfolio outcomes, and now they have more tools than they’ve ever had.

    David Brodnick: We live in the age of the ICO (the Initial Coin Offering), cryptocurrencies, all sorts of financial innovation taking place. What are the sorts of things that exist in the financial universe that maybe shouldn’t or can’t be indexed via traditional means?

    Martin Small: So most people when you talk about indexing, they think of one or two things. They really think of the S&P 500. But god didn’t hand down market cap weighted indexing on the tablets of Sinai as the only way to render a market. We haven’t really, really scratched the surface on all the other ways we might render markets via indexes. But I think of it this way, the simple definition of an index is anything that is transparent, investible and strictly rules based. Transparent meaning I know what it does, it does what it says on the tin. If it says it’s going to deliver me a value tilt, it delivers me a value tilt; if it tells me that it’s the MSCI Frontier Markets Index, I get that, not some weird other random disparate outcome from what the index says. Investable means we have to be able to deploy a material amount of capital against the index and realize its published return. The Gross Happiness Index of Bhutan is an index, but I can’t invest in it. And there are plenty of parts of the market where it’s very difficult to do that, so I think of down in credit, mezzanine lending and commercial mortgage backed securities, those are places that would be more difficult to index; it would simply be more difficult to transact all of the instruments involved. However, you have to be able to take big dollars and realize the index return. And finally, it’s strictly rules based. So if you tell me I screen the universe for high quality companies with strong balance sheets that have consistently grown the dividend. I like price to earnings, price to book, enterprise value to EBITDA, those are the things I care about, well I can make an index out of that. Those are strictly rules based concepts. I look at ICOs and digital currencies this way, let’s assume that they acquire the characteristics of money one day, meaning that they are a medium of exchange, an accepted unit of account and a stored value. Most digital currencies don’t do all three of those things or do them well today. Even if we get there, the foreign exchange market is the deepest, most liquid transacted market in the world today. It turns over $4 trillion dollars a day. The ETF is somewhat of a solution in search of a problem.

    David Brodnick: That makes sense. So there is this old saying or conceit within the world of technology that it underwhelms in the near term, but in the long term, far exceeds expectations. So adopting the viewpoint of the futurist, when you look at the ETF and what has happened in the past 25 years and projecting that into the next ten, 15 years, what does the world of investing look like as the ETF continues to become a foundational unit of function within the financial system?

    Martin Small: The ETF again, it’s just a vessel: we can put many different investment ideas and tools through the ETF into the portfolio of any investor. And I think if I go out ten years, 15 years, in my mind, it’s data and technology that will continue to transform what we are capable of accomplishing in indexing. So the idea that we were able to render emerging markets at all, if you went back 50 years, people would tell you, you’ll never be able to do that portfolio. The idea that you can deliver a value tilt today or deliver inflation hedged investment-grade corporate bonds in indexes, nobody believed that was possible. I think on the horizon for me, is that we are understanding more and more and we have more data to analyze historical relationships between risk and return, and to really understand what powers a given investment idea. So I don’t think we’re very far away from models of the endowment portfolio for all. What do I mean? I mean venture capital, for example. We somewhat understand what drives risk and return in venture capital. But in ten years, I could definitely see public markets proxies for traditionally private exposures like venture capital or private equity or commodity trading advisors, CTA type macro strategies.

    David Brodnick: Wonderful. Well, I guess to just probe this a little bit further, we look at the role of the investment manager is in the early days of the 21st century here. Do you view the index researcher as the portfolio manager of the future? And then contrary-wise, is the role of the individual stock selector, security selector, something doomed to go the way of the stevedore as we look into the future?

    Martin Small: It’s funny. I get asked this question in lots of different flavors in my job. Sometimes when the person from iShares shows up, I’m viewed as having horns on my head and we’re upending the investment management industry and we’re putting a lot of stock pickers out of work. That is just not true. It’s not the case. Every idea for an index fund came from somebody who was trying to spot a better way of rendering the market through a traditional active portfolio, the word we would call active. All portfolios in reality are active; the decision not to invest your money is an active decision. But when I think of what powered investment returns in mutual fund land for a long time, for example, I think of value tilts, I think of momentum. People have been using these strategies for the better part of 30, 40 years. It’s just that only in the last ten have we been able to index them. So I think over the long term, what happens is there is this great virtuous circle that comes from great ideas from alpha-oriented portfolio managers that ultimately become reduced to transparent investible, strictly rules based bundles in ETFs, and it forces all those people to find new sources of risk and return. And that relationship I think will go on for a very, very long time. And so I don’t think that person is out of work. That person is not a stevedore. They need to look to new sources of alpha, new sources of information in order to do things that the market portfolio can’t.

    David Brodnick: Wonderful. Well Martin, it’s been great speaking. Thank you so much for joining us today.

    Martin Small: Thanks for having me.

Episode 11: Advisors vs. volatility: Who won?

This year’s market swings have spooked investors, but there may be a reason to stay confident: when put to the test, the majority of portfolios actually beat their benchmark. But is this cause for celebration, or just the luck of the draw? Brett Mossman and Patrick Nolan discuss more.

  • View transcript

    Elizabeth Koehler: Recent volatility has spooked some investors, but there may be a reason to stay confident. In fact, when put to the test, the majority of advisor portfolios actually beat their benchmark. But is this cause for celebration, or just the luck of the draw? On this episode of The Bid, we’ll dig into real portfolio data with of Head of BlackRock Portfolio Solutions Brett Mossman and Senior Portfolio Strategist Patrick Nolan to learn just how advisors faired during bouts of volatility. I’m your host, Liz Koehler, we hope you enjoy.

    Brett, Patrick, thank you so much for joining us today. I want to take a moment to ask you about your team and what it is you do on a day-to-day basis, because I think it’s a unique story. Brett, you started the Portfolio Solutions Team back in 2014 as a group of consultants. What does your team do?

    Brett Mossman: The Portfolio Solutions Team was really born out of BlackRock’s ambition to become a trusted advisor to advisors. We’ve consulted well north of 10,000 advisors in the past three years, we’ve looked at well north of 20,000 portfolios during that same point in time, and really what we’ve been able to do is actually inspire a sea change not just here at BlackRock, but across all asset managers in the industry around how they work with advisors on building better portfolios. The way that we inspire that change is not just about how we deliver insight on markets and how to build efficient portfolios, but it’s also been around how we inspire advisors and how we inspire investors to use technology to really understand what they own at any given point in time, and to make sure that the way that they’re invested is consistent with their goals.

    Elizabeth Koehler: It’s a great story and a great mission. Patrick, turning to you. First, can you tell the audience a little bit about your role within Portfolio Solutions, and then move toward the trends you’re seeing. Recent volatility reminded us that markets can actually go down and do go down. How did portfolios hold up?

    Patrick Nolan: Sure, so my job on the team is to lead the portfolio construction research efforts for the team as well as to analyze the advisor model data that is a result of all of our consulting efforts. So Brett just mentioned 20,000 models collected over the past 3.5 years. For the recent volatility event, we actually took a look at 6,500 portfolios that we had captured during that time period, wanting to see how those models held up. It was the first correction we had had in 15 months. So we evaluated them from January 29th to February 8th, which was the high-low of the correction. And to our pleasure, 70 percent of advisor models actually outperformed the benchmarks that we measured them against. We had different benchmark measures set up for each of the risk type cohorts that we divide the data into. Generally speaking, there were two main reasons why we saw the outperformance. The first was on average, the investors were a bit allocated towards international equities, and away from U.S. large cap. And then secondly, inside the bond sleeves, we saw a bit of a preference for shorter maturity bonds versus the longer maturity bonds that were in the benchmarks that we were using. A combination of those two things is what led to the outperformance, but 70 percent on whole is a pretty darn good number and I think advisors should be pretty happy with what we saw.

    Elizabeth Koehler: It’s great to hear that advisors demonstrated that outperformance. Do you think that portfolio diversification worked this time?

    Patrick Nolan: Yeah. So the interesting thing about that correction and what we observed is what actually led to the outperformance, right? If you think about areas like owning longer maturity core bonds, owning U.S. large cap stocks, those two things intend to be the exposures that you would seek in your portfolio for stability at moments where equity markets were falling, right. And the irony of that situation was that it was owning less of both of those exposures that actually led to the outperformance, which I think reminds us that a proper diversification doesn’t always look like it’s working and there is a big difference between owning something that will zig when everything else zags in your portfolio, and owning less of the things that went down the most. In this particular case, our observation was that the things that would otherwise produce stability under more normal risk-off moments actually didn’t this time around. It doesn’t necessarily mean that diversification is broken when that happens. But it also tells us that we shouldn’t glean too much from a nine-day period of time, particularly when you’re seeing a sharp, short correction in the middle of a protracted bull market.

    Elizabeth Koehler: Brett, our BlackRock Investment Institute believes that 2018 marks a return to more normal levels of volatility. It seems like it’s a matter of when, not if, a market correction could happen again. How can investors be prepared for future swings?

    Brett Mossman: First and foremost Liz, I think it’s necessary to draw a clean distinction between what it means to be prepared versus encouraging people just to take action. And to be clear, we still think it’s a good time to be an investor. We still have positive expectations on the return of risk assets, especially in areas that are more susceptible for this “supposed correction” that may occur. There are three very basic things that I would encourage people to do and they’re going to sound basic as they are, but they’re not basic to implement. So the first is this, it’s to understand and plan. And really what I would encourage people to do is to really understand how the increase in volatility might actually impact them and their portfolio. It’s hard to be a successful long term investor if you struggle during short term periods of volatility. As we think about building great portfolios, we place a huge premium on not just understanding the horizon goals that investors have, but also understanding what the path needs to look and feel like during the journey to make it really stick and resonate with the investor. The second part is, to understand how and if they might change if the markets themselves change. So if they are an investor who is more prone or more sensitive to a pullback on a short-term basis in the markets, then what would be the things that they might do differently in their portfolio? Again, not from a timing perspective but from a strategy standpoint, to really make sure that what they are invested in matches their own ownership requirements. The second thing I would do after that understand and plan is to really focus on communication, and to make sure that there are good, clean, open lines of community between the investor and their advisor. If they were to take action in their portfolio and make changes, what are the implications of that, what are the implications on fees, what are the implications on taxes? And then the last part is to commit, it’s to really take action, it’s to make sure you understand why you’re taking action in your portfolio and focus on what an appropriate measure of success is. There’s this old expression, “It wasn’t raining when Noah built the Arc,” and what that means is that being prepared in the event that something either unlikely or unexpected or unforecasted could occur, if volatility were to uptick and the markets were to pull back, then it’s what are the things that you can do from a plan perspective to still make sure you reach a reasonable chance of getting to your outcome but do so in a way that essentially protects you from yourself.

    Elizabeth Koehler: That’s great, thanks Brett. And for those of you who don’t know Brett, he’s known here at BlackRock for his great analogies. So Patrick, moving back to you, you mentioned earlier and we know that your team works with thousands of advisors every year and has just an incredible view of trends across different portfolios. What are some new areas that advisors are exploring lately?

    Patrick Nolan: Yeah, so I’ll give you two, one is not so new and one I think is an exciting new area for the industry. The not so new area is actually international investing. We tend to see a fair bit of home country bias that exists in U.S. investors with their advisors’ portfolios. It makes sense, right, that generally speaking you tend to be more comfortable owning the stocks of the companies that you know and that you use every day. If the company happens to go through a rough patch, I still know who they are, I know what they do, I shop at their stores, I buy their products, right? Little harder to get comfortable when we’re dealing with international companies that you may not know where they’re located, what they do, what clients they serve, et cetera. The challenging part is that for the last eight or nine years, you could have owned nothing but U.S. investments and done really, really well, right. We think that is changing, right. BlackRock’s view of where returns will come from in the future we actually believe favor international investing. We’re just starting to see advisors tick up the international weightings in their portfolios; we’ve been watching this pretty closely for the past four or five quarters. It's been stagnant for the better part of the year. Just recently, we finally started to see a bit of an uptick in both developed market international exposures as well as emerging markets. The second newer interesting area for us is in the area of factor product usage. A factor is simply a characteristic that explains performance in some way on any given investment, right. It used to be that the only way you could access these factors would be through paying a manager, in some cases, higher than what was needed in order to access the search for that factor. Now there are products that actually deliver that factor in isolation to you and with a fair bit of specificity. So I don’t have to be curious about it, I don’t have to go on this exhaustive search, and I don’t have to overpay for it. I actually can get it in index product, an ETF in fact, that allows me to get it cheaply, efficiently and with tax efficiency as well. As we look across our advisor models, 57 percent of the models that are in our database today have at least one factor-oriented product in them, which is a pretty good growth rate from what we’ve seen in the past. We’re seeing growth in areas of minimum volatility as well as dividend strategies. These tend to be the two most used types of factors that investors are seeking out. But we’re also seeing other single factor, even multi-factor products now starting to emerge in client portfolios in a more meaningful way.

    Elizabeth Koehler: That’s great. It’s encouraging to hear that more investors are looking outside the U.S. and thinking about global investing, as well as new types of products like factor investing. So expanding on that Patrick, we recently spoke to Andrew Ang here at BlackRock about factor investing and the potential to use factors to beat the market. How can investors manage factors most effectively?

    Patrick Nolan: I think it’s important to talk about factor investing and the way it applies in a portfolio by calling out some very specific factors. And I’m talking about things specifically like momentum, quality, value, size and even low volatility. Each one of those has a rationale or reason for its demonstrated persistent outperformance of markets through time. The great thing about them, and to answer your question about using them efficiently in a portfolio, is that they actually tend to balance each other out. The reason why momentum would outperform is different than the reason why value, for example, would outperform. So if I can get exposure to both of them in my portfolio, I actually create a bit of diversification and a bit of smoothing in my own ride as the owner of both vehicles. Own all the persistent drivers of excess returns, give them the opportunity to diversify one another in a meaningful way to smooth out your ride. Hopefully over time, you derive the benefit of owning them all.

    Elizabeth Koehler: That’s great guidance, Patrick. Thank you. Brett, back to you. While recent attention has mainly been focused on market volatility, there are other risks to portfolios than just market swings. What else should investors prepare for in the quarter ahead?

