Investor to-dos for the
second quarter

Apr 10, 2017
By BlackRock

Since the start of the year, reflation has continued to reshape the economic landscape, presenting new opportunities and risks for investors. Here we outline concrete actions to consider in light of this theme and others, building upon the insights shared in our Q2 Investment Outlook.

Readying portfolios for reflation

Broadening reflation and an accompanying rise in bond yields means fixed income investing is likely to get more difficult over the coming quarters. In fact, seemingly commonsense solutions for a rising-rate world (such as short-duration strategies, floating rate securities and inflation-protected Treasuries) may not play nicely when combined and can carry risks of their own that must be weighed.

Coming up for air
10-year government bond yields, 1980-2017

Chart: Coming up for air

Sources: BlackRock Investment Institute and Thomson Reuters, March 2017.

In this more dynamic, less certain fixed income environment, investors may want to put more arrows in their quiver and deploy some combination of the below:

  1. Flexible Strategies: High-quality, long-dated bonds offer an important ballast to stock market risk in blended portfolios. Pairing more traditional bond strategies with flexible ones may help reduce duration – or interest rate risk – within fixed income sleeves, while potentially enhancing total return.
  2. Lower-Risk Floating Rate Strategies: Floating rate securities make intuitive sense for investors when bond yields rise. Resetting coupons allow them to potentially skirt some of the price declines that can confront fixed-rate bonds. However, the asset class has gotten pricey lately and a tilt toward more conservative strategies seeking greater downside protection may be prudent.
  3. Diversify Your Income Sources: For income investors, multi-asset strategies have shown themselves to be dependable performers when bond yields have risen, combining a range of less interest-rate-sensitive asset classes while still pursuing a consistent income stream.

Also worth noting: Interest rate risk doesn’t live in bond portfolios alone. High-dividend stocks may trade more like fixed income should yields surge, which contributes to our preference for dividend-growth stocks over the high-yielding bond proxies.

Eyeing the international opportunity

While reflationary forces are weighing on returns across much of the fixed income universe, they may be bolstering the outlook for equities, particularly those outside the U.S.

U.S. stocks surged after the November election in anticipation of sweeping fiscal expansion and regulatory reform. However, hopes for a speedy passage have receded, leaving U.S. equities beached near all-time highs. Concurrently, Europe and Japan have staged stealthier economic recoveries and, rather than trading on tough to parse signals from Congress, their respective markets have notched gains on the back of strong earnings momentum. Despite these compelling fundamentals, investor enthusiasm has been surprisingly lackluster.

European disconnect
Eurozone PMIs and Europe ex-UK equity flows, 2012-2017

Chart: European disconnect

Sources: BlackRock Investment Institute, MSCI and Thomson Reuters, March 2017.
Notes: Equity markets are represented by MSCI indexes for Japan, EMU ex-UK, USA, Asia ex-Japan and EM. Earnings growth is based on aggregate 12-month forward earnings forecasts. The dividend contribution is based on the difference between the index total and price returns. Multiple expansion is represented by the total return minus earnings growth and dividends. All returns are in local currency except for emerging markets and Asia ex-Japan, which are in U.S. dollars.

Looking to Europe, in particular, political worries have investors stuck on the sidelines. But while concerns around the prospect of an anti-establishment win in the forthcoming French presidential election are valid, polls suggest this outcome is looking unlikely. Should markets shake off these fears as polls more definitively suggest a win by a mainstream candidate, early movers in European stocks could benefit from market acknowledgment of underlying economic progress.

Low returns ahead

On paper, economic growth is easy enough to cook up. Only three ingredients required: a growing labor force, investment spending and productivity. Blend to taste. Reality is a different story, however. Growth across much of the developed world remains restrained by an aging population and stagnant productivity growth that is capping longer-term market return potential. Emerging markets (EMs), however, may still represent a comparative bright spot.

Our overweight to emerging market equities is a longstanding one, but we think the opportunity is particularly apparent today. As in much of the world, reflation is proving a catalyst. A rebound in EM growth, solid consumer demand, strong purchasing data and impressive price discipline among resource producers suggest a turnaround is afoot after years of underperformance. Handwringing around a purported “death of globalization” and accompanying collapse in trade is neither substantiated by the data, nor the likely trajectory of trade policy.

Have investors acted on this increasingly optimistic outlook? Only partly. Fund flow data suggest investors may be only dipping their toes: Flows into emerging market equities have closed just 5.5% of the gap with 2013 highs1, and our Portfolio Solutions group attests to significant underweights in many of the advised portfolios they encounter.

For some, slow uptake in EMs is understandable. The inhibitors: risk aversion, liquidity concerns and cost to invest. Regardless of the specific hang-ups, investment options now abound, ranging from rigorously risk-managed active strategies to minimum-volatility smart beta and low-cost core ETFs. For those able to assume the intrinsic risks, we believe there is much to like near term and longer term in EM stocks.

Diversify differently

Lower, generally less stable correlations across asset classes could challenge investors looking to perform one of their most critical tasks: diversifying their portfolios in a thorough and thoughtful manner. One of the most arresting data points surfaced in our Quarterly Investment Outlook was a sharp downshift seen in cross-asset correlations. This suggests that trusted relationships relied upon to manage overall portfolio risk are looking less dependable.

Go your own way
BlackRock Multi-Asset Concentration index, 2009-2017

Chart: Go your own way

Source: BlackRock Investment Institute, March 2017.
Notes: The line shows the 30-day average of the Multi-Asset Concentration index created by BlackRock’s RQA team. It shows the strength of cross-asset correlations based on principal component analysis. A higher index signals stronger correlations (prices moving in the same direction) driven by a single common factor across multiple markets. The index is based on rolling daily returns on 14 assets.

In a world in which a simple blend of U.S. stocks and high-quality bonds may no longer give the diversification benefits sought, more breadth may be needed in portfolios to help tamp down tough-to-reduce risks. For example, moving beyond U.S. stocks looks prudent not just from a valuation and economic standpoint, but from a risk management perspective, as well. A hypothetical scenario: Derailment of a sweeping corporate tax reform package could ding U.S. stocks, but might leave international equities comparatively unscathed. Similarly, bond investors may want exposure to markets where central banks look poised to maintain a more accommodative stance than the Federal Reserve.

In a world where traditional diversification or asset allocation models might not suffice, investors may want to expand their asset allocation toolkit and embrace factor strategies. In this reflationary environment, we believe the value factor is potentially well-positioned, offering another tilt for growth-seeking investors to explore.