BlackRock, the world’s largest asset manager, is calling investors to return to risk assets, particularly international equities, in the second half of the year.
The ETF issuer under the iShares brand, which commands more than $1.1 trillion in U.S. ETF assets alone—or about a third of the U.S. ETF market—said in its midyear outlook that there are three major themes driving markets in months ahead. Chief among them: 1) an ongoing and sustained global expansion; 2) the current environment is rewarding risk; and 3) volatility remains low.
According to Richard Turnill, BlackRock's global chief investment strategist, these themes should bode well for risk assets going forward, particularly because international equities are poised to outpace U.S. stock returns.
US No Longer Driving Returns
If you look at the performance of a U.S. stock ETF such as the SPDR S&P 500 (SPY) relative to the Vanguard FTSE All-World ex-US ETF (VEU) and the iShares MSCI Emerging Markets ETF (EEM) year-to-date, it’s clear that the U.S. market is no longer driving equity returns this year. That’s a notable change from as recently as 2016, when SPY outperformed both VEU and EEM significantly.
Global growth has settled at an “above-trend rate,” and should stay above 2% and above market consensus based on BlackRock’s proprietary metrics, Turnill says. That growth is all-inclusive—it reaches all major regions such as emerging markets and Europe, which had long been an underperformer and where growth is now at its highest level since 2011.
As Turnill put it, this isn’t just ongoing, sustained global growth, it’s “synchronized.”
“The typical length of expansions is eight years, so many investors think we are due for a recession, for the cycle to die of old age,” he said. “But cycles die because imbalances build up, and while this has been a long expansion, it has also been a weak, slow one. We are still somewhere in middle of a long cycle.”
Midcycle Data Affirmation
Core inflation in the U.S. is back down to a two-year low, and wages are picking up slowly—both data points that are consistent with being somewhere midcycle, he adds.
It could take years, “not quarters,” before the next recession, according to Turnill. For markets, this means the environment is very constructive for equities; for fixed income, it implies an environment of “gradually rising interest rates and yields for some time.”
An all-world stock portfolio like the Vanguard Total Stock ETF (VT) offers a good glimpse of the trajectory of global equities, while the iShares Core U.S. Aggregate Bond ETF (AGG) plots the struggle of U.S. investment-grade bonds to find much upside year-to-date.
Charts courtesy of StockCharts.com
Another theme driving markets in the second half of the year is investors’ rethinking of returns.
“As the cycle matures, looking at historical returns as a guide to future returns is not constructive,” Turnill said.
From a fixed-income perspective, the 35-year bull market for bonds where investors benefited from “coupon-plus returns”—returns higher than the level of yield and the level of coupon on bonds—ended last summer. “Going forward, we are going to see coupon-minus returns—returns lower than the headline yield as yields rise overtime,” Turnill said.
In equities, there’s a lot of concern about rich valuations, particularly in U.S. equities, compared to historical levels, but those concerns are misplaced.
“Just as mean reversion is not going to be a good guide to returns in fixed income, mean reversion may not be the right model to think about equity valuations,” Turnill said. “In an environment of sustained economic expansion, and bond yields are likely to remain low relative to history for some time to come, market valuations can be sustained at current levels.”
Attractive valuations still abound, especially outside the U.S. Consider that the iShares MSCI Emerging Markets ETF (EEM) has a portfolio price-to-earnings ratio of 15.5 currently, which compares to a P/E of 24.0 for the iShares Core S&P 500 ETF (IVV).
Investors still need to embrace risk in a way they haven’t since the financial crisis. That rethinking of risk—one of the market’s driving themes, according to BlackRock—could also be a supportive factor for equities going forward.
“Many investors have been cautious about investing in risk assets, and that caution was ironically exacerbated by a period of low volatility,” Turnill said. “Many saw that as a warning sign of complacency, keeping many from putting money to work.”
But periods of low volatility are normal, especially when it’s associated with a stable macro environment such as the one we are on—“over 80% of the time in history, we’re in a low-vol environment.”
“Many investors are overly concerned about a change in the volatility regime, but any short-term rise in volatility should be viewed as a buying opportunity,” added Turnill.
And at least for now, there’s no apparent broad systemic risk lurking that could derail this period of quiet we are in, he notes.
That said, investors should be aware of two types of risks. The first is “unintended risk—all risk should be deliberate in a portfolio.”
Second is catastrophe risk—things like a sudden, significant rise in bond yields linked to central bank balance sheet issues. An event like that could push valuations of all risk assets much higher, and be an important tail risk. The good news is that BlackRock doesn’t see that happening anytime soon.
Contact Cinthia Murphy at firstname.lastname@example.org
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