    Brett Mossman: While we’ve talked a bit about higher volatility, we haven’t really talked about the potential for lower, longer term returns. What’s happened since the bottom of the market in February of ’09, is that the markets had markedly higher returns with markedly reduced volatility versus the long term average. And I think it has artificially set expectations in a bad place for many investors. What I would do is use the lesson that we got at the end of January and early February as a wakeup call. It’s to really make sure that we’re evaluating our portfolios in light of a potentially secular shift of lower long term returns with higher volatility, and then make sure that we’re much more intentional about what we’ve done inside the portfolio. And I would say that intentionality really comes in two areas. The first is that we should be markedly more intentional about how we allocate to the types of products we use. Now this isn’t about stocks and bonds. It’s about how do we use low cost, incredibly efficient index products, how do we start to leverage factor products like Patrick just talked about. And then lastly, where we really want to pay a manager for their expertise to be brought to the market, how do we make sure that we have the right goal for that manager and hire a manager that really does deliver an experience that’s worth paying for? The second area that I think we should be intentional is really we should refocus our efforts as investors on outcomes. We think there’s an essential role in many portfolios for multi-asset class products. Products that have the ability to not just find returns across asset class, but more intentionally manage risk across asset classes. And then at the total portfolio perspective, whether it’s individual allocations to equities or fixed income or using products like the multi-asset class products I just spoke of, it’s let’s just make sure as investors that we understand at the portfolio level how we’re managing risk, where do returns come from inside our portfolio? That is not just guidance for the next quarter, but I think for the foreseeable future, making sure that investors really have this. Understand that it’s not going to be as good as it was, and likely it will be more challenging for both a return and risk perspective.

    Patrick Nolan: One thing I might add to that just to maybe create a little perspective on some work that we’re doing right now, which is trying to get a handle on what does the investor actually stand to gain from whatever the market can provide us? If you think about owning U.S. large cap stocks and core U.S. bonds, right, they tend to be two staples of any U.S. investor’s portfolio. We actually took a look at rolling ten year periods of time, and interestingly, if we were to ask anyone, “What is the rate of return that you think a 60/40 mix of those two assets would give you?” General answer we tend to get is about six percent, historically. Interestingly, there were 23 years of rolling ten-year periods where if you owned that mix, you not only beat six, but in every single instance, you were above eight, and you actually topped out around 15 percent. There is an old adage, “Don’t mistake brains for a bull market.” All I really needed to do in that time period was to index those two exposures as cheaply and tax efficiently as I could get them and get out of the way. The challenge now is where we are today, with U.S. large caps at some of their highest valuations on record, with U.S. core bonds also at some of the highest valuations on record, to Brett’s point, where will they be in the next ten years? What will that next ten year rate of return be? That number over the next ten years could be something more like three or four. And all of these things that we’re talking about here, whether it be factor products, Brett’s got a great call out of multi-asset products. These are all things that we think are the key pathways to helping advisors and investors get to that rate of return that they more are thinking about, even if the markets aren’t prepared to provide it to us as robustly as they have in the past.

    Elizabeth Koehler: I personally would prefer the eight to 15, but that’s really important guidance. Thank you both. So one last closing question for you, Brett. How do you see your team’s role evolving over the next few years?

    Brett Mossman: I think the next few years tends to look a bit more holistically at financial advice rather than just purely portfolio construction. From a trend standpoint, there are a couple areas where I think evolution will occur. The first is that we need to work collectively as investors, as advisors, as money managers, to make sure that we fully tap the power of technology not just to improve the scale and the efficiency that we have as portfolio constructors, but just to make sure that we can understand as much of the experience and remove as much of the uncertainty as we can about the investments that we put our money into. The second is to make sure that we create a great degree of personalization in the outcomes we have. Now that doesn’t mean that every single person should have a highly personalized/customized portfolio. Because of the complexity and because of the difficulty in following that portfolio, I think more often than not, it does more harm than good. But what I am suggesting here is we should make sure we have a very personalized approach on outcomes, on taxes, on costs, making sure that our objectives are always known and embedded fully within the portfolio that we built. I think all too often, many people base most of their decisions as they build portfolios based on the point in time that we’re at in the markets. But most of the investors who invest in those markets aren’t necessarily needing their money at that point in time. And the last thing I would say is this, I think this is personally a great time to be an advisor. I think it’s a great time to be an investor. Although volatility may be higher and the returns themselves may be lower, I think if we focus in earnest on realistic outcomes from a portfolio construction standpoint, that we link them to financial plans that should be thoroughly and completely vetted, that it’s a great time for us to think about how do we best manage the needs that we have, the wants that we have, the wishes that we have, with the constraints that are in place from the market, and make sure that we’ve made the best possible decisions focusing on us rather than just focusing on the markets.

    Elizabeth Koehler: Great. Brett, Patrick, thank you so much for sharing your insights with us today.

    Patrick Nolan: Thanks Liz, great to be with you.

    Brett Mossman: Thanks Liz, it was an absolute pleasure.

    Elizabeth Koehler: To our listeners, we’ll see you next time on The Bid.

Episode 10: A new Waze of investing

GPS apps help drivers get to their destination as quickly as possible, providing the efficiency and ease that consumers have come to expect from technology. But GPS apps aren’t the only way that individuals are getting more efficient. According to
Rick Rieder, Global Chief Investment Officer for Fixed Income, rapid changes in technology are dramatically influencing the way we live and invest.

  • View transcript

    Voiceover: Let’s take East 52nd Street Manhattan.

    Dennis Lee: That’s Waze, my go-to GPS app. Waze gets me to my destination as quickly as possible and informs me of any diversions along the way, whether it’s construction, accidents, and even potholes. That’s the way we expect our world to operate these days: We like efficiency and fast-moving technology. But Waze isn’t the only way we’re getting more efficient in our day-to-day lives. According to Rick Rieder, our Global Chief Investment Officer for Fixed Income and today’s guest on The Bid, rapid changes in technology are dramatically influencing the way we live and invest. I’m your host, Dennis Lee, we hope you enjoy.

    Rick, thank you so much for joining us today.

    Rick Rieder: Thank you for having me.

    Dennis Lee: So technology has made some pretty big changes to our everyday lives. We’re seeing some revolutionary but simple efficiencies like mobile banking and mobile payments come into play, as well as entirely new and more complex speculative assets like cryptocurrencies. So set the stage for us: What is driving these changes?

    Rick Rieder: So I think this is something that is unbelievably historic, and I think we’re going through the greatest technology revolution of all time. And I think it has to do with data storage, the cost of data transmission, the speed at which that data can be transmitted is extraordinary and hitting every possible part of our everyday life. And I think millennials growing up and being comfortable with that technology and respecting and trusting that technology is changing the whole framework today. And I call it the Waze Economy. We’re going to find the best way to get to our destination, and sharing the information flow of what is happening in front of us is going to mean we’re going to get there faster and more efficiently, and advertisers are going to be able to provide us services along the way. It’s all deflationary. It means that inflation doesn’t accelerate that much higher. Because we are literally in a world of, I need to get an answer, I need to get to what I’m going to do quicker, and by the way, I know what the prices are of everything in the world today. It’s historic and it’s faster than I would argue—I would put it up against telephony and transport, automobile, rail, et cetera. This is a pretty historic point in time.

    Dennis Lee: You mentioned data. A key facet to this new technological landscape is data, how we access it, consume it, and use it. How is data creating efficiencies that we haven’t had before?

    Rick Rieder: You know, I go back to this concept of Waze and how Waze has gotten it right all along. We are getting data that we wouldn’t otherwise have had and have used it more efficiently. By the way, I think that is going to be the greatest controversy for a number of years, about who has the data, who has access to it, how is it helping, in terms of it’s helping me in terms of efficiently making sure I purchase only at the best prices available in the whole world, not just down the block. It’s making sure that I am doing everything that I can do without overdoing it. And whereas I think the great controversy going forward is going to be, people have my data so they can learn more about me than I would want them to know. And I think that is going to be something that is going to be fascinating to watch develop. Because these efficiencies that are being created because we can utilize data effectively has a negative to it. And the negative, I think, is going to be something that we’re going to wrestle with—and regulation will wrestle with for a long time to come.

    Dennis Lee: We had seen people growing accustomed to sharing their information and it seemed as though that was on a natural trajectory. Given recent news, do you see that changing at all in the future?

    Rick Rieder:  I think the way a lot of services are going to be sold going forward is if you are willing to give up the data, you will pay a lower price for that service. And think about what that is. You’re literally thinking about, I’ve got to give up some of my privacy but it’s going to get me a better menu, the telephone companies and others providing you where you think about you’re much more selective about who gets information. The information flow now benefits from scale, but how much do I want to be in my small part in it, and how much do I want people being introspective in terms of me personally for the benefit of what is the broader good? Ultimately, there are going to be services that develop out of it like Waze has, or like an Amazon or Google, et cetera, that are incredibly powerful and drive a tremendous amount of commerce in the country today and in the world today and going forward.

    Dennis Lee: So let’s turn our attention a little bit to how this impacts markets. Last time you spoke with us on The Bid in October, inflation was still hovering at historically low levels. Your thesis at the time was that technology was causing a cost revolution changing commerce today and its distribution mechanisms. And your prediction was that we would start to see inflation trend higher, and since then, we’re starting to see this come true. Do you believe the same structural factors will continue to keep a lid on inflation moving forward, or do you see some of the elements of that thesis unwinding? 

    Rick Rieder:  Yeah. So I think some are certain to change. I think we’ve hit the lowest marginal cost point for a lot of industries and a lot of products. Food, apparel, transportation services, there are still some more efficiencies. I remember over the winter seeing where you could buy coats. Think about you could buy a coat for $8 dollars. I don’t think you can get a lot lower than that when you take into account production, manufacturing, distribution, logistics, et cetera. So I think what’s happening is you’ve hit the bottom price point where the marginal cost of production is pretty hard to shake out from where it is today. But there are other areas that you’re seeing developing, so what has created real inflation over the last couple of years? It’s in the services sector, healthcare is a big one, why are you looking at more and more mergers and acquisitions in the healthcare space, whether it’s generic drugs, whether it’s the delivery services, medical care generally. That’s where you’ve had inflation. That means that’s the next place where you’re going to go for disruption. Education, how do we deliver educational services, which has been this non-stop accelerating at a faster pace than inflation. That can press down. So my sense is that we’ve had nothing but deflation in goods products for years, and services have stayed reasonably high. I think where we’re going now is you can see goods start to trend a bit higher, services maybe come down a bit. But I think we’re going to operate at a higher inflation level than we have. But this is not scary. When you think about it, over the last couple of years, or five years, we’re going to get to two and a quarter, maybe 2.40, 2.50 in core CPI. You put that up in history by the 70s, 80s, and 90s, this is nothing that the Fed would be worried about. Because you still have those deflationary impulses, it’s pretty hard to get a catalyzing event to see significant inflation in them.

    Dennis Lee: What is it about services that has kept prices generally higher than goods? Is it the nature of the specific industry or business? Why are services less efficient in your mind? 

    Rick Rieder: So that’s a tough question, but I think there’s a few things. The more commoditized something is, the easier it is to functionally take away the pricing power of it. You could take a specific good and that one good is the equivalent of another. It’s easy to functionally create deflation around it. Educational services, healthcare services are more personalized, more customized. Those are harder. But when you put together large entities and you take the benefit of scale, whether it’s the JP Morgan, Berkshire, Amazon, you talk about providing that at scale—and by the way, there is another adjunct to that that I think is really important. It’s actually when we’re living in a world of doing the right thing by your employees, and much of what drove some of that is that I can provide a better service to my employees. There is something that is really powerful around that. And I think that will push not just the technology side, but whether it’s a populist movement, et cetera, I think you’ll push more and more to this dynamic of, I’m going to provide services that are lower priced, because it’s the right thing to do and it creates benefits well-beyond just the cost benefits of those people that take advantage of it. 

    Dennis Lee: You mentioned JP Morgan and Berkshire Hathaway, Amazon and now Wal-Mart perhaps, are moving into healthcare, industries typically outside their wheelhouse. How might that impact the inflation dynamic in the future?

    Rick Rieder: So I think about where the system has come from and this concept of goods, and I think the tradition of what was a department store is now a whole new virtual department store. So when you think about years ago, where you could acquire all your goods at a Macy’s or a Nordstrom or what have you, and that was your department store for goods acquisition. If you think about where we are today in a virtual world where you can provide, gets back to this concept of service data storage and being able to provide as much information flow as possible. The new department store is where can you provide the most efficient services? And I quite frankly think through scale, that places like JP Morgan and Amazon, Berkshire, or a Wal-Mart, it is probably a broader network, including an ear of longevity and demographics, that how do you extend your product line to create what is a larger department store over a larger group of people? Virtually. And I think that is a pretty exciting development when you think about how we’ve come full circle from the technology of a traditional department store to know what is the bigger virtual department store in the world today.

    Dennis Lee: Rick, you’ve mentioned before that disruption in investing closely follows disruption in consumption and industrial development. Do you think we’re entering a new phase of investing?

    Rick Rieder:  Yeah, I do. I think investing like other parts of the world is becoming more personalized and more efficient. And you think about the growth of ETFs and indices and portfolio construction where you can take data and break apart different assets. Understand if I look at an asset and I said, “What does that asset do in my portfolio?” It’s got a beta to it, it’s got convexity, it’s got a duration, it’s got a currency risk. If I can separate all those pieces out, then I could think about what is an efficient portfolio construction? And while I’m an individual, I can think about how I want to get exposure to a certain part of the world. I can do that efficiently through an ETF today. I would argue investing has been slower than other industries to really develop technology-wise and really become more customizable, more personalized, and it’s an exciting point in time. And I’ll go back to this analogy that I said about the Waze Revolution and how Waze has gotten it right. If you can think about what are the obstacles or what are the risks along the way in investing? You think about what is potentially going to be in my way, or what is going to create some risk? I can separate that out, think about what assets are the most efficient relative to that, that’s going to get me to where I want to go with what is a more stable return paradigm. I think investing is going to go through – is going through what is a revolution like other industries.

    Dennis Lee: So if we extend that metaphor a little bit more, if you are an investor and you have a portfolio, you could imagine a world where you get a notification on your phone that says you should swap in this fund for another to rebalance your portfolio. Can you help paint a picture of what that might look like?

    Rick Rieder:  Yeah. The other thing that I think is important – and I go back to this analogy of the Waze thing – is what do I care about? I only care about what is relevant to my portfolio. There is an incredible amount of information flow that comes through. And similar to that, I don’t really care about what the traffic is in California if I’m driving in New York. I don’t really care if it’s not going to affect my return, it’s not going to affect my assets that I’m investing in, why do I need that information? But if there is something that I could get an alert on my phone about something—I have investment in this, and I’m overweight to technology, I’m overweight in this area, and how could I rebalance that efficiently, and how do I think about those opportunities, then I think the application of  that is tremendous. And I think you will see much more of that, where you can dial up, not just you think about risk, but you dial up the different components of risk on your phone, and think about gosh, I want to take my beta up, or I want to take my liquidity down, up or down, or what have you, that’s where I think we’re going. And I think it’s going to be much more fluid going forward.

    Dennis Lee: Rick. Thank you so much for sharing your insights with us today, and to our listeners, we’ll see you next time on The Bid.

Episode 9: Is the U.S. leading
a new market regime?

Impending fiscal stimulus has boosted an already strong U.S. economy, and markets seem to be waking up to the return of U.S. inflation. All of this begs the question: Is the U.S. leaping ahead, or is the rest of the world falling behind? Richard Turnill joins us to discuss this shift and what this might mean for markets.

  • View transcript

    Liz Koehler: The synchronized global economic expansion rolls on, but with material changes from last year. Impending fiscal stimulus has boosted an already strong U.S. economy and markets seem to be waking up to the return of U.S. inflation. All of this begs the question: Is the U.S. leaping ahead, or is the rest of the world falling behind? On this episode of The Bid, our Chief Investment Strategist, Richard Turnill, joins us to discuss the shift in momentum from global to domestic and what this might mean for markets. I’m your host, Liz Koehler, we hope you enjoy.

    Richard, thank you so much for joining us, it’s great to have you.

    Richard Turnill: It’s great to be here.  Thank you for inviting me back.

    Liz Koehler: So Richard, the BlackRock Investment Institute recently updated their view on U.S. equities from neutral to overweight. Can you tell us a little more about the reasoning behind this? Is the U.S. now leading the global economy?

    Richard Turnill: Thanks Liz. So you’re right, we’ve become more positive on the outlook for U.S. equities, and the context for that is we think we’re in a market environment where returns are going to be driven much less by valuations going forward, and much more by earnings growth. And as we look forward, we believe we’re in an environment where the U.S. is going to play a greater role in driving global growth, both around GDP but importantly around earnings. We’re starting to see some signs of China slowing, and we expect that to continue as the Chinese authorities focus more on supply side reform. We think that will be a gradual slowdown, but we’re seeing signs of that gradual slowdown unfolding. We’re seeing some evidence that the European growth rate is stabilizing after a big acceleration. Last year in fact, probably the biggest single global growth surprise last year was around the outcome for European growth. That looks like it’s coming to an end or at least stabilizing. Whereas in the U.S., we’re seeing strong growth today but importantly on the back of the very large fiscal package announced, which we see boosting U.S. GDP growth by over one percent this year and boosting earnings significantly more. We see the U.S. being a key driver of global growth and in this market environment, we think that is going to be the most important factor driving returns.

    Liz Koehler: So Richard, when we think about some recent stock swoons like the one we had in early February, it rattled markets and investors alike. Yet we have seen that stocks have already retraced a large part of their losses. Do you think that these short-term swings might just prove to be blips when we look back at year end?

    Richard Turnill: For those of us who have seen a few market cycles, Liz, then the environment we’ve seen over the last few months actually feels really like a return to a much more normal market environment. I think it’s worth reminding ourselves that 2017 in particular was really an extraordinary year: it was a year in which we saw double digit returns, actually close to 20% returns from many equity markets around the world, record low levels of volatility and broad-based, very strong returns for any risk assets. This year already by contrast, we’re seeing lower returns, we’re seeing economic growth no longer surprising consistently to the upside, particularly outside the U.S. We’re seeing some signs of inflation coming back, albeit gradually, and we’re seeing some return to political risk, which we haven’t seen for some time in terms of driving markets. And as a result of that, volatility has increased and market returns have gone down. I think these periods of temporary market drawdowns are going to be more common, as they have frequently been in the past. But that doesn’t mean investors shouldn’t be invested in risk assets. Actually, quite to the contrary, I think now what these periods of short term volatility provide are opportunities for investors who have been underexposed to risk assets to put money to work. We know that many investors are still sitting on high levels of cash, and actually more frequently sitting on high levels of fixed income safe haven assets. We still believe that fundamentally we’re in an environment of sustained global economic growth. We still think that’s ultimately going to lead to an environment where risk assets will do well, and we still think we’re broadly in a low volatility regime.

    Liz Koehler: So in my mind it certainly makes the case why clients need to think about staying invested through some of these blips to see the bigger picture?

    Richard Turnill: That’s exactly right, and you think about clients who sold out in February, they’re already significantly behind the market. There’s been a repeated period of short-term volatility, you can go back to some very short-term volatility with the U.S. election, back to the Brexit result back in 2016. All of these periods created short-term volatility in periods of market anxiety—justified periods of market anxiety. But the key message in each of these cases is if you sold out of equities, it is very hard to get back in, and it’s very hard to make that decision. And our recommendation to clients is to take the longer-term view, focus on fundamentals, the sustained positive economic environment, the same positive earnings environment, which suggests you should remain in the market.

    Liz Koehler: That’s great, thank you. So emerging markets also had a stellar year. Do you think that this outperformance in emerging markets can continue?

    Richard Turnill: So Liz, you know we’ve been very bullish on emerging markets for some time. I think a lot of investors have missed the rally, and are worrying about is it time to get in now? Have we seen emerging markets perform so well over the last year or two, is there still an opportunity there? And our message is yes. Going forward, we still see very significant opportunities in emerging markets, particularly on the equity side. We also see debt being attractive, but we see particularly attractive opportunities on the equity side going forward. So why do we like emerging markets from here? Well, a few reasons; I’ll start with earnings growth. Similar to the point we made earlier on the U.S., in an environment where returns are more likely to be driven by earnings growth rather than valuation appreciation, then you want to focus on those markets which are going to deliver sustained high earnings growth around the world. We see double digit earnings growth across many emerging markets, again, in 2018 and beyond. And it’s worth saying that if you look at the earnings cycle, we’ve only just returned to levels of earnings that we saw five or six years ago in emerging markets. Whereas in many developed markets, we’re hitting record highs, so we see lots of scope that earnings growth can continue as many emerging markets are in an earlier phase of their cycle. On top of that though, from a valuation perspective, we still see valuations in EM being relatively attractive. Actually, most of the recovery you’ve seen in emerging markets in the last year has actually been about earnings growth, and emerging markets is one of the few asset classes today where valuations do not look high compared to history at all. In fact, you really are right in the middle of the normal range. And part of the reason for that is investor flows have only started coming back into emerging markets in the last year or two, with many investors having been scarred by their experience of emerging market investing during, particularly, the taper tantrum, which led to those sharp negative returns. And actually, I’d even just cite the recent market experience. We saw volatility in February and March in global markets, it’s really noticeable how emerging markets have held up in that context. Often in these periods of higher volatility, emerging markets are the hardest hit. Actually, that has not been the case at all this time; emerging markets have been resilient. I’d emphasize that there is an increasing number of what I think are restructuring stories within emerging markets. Emerging markets are not simply a geared play on the global cycle. Actually, what you’re seeing is evidence of restructuring, driving sustained growth and returns. So we’ve written recently around some of the very encouraging long-term signs we’re seeing in India. Actually in China, following the National Party Congress, you’re seeing more emphasis on implementing structural reform. I’ve seen many Latin American countries, we’ve been positively surprised by structural reform in the last few years. So we add all that up, we still think this is a great time to be invested in EM.

    Liz Koehler: On the topic of EM, we recently spoke with Gerardo Rodriguez, who is a portfolio manager for our emerging markets business, about global protectionism and the potential risk of a trade war. So obviously trade is one of the focus risks that you and our BlackRock Investment Institute are following quite closely. How fearful are you of a trade war taking hold?

    Richard Turnill: So one of the biggest risks we’ve seen to markets this year is the risk of trade tensions. Over the last few years, you’ve seen increasing interlinkages around the world, not just in terms of direct exchange of goods and services, but also in terms of the confidence effect. So a significant trade war has the potential not only to directly impact growth around the world, but also to hit confidence in a synchronized way. But, what we’re seeing so far we view as actually relatively encouraging in that the proposed measures out of the U.S. administration as yet have been relatively small and actually less severe than many commentators had expected. So for example, the recent tariffs proposal announced by the U.S. administration account for significantly less than not 0.1% of U.S. GDP and only around not 0.1% of Chinese GDP. On top of that, the Chinese response to these measures has so far been contained, and actually measured in proportion in response to that. And I think there is hope that China will look to avoid a trade war and the U.S. approach appears to be open to negotiation. So when I think about the risks around a trade war, I think it’s worth highlighting that those risks are two-way. I think people tend to always focus on the downside risks, that we get significant negative growth. And we have to be very vigilant to those risks at any sign that those trade tensions are increasing, which I think do have the potential to disrupt markets. But there’s a positive outcome here as well worth focusing on, and that positive outcome is actually that trade tensions diminish, and they diminish as a result of the imbalance in tariffs globally being addressed not through an increase in U.S. tariffs but actually a reduction in trade barriers in other parts of the world, particularly China. And that continues to be our base case. So we are hopeful that we will see a benign outcome here, but we have to recognize there are significant risks.

    Liz Koehler: That’s a great point. I think people have been focused on the concern over a rise in global protectionism and what that could mean, but it’s important to look at both sides of this coin. There are some potential positives as well to be considering.

    Richard Turnill: That’s right.

    Liz Koehler: So let’s turn to the fixed income market. We’ve seen a rapid rise in bond yields year-to-date, and it seems like fixed income investors are bearing the brunt of the accelerating economy and inflation. Is this is a trend we expect to continue?

    Richard Turnill: So it’s been a tough year for fixed income investors. And our view is that when we look forward, returns to many fixed income assets are likely to be very low compared to history. So we had 35 years of getting coupon plus returns across fixed income as bond yields fell around the world. And we think that era ended back in 2016. And we’re now adjusting to an era where you’re likely to get coupon minus returns across large parts of fixed income. But I think it’s important to recognize two things. So the first is that fixed income continues to play a very important role in client portfolios. Even though we see lower returns going forward, actually fixed income, and duration in particular, are very important from a diversification perspective. And actually in the very recent period of volatility, it’s notable that fixed income again did its job, actually that duration really helped mitigate some of those risks. When we look forward though, we see rates rising, but rising gradually. And that word “gradually” is very important. What we’ve seen in the past is markets struggle much more in a rapidly rising rate environment, particularly one where those rising rates are not associated with strong growth; they’re associated with bond vigilantes, they’re associated with a buyer strike. So what are we seeing today? Well the first thing is that we’ve seen a significant adjustment in rate expectations already. So this gives us encouragement. So the market is now priced for two further rate hikes here in the U.S. for the rest of this year, so that brings it now fully into line with the Fed dots. Secondly, though, is what we’re seeing in terms of flows. We’ve seen continued positive flows into fixed income mutual funds and ETFs since the beginning of the year. And that’s consistent with this huge excess of global savings we’ve seen around the world, $22 trillion dollars of new global savings this year alone. So we still see many investors around the world, particularly international investors, very focused on matching liabilities and generating income. As a result of that, when you see yields move higher, what you see is flows coming into fixed income yet attracted by those high yields, those higher interest rates which are now available and able to generate positive real return, investing in paper as short duration of two years in the U.S. It gives us confidence that the path of bond yields from here is one of gradual increases, rather than rapid increases. So I’ll put some numbers on that: In five years’ time, we see 10-year Treasury yields somewhere around 3.5%, so not dramatically higher than we are today. That means it’s a low return environment for fixed income investors, but it’s an environment where duration still plays a role in client portfolios and one in which we think that other asset classes can continue to do well.

    Liz Koehler: Richard, as always, thank you so much for your time and for joining us here today.

    Richard Turnill:  Thank you so much.

Episode 8: Treading a trail to
trade wars?

Beneath a benign economic backdrop, profound malaise brews. Populism and political polarization threaten the foundation of prosperity: free-flowing global trade. Gerardo Rodriguez, Portfolio Manager for Emerging Markets, explores how a potential slide toward global protectionism threatens economies and investors alike.

  • View transcript

    Elizabeth Koehler: Talks about trades are saturating the news cycle today, and between proclamations of new tariffs, NAFTA negotiations and talks on Chinese trade practices, worries about a slide toward global protectionism are looming over markets. But will words turn into actions, or are these worries misguided?

    In this episode of The Bid, we look to separate signal from noise with Gerardo Rodriguez, Senior Investment Strategist and Business Manager for BlackRock’s Emerging Markets Group. I’m your host, Liz Koehler, we hope you enjoy.

    Gerardo, thank you so much for joining us today, it’s great to have you.

    Gerardo Rodriguez: Thank you, Liz, great to be here.

    Elizabeth Koehler: Your story is incredibly interesting. You joined BlackRock after more than 14 years in the Mexican Ministry of Finance, where you really spent the bulk of your career participating in the rules-based world order, governing trade and finance. That multi-lateral model is clearly facing some new pressures, whether it’s populism in Europe, the policies of the current administration in the U.S., among others. What does it look like to see where we’ve come to today, given your background, and what do you think the future holds?

    Gerardo Rodriguez: It is a bit of a conundrum what we’ve been seeing lately, because the polarization and geopolitical risks have been going up, precisely at a time in history where people are doing much, much better than in the past. You can look at it from many different dimensions: life expectancy, the capacity to buy things. The world is producing a lot of stuff that is much cheaper right now. So the standards of living across the world are improving and inequality on a global scale has also been improving. So why is it that people are increasing their demands, it looks like, to politicians and asking for a larger seat at the table? In a sense, you have a similar trend taking place in many different places in the world. We’ve seen somewhat similar episodes in the past, perhaps, prior to the First World War where again, the world experienced a massive improvement in economic dynamics. The same thing happened after the Second World War, leading to the student protests and Vietnam protests here in the U.S. When people do better, their expectations rise pretty fast and they demand more. And it’s just not possible to keep that up. And also, you get in the U.S. precisely that immigration has been going up: Fourteen percent of U.S. residents are foreign-born. This is a multi-year high, and that drives some level of anxiety in certain areas of the population. Politicians are able to capture that to get to office, and that drives a lot of these populist movements that we’re seeing in Europe and certainly the type of policies we’re seeing here in the U.S.

    Elizabeth Koehler: So new tariffs, particularly on steel and aluminum imports, have revived a debate on protectionism, both in and beyond the U.S. What do you see as the potential impact of this on the markets?

    Gerardo Rodriguez: The tariffs themselves on steel and aluminum are actually not that relevant by themselves, but I think that the key element here is the strategy that the U.S. is following to back up this policy initiative. Because the use of national security as a justification for these types of tariffs is going to be challenged very likely in the WTO world. There is a perception that that’s not the whole story. And the U.S., actually, when they excluded countries like Mexico and Canada but they use the threat of steel and aluminum as a way to get concessions in NAFTA, actually weakens the case for the U.S. when it comes to the WTO. So what will happen when you have this argument at the WTO 11 of other countries challenging the fundamentals of this policy initiative in the U.S.? There is no precedent. And then what is the U.S. going to do on this, to what extent is the U.S. willing to challenge the WTO as an institution? So again, the tariffs themselves are not that important, but the implications for the global order for trade may be at stake with this recent initiative by the U.S. And we need to watch for that, we need to be careful.

    Elizabeth Koehler: So what you’re saying is, while limited trade actions may not hurt the risk-on sentiment, the potential escalation into a possible trade war could be a pretty disruptive geopolitical risk and we have to watch it, is that fair?

    Gerardo Rodriguez: Well, that is one aspect, and one of the risks is that countries retaliate. Europe has already listed a few things of Harley Davidson and a few other things being produced in key states here in the U.S. But also, there is the issue of whether the WTO is going to be able to handle all of the challenges to the concept of national security as a driver for these decisions, and what the U.S. is going to do about that. At some extreme level, can you think of the U.S. actually leaving the WTO and then leaving the global trade dynamics without a proper set of rules that are accepted by everybody? That is not good for trade, that is not good for the U.S., and that is not good for the world.

    Elizabeth Koehler: Expanding a little bit on what you were describing and in line with talks on tariffs, we know that BlackRock has been monitoring the NAFTA negotiations pretty closely. And we know there is some potential that the U.S. might withdraw from the agreement should attempts to renegotiate fail. What do you see as some of the risks of that type of withdrawal?

    Gerardo Rodriguez: NAFTA is an interesting example, because going back to the thing of WTO that we were discussing, the fears around NAFTA and the reason behind the big selloff in Mexican asset prices and to some extent Canadian asset prices was precisely that the U.S. seemed to be willing to do away with the treaty altogether, just to withdraw from the treaty and leave Canada and Mexico. That wouldn’t be good for economic activity in the North American region. Fortunately, what we’ve seen is that the U.S. has been willing to sit at the table and to come up with a constructive improvement of the treaty itself. And this is very relevant, because to the extent that the U.S. addresses the things that they want to improve when it comes to trade, to the extent that they try to address that through institutional means, I think that that’s good for the world. The U.S. or any country can have a different opinion. They can pursue their own interests, but if they do that through the rules-based global trade order, I think that the world is going to be okay. The problem is when you actually challenge the institution itself. So going back to the NAFTA case, so far, what we’ve seen is significant progress on different chapters that are being improved in the negotiation process and I’m sure that this will get to a positive end. So it looks like the probability of the U.S. withdrawing has been going down materially and because of that, the selloff that we saw again in Canadian and in Mexican assets last year is actually coming back.

    Elizabeth Koehler: Another key part of the trade debate is obviously the U.S. and China relations. Do we see tensions escalating in the short-term?

    Gerardo Rodriguez: So here I think that we have the highest level of risk when it comes to China. And it is because China historically, since they joined the WTO in 2000, they have had the most aggressive trade practices to protect their industries. And because of that, there’s plenty of room, not only for the U.S. but for other countries to challenge China in a more open manner. The non-trade barriers that China has established and continues to use are just massive. And because of that, it is really hard to do business with China, say, to export there, and also to create investments in a free manner, just the way that we’re used to in the western world. So because of that, the U.S. is now exploring this so-called 301 Section, which is related to intellectual property, because there is some evidence that the Chinese government forces foreign companies to have a partial local ownership and forced technology transfer in that way. So we’ll see what comes out from this specific initiative, but it is very likely that the U.S./China trade dynamic is only going to deteriorate going forward.

    Elizabeth Koehler: So despite worries about global protectionism, as we’ve talked about, we’re still constructive on risk assets at BlackRock, and particularly on emerging market equities. What’s behind this constructive view?

    Gerardo Rodriguez: Well, it is true that it is a bit hard to reconcile all this trade and geopolitical risk going up on one hand, and on the other, equity markets across the world doing so well. And looking forward, it looks like this situation can continue. So what is driving the performance of risky assets? It is mainly the good performance of economies. We haven’t had such a synchronized acceleration of global growth since the Crisis, and we saw that clearly last year, not only being a U.S. story but Europe certainly showing significant improvements, Japan, certainly China surprising on the positive side, and emerging economies in general doing relatively well and being at a much earlier stage in the economic cycle with plenty of policy room still to foster growth. So with earnings growth in emerging markets above 23% last year and projections for this year between 13 and 15%, equity markets are likely to continue well-supported in the emerging world going forward.

    Elizabeth Koehler: So despite the fact that we know EM can bring much-needed growth to a client’s portfolio, we also see that many investors tend to be dramatically under-invested in this space. Why do you think that is?

    Gerardo Rodriguez: These under-allocations have been particularly relevant in the current cycle. This has been one of the most unloved rallies for risk assets around the world. What we’ve seen in the past two or three years is that equity markets are doing really, really well, but people are still hesitant to embrace this trade. It is somewhat related to the damage done during the Crisis. But when it comes specifically to the case of emerging market equities, it is an asset class that tends to be more volatile than U.S. equities. And because of that, what we see is that people are just reluctant to invest. The average allocation of U.S.-based investors is only around three percent. And there are around 40% of U.S.-based portfolios that own no emerging market exposure. So recently, there have been different initiatives to try to find ways to reduce the volatility and make the emerging market investment case more appealing to the average investor in the U.S.

    Elizabeth Koehler: And help keep clients invested so they can gain access to that growth over time.

    Gerardo Rodriguez: Yes. And the emerging market story is one particularly of higher expected growth, and with that comes higher expected returns. So how can you participate in that and at the same time, perhaps, avoid the big drawdowns that may come with a higher volatility asset class? That is the challenge of emerging market equity investing.

    Elizabeth Koehler: Makes sense. Last question, you like to run and you’re a big podcast listener. Can you give us a sense of some of your favorites?

    Gerardo Rodriguez: Well, I think that podcasts are actually the perfect match for outdoor and indoor running. One of my favorite podcasts is Freakonomics. The Tyler Cowen podcast, that is one of the best economic podcasts. EconTalk also is one of my favorites. I like Tim Ferriss as well. And for those that like sports, The Bill Simmons Podcast is actually pretty good.

    Elizabeth Koehler: Great. Thank you so much Gerardo, we really appreciate you sharing your insights with us today.

    Gerardo Rodriguez: Thank you for having me here.

Episode 7: Maxing the factors of market outperformance

How can investors beat the market? One group at BlackRock is challenging the notion of traditional stock picking, instead zeroing in on certain factors to help lead to outperformance. Head of Factor Investing Strategies Andrew Ang explores how scientific, rules-based approaches to active and index investing have created unprecedented drivers of return.

  • View transcript

    Dennis Lee: How can investors beat the market? While the age old question unfortunately doesn’t have one answer, one group at BlackRock spends their days thinking about this very differently. Rather than relying on traditional methods of just picking individual stocks, this team zeroes in on certain factors to help lead to outperformance. Forty-five years ago, if you invested one dollar into the MSCI World Index, you would have about $34 dollars today. Not bad. But if you invested that same dollar into MSCI Momentum index, you have $98 dollars. Much better.

    In this episode of The Bid, Andrew Ang, Head of Factor Investing Strategies, explores how scientific, rules-based approaches to active and index investing have created unprecedented drivers of return. I’m your host Dennis Lee. We hope you enjoy.

    Andrew, thank you so much for joining us today. You publish a monthly commentary called Andrew’s Angle, which gives your perspective on factor investing. But before we dive deeper into that and factor investing itself, I do want to explore a little bit more about you personally. So how did you get here, how did you end up as a leader in this topic?

    Andrew Ang: I started off as a professor; I was a professor at Columbia for 15 years and in 2015, Larry Fink invited me to join BlackRock. And I’ve always studied factors, I’ve always believed in the power of factors. And I’ve worked with very large institutions as a professor and advisor and consultant. At the leading largest institutions that are practicing factor investing, factor investing has become a culture. It’s become a way for their private market colleagues to talk collaboratively with their public market colleagues, to look at their whole portfolio in one and to understand the risks, to look at efficient sources of returns, and to build robust portfolios to meet their liabilities and to serve their beneficiaries. It’s become far more than just factors in investments. And I wanted those same benefits for factors not only to be available to the largest, most sophisticated institutions, but to a widespread audience.

    Dennis Lee: You often write that factor investing isn’t some new invention. As you mentioned, institutional investors and active fund managers have been doing this for decades. So what’s really changed that we’re making those methods more broadly available, and how are we able to do that? Does technology play a key role?

    Andrew Ang: It plays an absolutely essential role, and you are absolutely right that these things are not some new invention – they’ve been done for decades. Value investing dates back to 1934. Two professors, Benjamin Graham and David Dodd, at my former institution, Columbia, wrote that seminal book, Security Analysis, in 1934. The first references to momentum that I know of in its modern form, of cross-sectional and times series momentum, date back to 1928. But I think it’s very similar to your phone. And on your phone, you have maps and hotels and you have airlines: all of those things we had 30, 40 years ago. But the ability to put that onto a phone has transformed our lives. And so buying cheap or finding securities that are trending, finding companies with high-quality names, gravitating to safety in minimum volatility strategies, finding companies that are smaller or more nimble, none of that is new. But the ability to do that transparently, to do that in a multi-asset context, to put it into an efficient vehicle, tax efficient and efficient from an implementation point of view, well, that is like the phone. It transforms our portfolios. The best revolutions are those that take something that is familiar but they put it into a new form, make it widespread, democratize it, and thereby, transforming our lives.

    Dennis Lee: So I want to get a little deeper into the mechanism of factor investing. If I were to set out to invest on my own, buying cheap stocks, companies with strong earnings or trending companies, why wouldn’t that work? And how are factors different than what some investors are already doing it on their own?

    Andrew Ang: You might be satisfied with a pure market exposure, you might be the market, but sometimes you want to beat the market. And you might start to add some of these return enhancing factors like value, quality, momentum, or size. You might also want to reduce your risk. You would like retain the same type of market returns, but experience a less volatile path and minimum volatility strategies allow you to do that. So there are some managers that are factor investors in disguise. And it’s very similar to what has happened in my music playlist. Now I’m old enough that I used to buy even cassette tapes. I used to buy LPs, I used to buy CDs, and I used to buy plenty of them just for one track. But the ability of iTunes or streaming radio, Spotify or whatever music service that you have, has improved my playlist and I buy exactly what I want, listen to tracks that I want at the time that I want. And as a result, my music experience has improved. In asset management, it used to be like that, that you used to go to one fund manager and you had to buy the whole LP, or the whole cassette tape. But you don’t have to do that now. You can buy factor exposure, we can buy market exposure, and we can buy security selection and pay appropriate prices for each of those. And one of the exciting developments now is to look at some managers, traditional managers, that are really just doing static factor exposures, but we can take that in a more efficient way: Tax efficient, cost efficient, and from an investment perspective, with more efficient factor exposure.

    Dennis Lee: Great. Help me understand something: if factors seek to outperform the market, are investors taking on excess risk by incorporating them into portfolios?

    Andrew Ang: It’s a great question. Because I think who wouldn’t want to buy cheap and find companies with high-quality earnings and look for those companies that are going up? So all these factors give us long-term performance, but we have to deviate from the market in order to do that. And sometimes, that means we might underperform the market. But in the long run, a large body of academic literature – six Nobel Prizes in fact – and long investment experience by practitioners have shown that these types of factors lead to high, risk-adjusted returns. We also might think about reducing risk with minimum volatility, but again, these are long-term statements over a full market cycle. We might expect the same return as the market, but with reduced volatility. In the short-run, sometimes we might deviate from that market and we might open ourselves to some disappointing returns, relative to the market.

    Dennis Lee: There is a perception that factor investing is an unconventional way of investing. What are some of the mental barriers that investors have? Why isn’t everyone jumping aboard the factors train? It seems like everyone should.

    Andrew Ang: Everybody is already a factor investor. The difference is whether people are doing this directly and having meaningful conversations about which factors would be appropriate and targeting them and holding them in efficient vehicles, or whether they are doing factors indirectly, in an ad hoc manner, sometimes that they might not know about. I like to think of factors as to investments as to what nutrients are to food. And there is nothing wrong with ordering off the menu. You might have an appetizer, main course, and dessert, but sometimes you have to look through to the nutrients. You might be allergic to something, you might be training for a marathon so you need another dose of a nutrient that other people might not have. And those are especially powerful situations where looking at the nutrients of investing, factors, will improve our portfolios.

    Dennis Lee: So one last closing question, what are you most excited about in the next several years? How do you think factor investing will evolve?

    Andrew Ang: We’re just at the beginning. The next couple of years we’re pushing the frontier of these factors: value, momentum, quality, size, minimum volatility strategies, carry or income, beyond equities to fixed income, to other asset classes. We look at this going long and short, not just in long-only vehicles. We look at fully holistic views of our portfolio, recognizing the factors in our private markets, like real estate, private equity, infrastructure, just as easily as we do in our public equities portfolio. We think about factor allocation and balancing those nutrients, mapping them to our asset class foods. This is so exciting; factor investing is in the beginning innings, and I think at the best funds, the largest, most sophisticated funds, factor investing has actually gone beyond just investing in factors. It’s become a common language that all these investments share so that we can meet the objectives of the whole fund and our total portfolios.

    Dennis Lee: It’s almost the genome of investing overall.

    Andrew Ang: I think it’s the soul of investing.

    Dennis Lee: Andrew, very much appreciate your time and thoughts today. For our listeners, if you’d like more info on factor investing, check out Andrew’s Angle on We’ll see you next time on The Bid.

Episode 6: Steeling for a market snapback

With unexpected momentum from U.S. tax reform and potential volatility spikes from central banks globally, investors need to be prepared for potential snapbacks. Jeff Rosenberg discusses the role of fixed income in a market that’s heating up.

  • View transcript

    Elizabeth Koehler: In a market where equities dominate headlines, fixed income has stayed relatively out of the spotlight. 2017 was an incredible year for stocks, and while expectations are tempered for 2018, it seems this bull will keep on running.

    But it’s precisely in these times where fixed income plays an important role in portfolios, and needs its time in the sun. On this episode of The Bid, we’ll talk to Chief Fixed Income Strategist Jeff Rosenberg about why fixed income is still important to portfolios today, perhaps more than ever, and what investors can expect in the year ahead. I’m your host, Liz Koehler. We hope you enjoy.

    Jeff, thank you so much for joining us today.

    Jeff Rosenberg: Thanks Liz, great to be here.

    Elizabeth Koehler: So we have a small challenge on today’s podcast. As of this recording, the Dow is over 25,000, even Bitcoin is worth almost 15,000; but we’re here to tell a compelling story about fixed income.  So before we dive into the drama of tightening credit spreads or the potential rise of inflation, I just want to ask you: What gets you out of bed in the morning? What do you love most about being a student of fixed income?

    Jeff Rosenberg: Well, I hope our listeners will find fixed income dramatic, rising inflation and tightening credit spreads. It's not quite the sexy story that Dow 25,000 or Bitcoin is, but I’d answer the question first by saying, I’m not a student of fixed income; you have to be a student of the markets. Larry says that a lot, it’s a big theme here at BlackRock. You can’t understand what is going on in interest rates without understanding what is driving the Dow to 25,000, what is going on with Bitcoin. What gets me out of bed in the morning? I’ve always been interested in this job because I’ve been very interested in financial markets, the idea of a place and a measurement, the price of the amalgamation of all of these individual actors coming together. And you can see in the summary measure, the price and its movements, all of this incredible complexity and diversity. My entry into the field was the quantitative aspects, the incredible application of hard science to finance. But what we found, particularly through the Financial Crisis, is that you can’t only view it from this perspective of hard science. It’s ultimately the actions of human beings – it is a social science, not a hard science – when we’re talking about financial markets. I spent a lot of my academic and practitional career applying hard science techniques. It’s this intersection between people, the arts and science together. That’s what gets me out of bed in the morning, and what got me out of bed this morning was my 10-year-old with a 102 degree fever. So he’s staying home today.

    Elizabeth Koehler: I’m sorry to hear that.

    Jeff Rosenberg: Yes.

    Elizabeth Koehler: But I really like that blend of art and science. Getting back to your point about complexity, sorting through the complexity, what do you think were some of the most important headlines of 2017?

    Jeff Rosenberg: There were so many. There were obviously the obvious ones, the politics, the election. The ones that I think a lot of U.S. investors maybe forgot about is how important the French elections were, and that was a huge surprise and a big change for currencies, for market performance. Our European colleagues are much more centered on that; U.S. sometimes can get a little centered on the Republicans and the tax bill, and obviously the administration and Trump. But that was a really big deal: We went into 2017 with a lot of fears over European disintegration, we were going back to that. Macron really changed that narrative quite dramatically and had some significant investment implications. The other big significant headline is the one that we just absorbed. If you asked most people expectations on fundamental tax reform, it wasn’t supposed to happen in 2017. That was not where the center of the market distribution was, and it really kicks us into the 2018 outlook as a critical theme. But that was a surprise that it happened as quickly as it did.

    Elizabeth Koehler: Great. So you mentioned the 2018 outlook, and in that outlook, you’ve written that we believe inflation is poised to make a comeback. What does that tell us about the economy and what do you feel that means for investors?

    Jeff Rosenberg: So I guess to understand the theme “inflation comeback” is to answer another of the previous questions, the significant headlines, and even the significant surprises of 2017 was that in the U.S., inflation disappointed. And we came into 2017 off of 2016 with inflation on the rebound and a lot of expectations in 2017 that that would continue, and it didn’t. It turned the opposite direction. And so “inflation comeback” for 2018 is about that experience in 2017 really being a temporary one-off, technically driven with wireless services, being really temporary. But there is another part of the narrative that is still evolving relative to when we published “inflation comeback,” which was really prior to that other major significant headline in 2017, which I just mentioned, which was the tax bill. And the tax bill is creating some additional momentum to the outlook in 2018 that is not really fully factored into markets, into expectations for growth and inflation. And on top of that is the spending part of fiscal policy. So when you put tax reform together with spending initiatives, and all these initiatives are uncertain and they’re in front of us in terms of the headlines, you are talking about the potential for a major uptick in fiscal policy’s contribution to growth. And I think it’s one of the core issues for our 2018 outlook, is just how much of a lift do you get and at what inflationary consequence, how quickly in terms of realized inflation. More importantly, because I think it will happen sooner, is how quickly does it affect inflation expectations?

    Elizabeth Koehler: Jeff, we’ve seen little volatility coming out of the last few rate hikes and we’ve projected the Fed is poised for three rate hikes this year, possibly a fourth. Are markets pricing this in, and what should investors be watching?

    Jeff Rosenberg: The question is very U.S.-focused, and here I would say we expect the least contribution to volatility from the Fed relative to what we might see from, say, the ECB and the BOJ. When it comes to what is priced into the markets, about two and a half hikes are priced in. It’s moving during this time period that we’re recording this quite aggressively, so I’ll put it that way. And so you still have a market that is underpricing relative to three, and certainly underpricing relative to the possibility of four. There are a lot of good reasons for why that is the case. You’ve had a persistent disappointment with regard to the pace of Fed hikes. 2017 was the first year that the Fed delivered on its projections for three hikes. And that was kind of surprising. 2018 is shaping up much to be the same with the upside potential. My earlier comments around growth and the contribution from fiscal policy might push us even beyond that. But the Fed has been very clear to be the most transparent and gradual and to put itself on autopilot. Where we have real potential for volatility in global rates markets, and even if you’re not invested in global rates markets and it’s just a U.S. fixed income portfolio, the impact back on U.S. rates is from those other central banks, the ECB outlook and the BOJ outlook. We saw a little bit of this volatility in terms of some of the changes to the sizes of the BOJ, a lot of anticipation as to what the BOJ is going to do with regards to its program on yield curve control, and a lot of anticipation as to what the next evolution of the ECB will be. And this will start to happen around June or July. In September, the ECB is going to have to clarify what they do next with their balance sheet, and there, there is a lot more uncertainty because there’s not been as much forward guidance for the 2018 outlook relative to what the Fed has done.

    Elizabeth Koehler: That’s great. Well, just like there’s been no lack of headlines in 2017, it sounds like there is a lot to watch heading into the new year, too. Jeff, when we look at BlackRock’s own 2018 investment outlook recommending taking risks in equities over credit, and that credit spreads themselves are tightening, how should investors think about investing in fixed income?

    Jeff Rosenberg: So just to elaborate a bit about the context, because the premise to the question is about contextualizing fixed income relative to overall portfolio allocation. So the broad BlackRock Investment Institute outlook for 2018 is, to summarize it very simply, a supportive growth environment, inflation comeback, reduced return expectations relative to risks, relative to 2017 where everything went right. But still a pro-risk portfolio stance where for most of the regions of the world, we have overweight recommendations to equities. And so the tightening in spreads at this level, given what has occurred over the last couple years, leaves less room for tightening going forward. And in fixed income, that lack of tightening means most of the return potential from credit exposures comes from income. And if you have an income-centric portfolio, that’s a very good place to be. We think it’ll still continue to be that way in 2018, and a benign environment for defaults and default risk given the backdrop of economic growth. But if you have a portfolio that already has a tremendous amount of equity exposure, then what should we be doing in fixed income? We should be focusing on fixed income for its diversification properties, that’s ballast, that’s higher credit quality, it’s more liquidity, it’s less fearful of duration in that kind of environment because duration is a friend. Now we expect interest rates to rise, so there is a cost to this diversification, there’s a cost to the ballast. So some of the strategies we want to employ within fixed income are, “how we can minimize those costs of rising interest rates while maintaining some of that core role of fixed income?” And those solutions are pivoting toward more floating rate exposure, having some of that floating rate exposure in higher quality floating rate exposure. Traditional floating rate is bank loan kind of exposures. Those are very high income but higher credit risk, more economically sensitive instruments. If we’re looking at the higher income areas of the market like high yield, we might pivot more of that toward bank loans, take out some of that interest rate risk. And looking at TIPS as a substitute for ballast in my fixed income portfolio because they’re going to have a little bit better performance outcome in an environment of rising rates, because of where they’re pricing inflation we think is underpriced relative to where we see some inflation expectations. In a world where if everything goes well, you’re not going to need the diversification and interest rates are rising, but you have the diversification in case everybody’s forecasts, including our own, prove to be wrong and in which case fixed income is going to be important.

    Elizabeth Koehler: I think fixed income is very exciting, and what you’re telling us is that the role of fixed income really matters, so it’s critical for clients to understand what they want their fixed income to do in their portfolio and to invest accordingly. One last closing question that we get from some of our clients, which is around book preferences. So you’ve recently authored the annual blog post by BII, outlining our strategists’ book recommendations for the holiday season. On our last episode, Richard Turnill mentioned he was looking forward to picking up The Secret Scripture by Sebastien Barry. Which book are you looking forward to reading this winter?

    Jeff Rosenberg: I did author that post and my recommendation—I’ve already read it—so my recommendation was to reread it, and it was in reference to the Bitcoin enthusiasm, and it’s Charles Kindleberger’s classic Manias, Panics, and Crashes. And so that should give you a hint as to where I stand on Bitcoin. And I think we’ve seen some of that already. And so that was a good read.

    Elizabeth Koehler: Wonderful. Well Jeff, thank you so much for sharing your insights with us today. I’m sure we’ll continue to circle back with you and the rest of the BlackRock Investment Institute as the year unfolds. Thanks for your time.

    Jeff Rosenberg:  Thank you.

Episode 5: What’s greater than great?

The global economy seemed to hit its stride in 2017, and 2018 looks to be starting off on a similarly high note. Global Chief Investment Strategist Richard Turnill dives into the drivers of this run, and answers the tough question: Can it persist?

  • View transcript

    David Brodnick: MAGA. MAH-GA? “Make American Great Again.” However it's pronounced, the saying harkens back to a purportedly better economic time. And when was this golden age, exactly? Estimates vary, but if we had to pinpoint one period in the past, the 1960s feels about right – it was a time of astounding, stable and prolonged economic growth.

    Now surely there's more to national greatness than the duration of economic cycles. But that said, by this measure, the current one is just months shy of being the second greatest in U.S. history. In this episode of The Bid, Richard Turnill, our Chief Investment Strategist, will dive into the drivers of this tremendous run of economic growth we’ve seen and ask the tough question: Can it persist? I'm your host, David Brodnick, we hope you enjoy.

    Richard, thank you so much for joining us today.

    Richard Turnill: My pleasure, great to be here.

    David Brodnick: So it was this past summer that we last spoke, and I recall this collective feeling that the global economy was just starting to hit its stride. Obviously since then, we’ve heard the phrase synchronized global expansion kicked around a lot in the financial media. Can you just characterize for us what exactly transpired in the back half of 2017?

    Richard Turnill: Well, first of all, David, it was a tremendous year for investing in risk assets and we’ve candidly been surprised by quite how strong returns have proven to be. We’ve been positive on markets, but candidly I don’t think anyone has expected to see a 20 percent return from the S&P and even higher returns from many international markets. And what has driven that has been this synchronized lift in global growth. Growth has been above trend in every major region simultaneously really for the first time since the global financial crisis, and it’s that breadth of growth which I think has given confidence to investors to reenter markets. At the same time, volatility of economic data, the volatility of earnings has been incredibly low. So this has been a near perfect environment for risk investing, and in that environment you’ve started to see many investors reassess their portfolios and reassess the appropriate risk premium in markets, and that’s clearly provided a big lift to many equities in particular.

    David Brodnick: So looking at the corporate bond market and stock market, over these past couple months and given where valuations currently sit, it seems that the markets are pricing in a continuation of this sort of goldilocks environment. Do we share the view that this sort of backdrop is likely to persist?

    Richard Turnill: Well the first thing is I would hesitate to use the term goldilocks because, certainly for people in my generation, I associate goldilocks with the late-1990s, with a period of highly elevated valuations, the perception that this time it’s different. And actually when you look at markets today, yes, they’re pricing at better outcomes. You’ve seen a rerating across equities and fixed income since the beginning of the year, but they are far from pricing in at any sort of extreme outcomes very different from the peaks of previous cycles. I don’t think we’re anywhere near the type of goldilocks market environment that we saw previously. So when look forward, where we do agree is that we think there is favorable economic background, that being one of stable growth, central banks very gradually raising interest rates or exiting QE. And where we really differ from the consensus is how long this cycle could run. We see the cycle having potentially years to run. So we are in our view approaching the middle of the cycle, approaching the point where output is reaching full capacity in many economies led by the U.S. But what we’re seeing historically is once you reach that point, typically the cycle runs for several years. And this is a cycle where growth has really played out in slow motion. And even though we’re starting to build up some capacity constraints, the rates at which that is happening implies that this cycle could well run for another two years if not significantly longer.

    David Brodnick: So we seem to be of the view, it sounds like, that markets haven’t reached the state of euphoria similar to the late-90s or let’s call it 2006/2007, so we’re not at the sort of extremely stretched valuations that would give us pause. What kind of tells would you be looking to see that would suggest to us that we might be entering this latter stage of the cycle?

    Richard Turnill: We’re in the ninth year of the bull market now and the S&P is hitting all-time highs, many global markets hitting all time highs, Bitcoin up four digits, Da Vinci painting being sold for a record price. There are lots of potential signs that commentators will point to and say, look, clearly this is a sign of euphoria in markets and it can’t be sustained. We disagree on two fronts. So first, we disagree that what we’re seeing today across the bull market is anything close to euphoria. The second point is even if there was euphoria, what history teaches you is that can last for a long time. So why do we think we’re not seeing signs of euphoria today? Well, the first is when we look at the valuation of markets, markets are trading at above their long-term average, in most cases. They’re trading above their long term averages because volatility is incredibly low, we’ve had significant financial regulation, the world is a safer place, and the financial system is a safer place than it was going into the global financial crisis. We’ve got huge excess savings which are holding down the level of bond yields. And that justifies higher valuations. So we take all these things into account – actually, when you look at valuations across most risk assets, they look very reasonable to us, they don’t look stretched, they certainly don’t look extreme. You also just don’t hear the language of “This time it’s different,” you don’t hear that, “Yes, of course you can justify record valuations because growth is going to be strong forever, the cycle is dead, technology is changing the world, inflation is confined to history.” The reality is, most investors are actually still relatively cautiously positioned. And the reason for that is that the memory of the global financial crisis is a very vivid one. What are we seeing in terms of flows? Now we’re seeing that flows are coming back into risk assets, but really in a very gradual way. What we’re not seeing is a great rotation. Particularly, when you look in many client portfolios, what you see is those portfolios are still typically relatively conservatively positioned. In fact, this year we’ve seen record flows into fixed income assets. So that feels like an environment which is a long way away from a euphoric one. And then finally, I would add we would look for signs of financial leverage in the system. One of the big warning signs/big red flags particularly in the 2005 through 2007 period was this big buildup in financial leverage, which is often a warning sign of a potential shift to a different risk regime. In fact, all major shifts to sustained higher volatility regimes have been associated with some pickup in financial leverage. And in aggregate, we don’t see that today.

    David Brodnick: So this may come as a shock to you, but as the host of a podcast, I am myself a millennial. For those of us who enter the workforce, the entirety of our professional and investment career has been on the back of the global financial crisis. We’ve been in this period of consistent gains as we cross the decade mark on this economic cycle. For those of us who haven’t experienced a significant economic downturn or a significant market shock within our lifetime, what would your advice be as someone who has seen the tech bubble, seen the financial crisis from the driver’s seat?

    Richard Turnill: So David, it’s interesting. Thinking about this, there are a lot of people here at BlackRock, a lot of people who invest in markets, who simply have never seen a bear market. They’ve never seen a major recession. They’ve only seen markets go up persistently, they’ve only had their professional lives in an environment of low volatility. I go back in time, I saw Sterling getting kicked out of the ERM back in 1992, the building and then bursting of the tech bubble was an extraordinary environment. I recall looking out of our offices here in London and seeing a queue form outside of Northern Rock over the road. I thought a run on a bank was something consigned to history. So one of the lessons to me is that you’ve got to be open-minded. You’ve got to imagine an environment in the future which is potentially very different to the one that we’re having today. And we believe in this favorable environment, we believe that it will last a long time. But it will change at some point in the future, and we have to be very cognizant of that. The second thing is, I think you have to learn to adapt to the environment, in that I know many people doing careers now, working in industries now – those industries didn’t even exist when they left college or university. And I think from a financial markets perspective, again talking about my own experience as well, which is that many of the best investment decisions that I’ve made in my career were not made because I had amazing foresight and I had the ability to predict major turning points in markets. But I was able to react when they happened and react quickly. It’s easy to think the world will always be one way, and when it changes, sometimes it’s very hard to react to that. And part of that is about thinking ahead and really answering some of the questions you’ve asked today, David, which is “What would make you change your view?” And then when you’re seeing that, being in a humble enough position to actually recognize that the world has changed and you need to change your thinking and the way you make decisions.

    David Brodnick: So a bit of a digression here: My own reading this holiday season I’m looking forward to is Andrew Lo’s adaptive markets hypothesis, confronting the bounds of one’s rational construct or heuristic to the world is such an important skill. As you’ve reflected upon, Richard, it’s that the gains aren’t made necessarily when the markets are on the upswing and you’re outperforming your benchmark sizably and everything is rosy, but it’s being able to be adaptive when a period of fear or concern strikes and the ability to be positioned, be it professionally or within your portfolio, appropriately that can be the greatest cause for success in the long term. Richard, I’m hopeful that over the holidays you will have spent some time in front of a fireplace reading some wonderful book – I know BII recently released their holiday reading list. What book would you suggest to our listeners as a good read for this time of year as we look to confront another year of investing?

    Richard Turnill: So this is always a tricky question, because the reality is what I want to say is that I’m going to read some amazing academic book that everyone is going to think I’m super-smart, I spend my life reading literature such as Andrew Lo’s book, which you just highlighted, which is a tremendous piece. But the reality is when I clock off and go and sit in front of a fire somewhere, I really like to read fiction and unwind and take my brain away from the turbulation of financial markets. So one of my favorite authors is an author called Sebastian Barry. He’s been around for a while but I’ve only recently started reading his novels. I’ve read two so far: A novel called Days without End, which is about the Indian wars and actually the American Civil War, and then a subsequent book, called A Long, Long Way, which is actually about the Irish in World War I. And he’s a tremendous author, writes beautifully, he always write from an Irish perspective, in fact, many of his books are based around multiple generations of the same two Irish families. And for sort of no good reason, I seem to be reading them in reverse order, in that I think his original book that was really brought into the public was called The Secret Scripture, which I have not yet read and recently downloaded onto my Kindle. I’m looking forward to sitting down the next couple weeks and reading that.

    David Brodnick: Terrific. Well, Richard, thank you so much for spending the time with us today and here’s hoping you have some restful time off ahead of you.

    Richard Turnill: David, great to speak to you. Thank you very much.

Episode 4: Is geopolitics the next investment x-factor?

From North Korea’s nuclear program to expansion in the South China Sea, geopolitical risks are permeating the news cycle regularly. We inventory the risk landscape with Isabelle Mateos y Lago and delve into China’s 19th Party Congress with Wei Li.

  • View transcript

    David Brodnick: Lately, it seems like we've been constantly under the pall of geopolitical risk. Things like North Korea's nuclear program and China's expansion in the South China Sea are just a couple of examples of stories that seem to be permeating the news cycle. And to be clear, this feeling isn't imagined. According to Stanford University's geopolitical risk index, global risk has climbed higher in the past few years than at any point in the past decade. This all begs important questions for investors. Is this sense of foreboding just an unfortunate fixture of 21st century life, or does it carry real implications for how we should invest? And indeed, could good political foresight help drive better investment outcomes?  We'll dedicate this episode of The Bid to finding out, inventorying they risk landscape with Isabelle Mateos Y Lago, our chief Multi-Asset Strategist, and confronting developments in China with Wei Li, head of iShares ETF investment strategy for EMEA. I'm your host David Brodnick. We hope you enjoy. 

    Isabelle, thanks so much for joining us here today. So you've spent a lot of your career in the world of policy making at the IMF and elsewhere, and you're no doubt a keen observer of developments on the world stage. Can you help level set for us; is the geopolitical landscape really more hazardous today than it's perhaps been in the past?

    Isabelle Mateos Y Lago: So I think, look, there are objective ways of measuring the level of attention to geopolitical risks in the world, and they do point to a sense of elevated risk and elevated anxiety right now compared to history. I think it's also fair to say that because markets are more interconnected globally, the same event has a bigger impact on global markets than it might have had 30 years ago when investors in the U.S. or in Europe cared much less about what was happening in the rest of the world. 

    David Brodnick: So as we look at the global, macro-political risk landscape, are there any particular hazards that you think are ones that should be particularly on the minds of investors these days?

    Isabelle Mateos Y Lago: At BlackRock, we've decided to try to be less reactive in the way we look at geopolitical risks, and so we've actually come up with a Top 10 geopolitical risks that we think require special continuous monitoring. To mention two that are particularly top of mind right now, one would be the discussions around NAFTA, which we feel could be quite significant particularly if they break down. Another one would be the U.S./China relationship, which has the North Korea dimension folded into it, and that's also something with potentially very significant ramifications. So we're trying to look at these 10 risks along two axes. One is how likely are they to turn from a risk into a shock? And the other one – the other axis – is what would be the market impact if this risk turns into a shock? And we're in the process of developing quantified metrics to assess both, and that's a very interesting line of work.

    David Brodnick: So, Isabelle, just to dive a little bit further on this idea of connectivity amplifying the effective geopolitics on the global stage, what are the catalysts behind this? Emerging markets have grown in terms of their representation in equity and bond markets, global supply chains are becoming increasingly interconnected, but how should we think about this as an amplifying effect? 

    Isabelle Mateos Y Lago: Many countries didn't used to allow foreign investment on a large scale. I think today most of them do, so global investors simply have a broader opportunity set. Now for a long time, this didn't make much of a difference because investors in developed markets were perfectly happy with the opportunities they were finding there, and only a small number had appetite for the extra risk and volatility that you tend to find in emerging markets. But in recent years with yields and returns in general being depressed in developed markets, a number of investors have learned to like the extra kick to your returns that you can find in emerging markets. And that's good, that's just allowing better returns to portfolios everywhere. That's healthy. But it does mean that developments in one part of the world are having an impact well beyond the region or the specific country. I think also realistically, a lot of what's been driving this globalization is the growth of China. So you could say, you know, there's emerging markets, but there's also China that has an outsized impact on both trade flows and capital flows, and what China buys and sells has an impact on all asset markets, on commodities markets, et cetera. So that's been a key driver of market prices globally.

    David Brodnick: So just to conclude things here on a, you know, not overly glum note, clearly all of the news in the world today is not bad. There’s a lot of positivity, and I know BlackRock leaders are engaging very heavily with a number of individuals across the world who are advancing very pro-growth, pro-reform, economically liberal agendas. Are there more positive geopolitical themes out there that are important for investors to be considering alongside the multitude of risks that inevitably grab headlines?

    Isabelle Mateos Y Lago: So if I go back to our dashboard of the Top 10 geopolitical risks, I think it's fair to say that if you look at the last six months, maybe, the majority of them have been getting worse. But there are definitely some good trends, and I would say one of those is the risk of fragmentation in Europe, which has gone down very, very significantly since the spring; one would say really since the election of President Macron in France on a very pro-European platform. I would say another trend is the pursuit of healthy globalization outside of the United States remains very, very strong, and you hear statements in that direction every day coming from leaders in Asia, and in Australia and China and Japan, and in Europe as well. There's increasing focus on not just growth, but the quality of growth and the sustainability of growth, which is really a common thread that you find in many, many countries across the world, China being a prime example and one that is very important because it is the second largest economy in the world and one of the fastest growing ones. But it's also the case in Europe, which has restated very firmly its commitment to the goals of the Paris Treaty on climate change. So there are very positive trends, and likewise, an appetite for trying to harness technology in a way that supports higher standards of livings rather than undermining jobs and living standards in a number of countries.

    David Brodnick: Wonderful.  Well, Isabelle, thank you so much for sharing your insights with us today, and I'm sure we'll continue to circle back with the BlackRock Investment Institute as these geopolitical concerns evolve.

    Isabelle Mateos Y Lago: Thank you very much. 

    David Brodnick: China's 19th Party Congress concluded on October 24th, leaving investors, China watchers and podcasters alike with a real grab bag of treats: New insights into the path forward for the world's second largest economy, the shifting power dynamics at the top of the Chinese Communist Party, and the rare chance to use the word quinquennial. We're fortunate to have Wei Li join us from London to help us read the proverbial tea leaves around this notable political happening. Wei, thank you so much for joining us this morning.

    Wei Li: Thanks for having me, David.

    David Brodnick: So let's start with a really basic question here: For those not close to Chinese politics, what is the National Party Congress, and why does it matter?

    Wei Li: Every five years the Chinese Communist Party presents a new cohort of senior leaders. The Party Congress is probably the most important date on China's political calendar. It took place this past October, and we saw the unveiling of the latest group of senior party members. They will decide China's next stage of development, and the implication of that will likely last longer than simply just a five-year term the new leaders will serve until the next Party Congress in 2022. But we're not done yet, though, because it's important to know that the Party Congress is really just the first phase of the leadership reshuffle in China. The second phase is the NPC. It's short for the National People's Congress. That takes place in March 2018, and the difference is that the Party Congress in October is about the leadership of the party and the NPC is about the leadership in the government. In between these two very, very important dates, we also have the Central Economic Working Conference, which is happening in December, and this is an annual event instead of once every five years where the party leaders will discuss economic policies for the next year and they also set the very important GDP growth target.

    David Brodnick: Wei, the opacity of the Chinese Communist Party is the stuff of legends, and perhaps even more so in the Xi era. What would you say are the high points of this conclave in terms of policy-making and signaling of what may be taking place within the leadership ranks of the Chinese Communist Party?

    Wei Li: Internally, we're talking about how China will pursue innovation, environmental protection, SOE and supply side reforms, and higher standards of living. Externally, we're talking about how China will likely become more assertive in foreign matters and seek to raise its standing on the international stage. The second aspect of the Party Congress is really about how President Xi Jinping has consolidated greater power after the leadership reshuffle and seems now really well-positioned to push forth even the most challenging structural reforms. Specifically, if you think about the five new leaders replacing the retiring members of the seven-member Politburo Standing Committee, they are really a combination of Xi's supporters and reformists from the other camps. So really, subsequently, we expect various reform and cyclical policy adjustments to roll out in stages into mid-next year.

    David Brodnick: The National Party Congress isn't traditionally thought of as a policy setting event, but perhaps a way to telegraph some of the likely policy changes that'll get netted out over the coming months and years. It seems like one of the takeaways from President Xi's three and a half hour opening remarks was a willingness to sacrifice the pace of economic growth in China for higher quality growth. Obviously, the second order effects of China's economic trajectory are increasingly massive. Could a deceleration or a mixed shift in the drivers of China's economic growth play out in differently in some of the markets that are shackled to its economic growth trajectory?

    Wei Li: It's really a fine balance between well, quality and quantity of growth and reform. Specifically, if you think about China's growth model, up until 2008, China's very impressive growth rate was largely dependent on a combination of rising exports and rapid investment.  Then came the global financial crisis, which very much undermined the country's previous growth strategy.  So external demand then subsequently slowed and competitiveness deteriorated. Now, things are balancing out a little bit better, and we're moving towards a consumption-driven economy. So as drivers of growth in this enormous machine change, the investment implications differ as well, and potentially warrants a more differentiated, single-country approach for those looking to play this theme. Also, more broadly, emerging market economies are at different points in their cycles. They are still behind where developed markets are, and have more room to run. This has contributed to a lower correlation amongst assets and further raises the importance of country selection. Now tying all of that back to China, we see real GDP growth around the 6% to 6.5% mark really quite achievable and a reasonably desirable outcome for economic growth for next year. 

    David Brodnick: So there's an old investment adage that the further you are from China, the risker investing in China looks. And sitting in New York, I quite literally couldn't be farther from Shanghai or Tianjin or Beijing. But nonetheless, it's really impossible to deny the incredible dynamism we see across many areas within the Chinese economy. What has you most enthused and optimistic about China?

    Wei Li: There are quite a few, but if I have to pick one, it's going to have to be innovation. Innovation is a cornerstone of President Xi's agenda. Reforming the old economy SOE in sectors such as energy and telecommunications will not be just about reducing capacity and removing redundant workers. It is also about automation and it's also about artificial intelligence. These are going to play increasingly important roles in really making changes to traditional industries, and at the same time, the world’s race for digitalization and AI across a range of problems is really open to anyone, and China's very broad and very deep manufacturing provides a very solid testing ground. Speaking to investors all over the world, it's clear that even though it is slow in starting, the Chinese market is really going from niche to necessity. The last two decades, if you think about the transformation of China, it's been very much about the integration of China into global trade. But in the next decade, or maybe even shorter, it will be all about the integration of China and Chinese assets into global financial markets. So think about index providers including Chinese assets into their compositions, MSCI for example, all of that is happening and it is massively exciting. One thing for sure is that China is definitely getting too big to ignore.

    David Brodnick: Thanks so much for joining us, Wei. To our listeners, we’ll see you next time on The Bid.

Episode 3: A taxing path to reform

It seems like the provisions of Washington’s latest tax package are intentionally aimed to confuse. With debate occurring on all sides, we set out to separate signal from noise with Chief Equity Strategist Kate Moore.

  • View transcript

    David Brodnick: Sometimes it seems like tax policy is intentionally aimed to confuse. But we wanted to ask around to see if some of the big buzzwords surrounding the current Republican tax proposal were making sense to people.

    Have you ever heard of the term “Pass thorough entities”?

    Male 1: No.

    David Brodnick: No, okay, what about reconciliation in the context of Congress?

    Male 1: No.

    David Brodnick:  Does the term “unified framework for fixing our broken tax system” mean anything to you?

    Female 2: I understand the individual words, like unified and framework, but no, I have no idea what you’re talking about.

    David Brodnick:  Is dynamic scoring a basketball term or something pertaining to tax policy?

    Female 2: Sounds complicated, but not basketball or tax. Maybe something finance.

    David Brodnick: It seems like the answer is a resounding no. For this episode of The Bid, we decided to consult Kate Moore, BlackRock’s Chief Equity Market Strategist. I’m your host David Brodnick, we hope you enjoy.

    Kate, we appreciate your joining us here today. So just a couple weeks back, we got a first indication of what the Republican led tax package is going to look like. Can you just paint a broad strokes picture for us at what we’re looking at?

    Kate Moore: Sure. Let’s just be very clear, I think the proposal that we received thus far beat market expectations in terms of having more detail than many people expected. There were lots of expectations before the announcement that it was going to be very, very short on structure, but we did get some good meat about what the plan would like in an ideal scenario, both on the corporate side as well as the individual side. Effectively, some people will see their taxes cut, others will not. There’s going to be some reduction and removal of exceptions and deductions. It's really hard to say at this point what the final package will look like, or what the timing of that package will actually be.

    David Brodnick: When we talk about tax reform, there is this penchant in the news media to latch onto specific headlines like four tax brackets, or 20 percent corporate tax rates. But some of the provisions in there are extremely nuanced and complicated. At a corporate level, obviously some of these reforms are going to be very impactful for large publicly traded multinational companies, the sorts of securities that are held within the portfolios of many of our clients. Can you just spec out for us what some of the current reforms that are being mooted are?

    Kate Moore: This is really a comprehensive proposal that involves both corporate and individual, and so while from an equity investment perspective, I often think about the corporate side, the truth of the matter is, it may be hard to get through some of the corporate changes if we don’t concurrently have the individual changes. So we have to think about this as being really comprehensive; where can we borrow from one place, or where could we fund change in another? I will say the framework released would cost between $4 and $6 trillion dollars over ten years. That’s the standard proposal, or what consultants are suggesting might be the cost. And there is a way to offset what might be a significant change in the deficit as a result of some of these tax cuts, using something we call dynamic scoring, or the governments calls Dynamic Scoring, using GDP growth as a result of the tax cut to offset and change the overall magnitude of the debt increase. And I think a lot of this is going to depend on how growth generative each of these tax packages or tax cuts will be for both the corporate side and the individual side. And trying to understand what the implications might be for companies will depend a lot on if there is a change in consumer behavior as a result of this; if the growth juice that the Republicans are hoping will come from this really manifests, and over what time period. So just want to say that at the beginning, there’s a lot of moving parts here. When we think about the corporates, the main components are a massive cut from 35 percent to 20 percent for the headline corporate tax rate. There’s a change in some expensing provisions, allowing 100 percent of capital expenditure to be expensed in the first year for the first five years. There are some changes in interest deductions, changes in dividend treatment, and then I’d say the next big bucket about this is really around foreign earnings and repatriation. And thinking about how companies who generate large amounts of cash overseas but may not be taking that back into the U.S. should pay the U.S. government if they are U.S. domiciled companies. So those are the main things we’re watching for. I would just note again, on the individual side, that it’s really important to think about the simplification here, and if we end up reducing the individual tax rates across a number of different brackets, then we’re going to have to offset that someplace else. It can’t just be offset by segment of wealthy individuals, it also will have to be offset, I think, with some of the concessions on the corporate tax side.

    David Brodnick: So do we see this impact, acknowledging it’s very early days, impacting specific sectors more heavily than others? How does this manifest itself looking at the totality of the equity market?

    Kate Moore: Without going too far into the weeds, but also acknowledging the different components, here is what we’ve thought about so far. First, on the headline corporate tax cut and the implications that that could have, let’s be very clear: a lot of domestically oriented large cap and mid cap companies don’t pay 35 percent in their taxes. The truth of the matter is, it’s a much more living and breathing activity than this straight 15 percent reduction. Just looking at this, though, you would say there are a couple of things that should do well. Financial services in particular really stand out. It’s a sector you might know that we’ve been really constructive on for a number of regulatory and growth reasons. Consumer sectors, staples, and discretionary should also benefit.

    David Brodnick: In terms of investment implications, would you say, netting all factors here, this continues to support our longstanding preference for risk assets for equities in particular?

    Kate Moore: Absolutely. It should be largely positive for earnings, and if we were to get – even if it’s not the same magnitude as the proposal that’s been put on the table – movement in the tax code, I think we will see earnings estimates move up for all sizes in the U.S. equity space. That will be an interesting tailwind, I think, and help sentiment even further. But one of the things we’re also watching is what is the feedback loop going to be of getting some movement in Washington, finally, after a series of failures in 2017? Business confidence is already quite buoyant, consumer confidence is high, small business confidence and intentions to hire and invest are all at post-GFC highs, and so if we get this positive feedback loop, we’re just feeling like there’s progress in DC and also perhaps some regulatory easing on the side. Maybe this leads to a sustained period in 2018 where we grow significantly above what we think potential growth is in the U.S. Some people are talking about GDP with a three handle, which we used to think about as being normal, but is now more of an exception. So I think the sentiment impact that has on corporate behavior as well as consumer spending and on willingness to take risk in the equity market is something we can’t discount either.

    David Brodnick: Kate, thank you so much for joining us this morning.

    Kate Moore: It was great to be here. I think it’s going to be a pretty exciting next few months as we watch this play out in DC.

Episode 2: Is Amazon eating inflation?

Consumers love a good deal, but bargain hunting is more than a fad. According to Rick Rieder, it’s reshaping the economic landscape in a big way. We explore how Amazon and its peers are eating inflation and what this means for bond investors.

  • View transcript

    David Brodnick: So my wireless mouse is out of batteries and I need a single AAA battery, which is a pain because you can’t buy a single AAA battery. So I’m at a Midtown Manhattan pharmacy, looking at batteries, and it looks like for 16 batteries it’s 20 bucks, so a $1.25 a battery, but there is no way I need 16 batteries. Let’s go look somewhere else.

    Okay. On Amazon, AAA batteries, Amazon Basics. This is 20 batteries for 24 cents a battery. 16,000 reviews, 4.5 stars. I have no choice. I’m going to buy these.

    So this isn’t just a battery thing; we actually looked at the data, and prices for books, and consumer electronics, apparel and accessories, they’ve actually been falling for years, and these are the sectors of the economy that have seen the biggest uptick in terms of online consumption. We know all Americans like cheap things. But according to Rick Rieder, our Global Chief Investment Officer for fixed income, this sort of bargain shopping is fundamentally reshaping the economic landscape. I’m your host David Brodnick, we hope you enjoy.

    Rick, thank you so much for joining us in the studio today. So let’s get right to it. Set the stage for us. Inflation rates globally are incredibly depressed across the developed market world, can you just give context around how low and how sustained this period of low inflation is looking?

    Rick Rieder: So I think there are a couple of things to factor in. First of all, the economy can grow without as much inflation globally as it has before. It’s one thing when people talk about inflation, and historically, people thought inflation, my god, if it’s not staying at the level at a two percent or so level, that there’s no growth and there is no inflationary expectations, no investment. It’s not what is happening today. We’re going through a cost revolution of epic proportion. I think it’s the greatest cost revolution we’ve ever had. Inflation is not happening while growth is extremely strong. In fact, when you look at the quantity of goods, quantity of services that are taking place through the system globally—you see this in global trade, you see this in exports, you see it literally in things like apparel, why is the quantity going up? It’s going up dramatically. People are consuming more apparel, they’re consuming more goods, just at a lower cost. It’s because technology is changing the distribution mechanism, changing commerce today and this concept. And you’re now seeing central banks that are saying, okay, we can actually move rates moderately higher, even though we’re not hitting this two percent target. It’s because we’re never going to hit the two percent target in this type of framework.

    I should say that we are starting to see inflation trend higher. You’re seeing it in places because you’re seeing wages now moving higher. When you measure wages right, you’re seeing a dynamic. We showed this in our last monthly that the median wage as opposed to the mix shift, because you’ve hired so many lower income jobs, that have depressed the hourly average earnings. The median wage is up somewhere between 3.5 and 4.2 percent. That is strong. So you’ve hired a tremendous amount of people, by the way, not just in the U.S. You’re seeing this in Europe and other parts of the world. Now you’re getting some wage acceleration. We do think you’re getting inflation that is trending higher, and we will approach that two percent number, but boy, the headwinds to get there are difficult.

    David Brodnick: So the demographics and wage growth, we’re seeing that starting to flow through into the inflation rates. But the countervailing force in your opinion is obviously technology: how is technology, for lack of a better term, eating inflation, and how is that suppressing inflation rates so dramatically?

    Rick Rieder: So it is incredible, and people talk more and more about the Amazon effect, which is clear in terms of what to do, and you see that in the prices of goods. And I think it took people a long time to figure out that gosh, we see it in things we consume and it’s cheaper, it’s easier to get them; logistically, you’re taking out the middle man in a lot of these places. But now it’s been flowing through the inflation data. So obviously you have that. What people don’t focus on is the second and third order effects that are so profound. For example, in New York City, you can use one of the car services to get around, and I think it’s $5 dollars to get from one point in the city to the next. What does that do? The other services all of a sudden now have to lower their prices. By the way, then the rental car companies have to lower their prices, and then all of a sudden, now they’ve got to reduce the size of their fleet. So what happens? Used car prices come down. Then what happens to new car prices? They start to come down. It’s the second and third order effects that are so powerful in terms of what is creating this pressing down of inflation.

    David Brodnick: So presumably you can’t squeeze your supply chain to a zero cost basis.

    Rick Rieder: Right.

    David Brodnick: Is there a peak point of disinflation that we’re going to see? Is this compression going to occur over five, ten years?

    Rick Rieder:  Yeah. I think that’s a fair point, you’ve hit this Moore’s Law curve that’s really been accelerating. I think we’ve got probably another year or two where costs continue to come down, and you shift cash flow in the world to different places.

    And by the way, you create pricing power in some areas, such as the big introduction of the Apple iPhone. Boy, people are impressed with how high that price is. You’re shifting cash flow around and you’re shifting pricing power around in the world. If you can’t lower the cost anymore, then I think investment starts to get cut off. And I don’t think we’re there yet, but I would argue in some places, transportation services, it seems pretty low right now. And I think you’ll probably see it start to level off and then start to improve again. But I think we’ve got a period of time before it takes place. But I don’t think it’s a five to ten year range; I think most of this will play through in the next year or so.

    David Brodnick: So this is a bit of a provocative question here, but I just remember a couple weeks back, post the Amazon acquisition of Whole Foods, everybody was talking about a 15 percent reduction of price of avocados and bananas. It seemed that embedded in this conversation was this feeling that maybe price reduction, this deflationary pressure, has costs. Do you think in aggregate, this reduced ability for corporations to generate cash flows is ultimately going to have a negative cost in terms of unemployment rates or compensation for individuals, or is the deflationary benefit outweighing the inability to drive wage growth or the possible layoffs that might accompany this kind of pressure?

    Rick Rieder: So, that is a really hard question because you can go a bunch of different ways on that. I do think automation robotics will continue and there will be a cost in terms of jobs; part of why I’m such a devout believer in education is as you move to a more service economy, as you move towards this automated economy, you have to make sure people are educated. And I think you’re going to see that shift. So yes, I think there is a cost there. I do think there is a cost of investment dollars where they go. You’re seeing it with companies today, what are they doing, their cap-ex expenditure is not that high, the heavy infrastructure plan to build, do I need another building? What are they spending on? Research and development, software, make my business more efficient. That has costs as well that we’ve seen play out. When you don’t build those plants or you don’t build out infrastructure, it certainly creates a dynamic where those businesses don’t grow, which we’re seeing in some of the retailors. There is a lot of real estate that is available as a result of this. So absolutely there are costs as the system shifts. I’ve seen quotes that I believe in that ultimately I think people are going to work fewer hours and I think it’s going to be more about experiences, and automation and people working fewer hours. How we get from here to there is tricky.

    David Brodnick: Maybe the Tim Ferriss or Maynard Keynes four hour work week. I wouldn’t object to that.

    Rick Rieder: No, I’m looking forward to that. What was it, if you go back 100 years, the average work week in the agricultural period was about 100 hours on average, now we’re down to about 35, and the view is, by 2050, we’re probably down to 15. I’m still at 100, so I don’t know, hoping to get it down sooner.

    David Brodnick:  So a last question here, just to render this investible, you alluded to the fact that this disruption is not happening—it’s not equally unfolding across different sectors. For bond investors, what are the implications of this? Obviously retail being more exposed to the risks than say, a technology firm. How do you think about that when constructing bond portfolios?

    Rick Rieder: So a bunch of different ways. First thing you think about is interest rates are probably going to stay lower for a long period of time. What drove volatility in the system certainly in the last decade—if you go back 20, 30 years, it was housing prices that during the baby boom created this tremendous volatility of inflation, but then energy, in the last 20 years, you had oil go from 40 to 150 to 80. Because of technology, because of horizontal fracking, we’re not going to have another shock in energy again unless there is some geopolitical event, because of where it’s produced around the world. It means interest rates stay lower for longer, it means that discount rates on assets is lower. It means valuations, whether it’s real estate, the equity market, any asset, your valuations can stay higher for longer. And I don’t think people can take that into account when the volatility of inflation is lower. When the discount rates stay down, you can be more confident in a long duration asset, meaning you hold arguably more risk. But if the discount rate stays down, your net present value of those flows is more powerful. So anyway, I think that is a really big deal.

    In terms of from a granular asset class point of view, energy was what created stress in the markets last year. Retailing then took over. So we’re thinking about how cash flow is shifting in the world: where do I go and get my cash flow? The demand for income is not going away. It won’t go away for ten years because of the demographic. Emerging markets, the places where they’re growing, they are the beneficiary of trade growing in the world, growth being good. So we like emerging markets quite a bit. It’s a place where we think cash flow will be durable.

    David Brodnick: Wonderful. Well, Rick thank you so much for doing this.

    Rick Rieder: That was fun. Thank you very much.

Episode 1: When reflation becomes expansion

Is the market’s current calm a positive sign or signaling something ominous? Will global central banks stick the landing as they shift to a tighter policy stance? Richard Turnill and Jeff Rosenberg answer these questions and more.

  • View transcript

    David Brodnick: At BlackRock, July starts as it always does with the launch of our Investment Institutes media outlook. In fact, just weeks ago, 90 of our investors and strategists gathered in London to debate the state of the markets, the economic cycle and what the future holds for our clients. There’s a lot of debate. Is the market’s incredible calm a positive sign or does it signal something ominous? With the U.S. steel low globally, are stock valuations really as lofty as they seem? Can central banks stick the landing as they shift to a tighter policy stance? In this episode of The Bid, we’ll turn to some of our senior most thinkers to unpack BlackRock’s views for the back half of 2017. I’m your host, David Brodnick. We hope you enjoy. Our Chief Investment Strategist, Richard Turnill joins us straight from London and from what I believe is a fairly aggressive charity bike ride you completed last week?

    Richard Turnill: That’s right, David. That’s 500 kilometers across Europe, so glad to be back.

    David Brodnick: I imagine so. Richard, in the U.S. we’re about a decade into the current market cycle, but the sentiment amongst our investors at our investment forum was pretty constructive this quarter. Can you explain to our listeners why you think this cycle continues to have legs?

    Richard Turnill: I think cycles die of old age and we’re eight years into this expansion and the typical length of expansion has been eight years, so many investors think that we’re due a recession and, therefore, one must be around the corner, but when we at BlackRock look at the cycle, we think you’ve got to take into account the fact it’s been an incredibly slow growth cycle so far. The pace of growth has been far, far below what we’ve seen in previous expansions and as a result of that, we haven’t created the unbalances, which typically lead to the end of the cycle. We take into account the fact that growth has been so slow.

    Actually, we’ve come to the conclusion that rather than being at the end of the cycle, we’re somewhere in the middle. What that means is that the time to the next recession could potentially be measured in years rather than quarters. Some of the evidence I look at to support that would be some of the inflation data. We saw core inflation in the U.S. fall back to a two-year low. The wage data we’re getting, which is rising gradually, but at 2.5%. Average out of the earnings growth is, again, consistent with an economy, which is somewhere in the middle of its cycle rather than late cycle, so we think we’ve got potentially years to go in this expansion and I think for interest rates that means gradually rising interest rates, gradually rising bond yields over time, but it sets a pretty, I’d say, constructive backdrop for investing in equities.

    David Brodnick: We’re in the midst of a kind of slow motion recovery compared to predecessors. Seems fairly average with some significant room to run, but with valuations where they current stand, it doesn’t look like anybody’s getting rich quick in the markets today. Are there ways you suggest investors should be positioning to take advantage of this recovery and perhaps make the coming years a bit more fruitful?

    Richard Turnill: You’re certainly not going to get rich quick by keeping your money in cash. Actually, what’s going to happen is you’re going to get poor slowly. You’re losing purchasing power every single day that you keep your money in cash over the next five years. We estimate you’ll lose around 3% of the value of your assets in real terms by hoarding money in cash whereas in fixed income your real returns are likely to be close to zero. For those looking to build wealth, I think it’s time to start looking at areas other than cash and fixed income and where to generate returns. Actually, the area we think they should be looking is in equity markets and specifically in international equity markets.

    We like the U.S. market, but we think we’re going to get even higher returns if we look at markets like Europe, Japan and actually like emerging markets.

    If we look at the European markets today, they trade at around a 20% discount still to the U.S. market. They’ve done well this year, but we think there’s still further scope for the valuation gap to close. We’ve seen strong fundamentals in the European economy. PMI data now at a six-year high in Europe. We’re seeing a decline in populism. One of the reasons investors have been very nervous about investing in Europe and actually the potential for stable pro-EU governments in both France and Germany going forward, so we think Europe offers a very attractive opportunity for U.S. investors and emerging markets on close to a 30% discount to the U.S. and where we’re seeing increasing signs of broadening growth across many emerging markets, particularly in Asia where we see China in a self-sustained expansion.

    David Brodnick: I thought the investment outlook this quarter really exposed a very interesting myth about volatility and for those who are listening who haven’t read the full report, essentially the BlackRock Investment Institute is proposing that the low volatility that we’ve seen in markets of late is really just reflective of a very benign economic backdrop and the sort of mean reversion that so many market prognosticators have called for may not come to pass the way that we’ve predicted. Can you flesh this out a little bit for us, Richard?

    Richard Turnill: Yeah, there’s an irony here, which is that many investors look at the current low levels of volatility, low levels of the VIX, the so-called fear index and they see that as a warning sign. They see low volatility, low VIX as a sign of complacency in the market and, therefore, a reason not to invest. Our analysis doesn’t support that at all, so first of all, low levels of the VIX give no forward-looking indication as to the direction of the market either way, but perhaps more importantly, what we see is that periods of low volatility are actually normal. Many of us have had an experience of markets heavily influenced by the last decade and particularly the global financial crisis. When we see the VIX down close to ten, that feels extreme, feels abnormal because it’s low in the context of what we’ve seen the last decade, but actually we look at longer periods of time. What you see is volatility is better characterized by prolonged periods of low volatility often associated with periods of stable economic growth followed by short periods of much higher volatility. It was often characterized as fear and greed.

    Today, we’re in this low volatility environment. That’s important because if you’re in a low volatility environment today, one in which the economic environment is constructive, then actually the likelihood is that you stay in that volatility environment until one of two things happen, so the first is you go into a recession. Sustained spikes in volatility are always associated with either a recession or a significant financial crisis.

    We see pockets of risk, but no systemic risk, partly because we’ve seen authorities take a much stricter regulatory approach since the global financial crisis, which has really helped cap leverage across the system.

    This is an environment where investors should look to take advantage of opportunities of short-term volatility to add to their risk positions over time and rather than fearing a market volatility, actually I think it should be embraced. Most investors today still don’t own enough risk in their portfolios to meet their financial goals.

    David Brodnick: Richard, thank you very much for spending the time with us here today.

    Richard Turnill: Thank you.

    David Brodnick: Let’s turn to the world of bonds now with Jeff Rosenberg, BlackRock’s esteemed Chief Income Strategist. Jeff, we’re thrilled to have you.

    Jeff Rosenberg: Esteemed? That’s a very nice compliment, thank you.

    David Brodnick: It’s been an odd year in bonds and I’ll just be blunt. What the heck is going on? Monetary policy is turning tighter. Growth is stabilizing, yet the yield curve just keeps flattening. Has the term premium vanished or is it just dormant?

    Jeff Rosenberg: There’s a lot of stuff in that question, David. Let’s just unpack it just a bit. What’s really confusing in the big picture sense is the Feds raising interest rates, the economy’s doing well. That’s why the Fed’s raising interest rates, yet long-term interest rates up until this last week or so have been trending lower. That’s what you meant when the term premium, the difference between long-term interest rates, say the ten-year and short-term interest rates, say the two-year, what the Fed is moving up are moving in opposite directions. Now there are a lot of reasons for that, but basically the story is that the post-election environment saw a big surge upward in growth expectations that fueled expectations for a faster pace of policy accommodation normalization by the Fed that now we’re getting, but it’s not as fast as what market participants expected. There’s more in there as well around inflation expectations. Near term inflation data has actually been quite disappointing and as I think we’ll get into, the global picture has really been a big factor in pushing long-term, interest rates in the U.S. lower as up until most recently, long-term interest rates around the world have been declining and term premiums have been flattening as well.

    David Brodnick: Just looking at the Fed a little bit further, we’re getting increasing clarity in terms of the pace and timeline against which they’re going to be pairing their balance sheet. Do we think they can really stick the landing here?

    Jeff Rosenberg: There was a lot of angst a number of years ago around the taper tantrum 2013. It was a different environment. There was a lot more reliance on an ever-increasing balance sheet and we just evolved away from. More importantly or as importantly, the Fed’s communications strategy is learned from the mistakes around taper tantrum. There’s been a much greater degree of priming the market for the communication that we got last meeting, which is here’s the path that we’ve laid out. Now the focus and we got the minutes recently. When exactly are they going to execute the plan, but we know what the plan is and expectations are pretty much centered around sometime in September. There’s a possibility in the July meeting, but generally people expect they’re going to start the plan and we know what the plan is and, importantly, the plan is to just run it off in the background. Not make it an active communication strategy, not try to confuse the market about tinkering with the pace or the level. They’re going to set it on autopilot. We’re going to have a very, very gradual normalization process.

    By 2023 or so, the balance sheet will be normalized. That’s under everything else unchanged. Of course, everything else won’t be unchanged. That’s kind of your best case scenario. The balance sheet will normalize and the market will focus on what they’re doing on short-term interest rates. The short answer to your question is, yes, we don’t expect the market to have a taper tantrum type of event because the Fed is paring to back its balance sheet through this very gradual runoff.

    David Brodnick: Just to take it into the more investible realm here, we’re dealing with an environment in which we’re expecting the term premium to come back to life, yield curves to steepen, rates to gradually rise. We have kind of complex views on the bond market today. We like investment grade over high yield, inflation length over nominal exposure. There’s a lot to balance. How do you suggest investors go about positioning in fixed income?

    Jeff Rosenberg: The first thing really is to just understand what role fixed income is playing in your portfolio. I can’t make a recommendation without knowing what role you are looking for fixed income to play. The general role, the kind of generic perspective is that we’re talking about a balanced portfolio where fixed income is balancing risk against an equity portfolio and there’s some kind of mix of assets. Within that kind of context, what we’re talking about is an outlook for Fed normalization, rising interest rates, normalization of the term premium, everything that we just talked about and how that manifests itself into portfolio structure. Well, you want to take a bit less duration risk in an environment of rising rates and increasing term premium because those things are going to ultimately be good for your fixed income portfolio, but along the way, if you have too much interest rate exposure, too much long maturity exposure, it’s going to be damaging to your price return performance. What we’re talking about is just paring that back a little bit.

    Now how that manifests in a specific portfolio, again, it depends on the degree of risks that are going on on the other side, but generally it means bringing down durations, generally means managing some interest rate risk. When it comes to term premium, there’s some tactical views around where on the yield curve we like to take duration exposure. Right now, that tactically means we actually like the longest end of the curve, but that means offsetting that overall duration by having some either short positions, which you can implement through flexible strategies or through having a bigger position in the very frontend of the curve. Those are going to be tactical. We’re going to move around on those. Now on credit, what we’re talking about is an environment where valuations are relatively full. The prospective return outlook is less than what we’ve recently experienced because valuations have already seen a compression in the relative value, the credit spread, the difference in yields versus treasuries.

    Going forward, we think there’s really little of that to be had and so it argues for a bit more defensive positioning, hence the focus on higher quality positions in investment grade. Finally, when it comes to inflation protection, that’s a way to add a bit of diversification, a way to mitigate some of the impact of rising interest and valuations have cheapened up recently on this inflation scare, making the inflation protected market a bit more attractive over the medium term where we expect inflation to eventually start to tick back up. Now that’s a medium-term view because of the near term. Over the next one, two, three months, inflation and headline inflation is going to continue to tick downward, but over a 12 month horizon we’re going to get back to in our forecast closer to that 2% objective and that kind of environment, substituting nominal treasury exposure for some inflation-protected exposure if going to be a successful strategy for maintaining the role of fixed income in a balanced portfolio i.e. ballast, but mitigating some of the cost of that rising interest rate environment.

    David Brodnick: Last question here. I know your travel schedule is relentless, but I’m hoping to get some time out of the office this August. If we were to find you on the beach, what cocktail would be in your hand?

    Jeff Rosenberg: Well, it’s hard to make a good cocktail on the beach because you lack the proper equipment, so if I’m in my backyard or I’m in a place where I can make the cocktail, I make what I would call the bond guy’s version of a mojito. Now what that is is this is not your bartender 7-Up, Bacardi, a lime and some mint leaves. This is the dark and brooding version of a mojito, so it’s really the key that the ingredients are dark rum. It’s brown sugar and then some club soda. The club soda, brown sugar allows me to modulate the sweetness because I don’t like my mojitos too sweet. It’s got to be a nice balance and I like it dark and brooding, the way a bond guy would drink his mojito.

    David Brodnick: Garnish with a prospectus run to taste.

    Jeff Rosenberg: Exactly.

    David Brodnick: Wonderful. Well, Jeff, thank you so much for joining us today and for our listeners, thank you as well. Here’s wishing you all a restful and profitable summer. We hope to hear from you next month.