Continued low returns, slowing divergence in monetary policy and further spikes in volatility are issues that investors should be preparing their portfolios for over the years ahead, according to the latest outlook from the BlackRock Investment Institute.
While 2016 started with heavy losses in global stock markets – prompted by concerns such as slowing economic growth in China, depressed commodity prices and the risk of a recession in the US – the past six weeks or so have seen a steady improvement in risk assets.
As the graph below shows, the MSCI AC World index has made a 2.87 per cent total return over the year to date, having fallen more than 9.5 per cent by mid-February. The FTSE All Share, which was down more than 11 per cent, has recovered to be sitting on a loss of just 0.64 per cent.
Performance of indices over 2016
Source: FE Analytics
With this recent recovery, the BlackRock Investment Institute argues that global markets seem to be leaving fears of a new recession behind them – especially as manufacturing activity in the US, China and the eurozone appear to be stabilising from their recent downward trends.
Furthermore, activity in the service sector is in much better shape than manufacturing while the US and European financial sectors are “healing” following the blow dealt by the global financial crisis.
The institute said: “We are in the midst of a long, shallow economic recovery – and we do not see a recession on the near-term horizon.”
In the following article, we look at three themes that BlackRock Investment Institute global chief investment strategist Richard Turnill, head of economic and markets research Jean Boivin and chief fixed income strategist Jeff Rosenberg are highlighting for the times ahead.
Theme 1: Low returns ahead
The strategists point out that the hunt for yield is “getting even harder”, given negative short-term interest rate policies in Europe and Japan have pushed the yields on many bonds below zero. Indeed, close to $7trn of government bonds – or around 27 per cent of the JP Morgan Global Government Bond index – were in negative territory at the end of March.
Government bonds with negative yields, 2014–2016
Source: BlackRock Investment Institute, MSCI and Thomson Reuters, March 2016
“A long period of low rates has encouraged investors to assume greater risk in the stretch for yield. This has inflated asset prices. Higher valuations today typically mean lower returns in the future,” the report said.
“Our five-year capital market assumptions, for example, are near post-crisis lows. We are in a low-return, but not no-return, environment. This poses a dilemma for investors: accept lower returns or dial up risk by taking equity, credit and interest rate exposure.”
Amid this backdrop, Turnill, Boivin and Rosenberg argue that equity valuations appear to be “reasonable” given the low interest rate environment and have an overweight recommendation on the asset class. In contrast, they are underweight fixed income and neutral when it comes to commodities.
The strategists do not view any major equity markets as materially overvalued – including the US. They are most positive on US equities, thanks to strong consumer and housing sectors as well as stabilising economic growth, and Europe, when valuations are reasonable and central bank policy remains support; they are also “warming up” to emerging markets, which look cheap after a period of underperformance.
They added: “Value stocks have underperformed since the financial crisis. We are seeing signs of a rebound. A value renaissance may just be getting started.”
“First, value equities still traded at a 35 per cent discount to the broader market globally as of March 2016, compared with an average 20 per cent discount over the last decade, our analysis based on forward earnings shows. Second, economic fundamentals are improving. Third, there is room for flows to come into the asset class as underweight investors raise allocations.”
Theme 2: Divergence is slowing
Divergence in the monetary policies has been a key market theme since 2014 and continue of late as the Federal Reserve’s moves to tighten policy led to steadily climbing two-year yields while they declined in Europe and Japan as their central banks loosened further.
Two-year government bond yields, 2013–2016
Source: BlackRock Investment Institute and Thomson Reuters, March 2016
However, Turnill, Boivin and Rosenberg argue that monetary policy divergence is now slowing and its effects are largely priced into markets – meaning that “surprises at the margin are what matters now”.
“Bond futures point to a further divergence in yields across countries. Yet we believe this is mostly priced in. The era of ever-widening policy divergence through interest rates is likely behind us,” they said. “We believe future divergence will be more subtle, driven by incremental QE in Europe and Japan as well the trajectories of US growth and rate increases.”
One important element of this theme is the appreciation of the dollar, which has been driven higher as investors started to expect an interest rate rise from the Fed. This put pressure on commodity prices, hurt emerging market assets and weighed on the returns of US companies with overseas revenues, making the dollar a key driver of investment returns.
“Yet further significant dollar appreciation appears less certain from here. This is partly because central banks have expressed concerns about the global impact of a stronger dollar, and agreed at a recent G-20 meeting to consult closely on exchange rate markets,” the institute said.
“The dollar’s rise petered out against other G3 currencies in early 2015, but remains on an uptrend versus a broader set of currencies. A halt in this trend could light a fire under oversold commodity and emerging market assets. We see dollar appreciation slowing in the near term. This bodes well for markets, we believe. The dollar will likely only resume its uptrend once markets start pricing in faster Fed rate increases.”
Theme 3: Volatility and dispersion
Turnill, Boivin and Rosenberg point out that recent years have seen many investors focus on very similar strategies, meaning that the market is now characterised by a number of “me too” trades. Examples of these include overweighting the US dollar and underweighting emerging markets and commodity assets – the following graph show the overweights and underweights to these trades, based on portfolio flows, reported positions by fund managers and price momentum.
Crowded positions, 2013–2016
Source: BlackRock Investment Institute
“We see two problems with this picture,” the strategists said. “First, many of these trades are highly correlated. This means portfolios may be riskier than they appear. Second, monetary policy normalisation is likely to increase volatility, we believe. This raises the risk of rapid momentum reversals and shifts in market leadership.”
They add that gold, inflation-linked bonds, government debt and currency exposures could prove to be useful portfolio hedges should volatility – which has generally been supressed by extraordinary monetary policies since the financial crisis – spike.
Recent months have seen volatility increase and there are now clearer gaps between the winners and losers in some markets. Cross-sectional dispersion in global equities – which is a measure of the variation in returns across individual securities – recently reached its highest level in four years, according to BlackRock, which a similar trend is spreading to other asset classes, such as credit.
“Volatility and dispersion tend to rise late in monetary policy cycles when central banks start raising rates and shrinking their balance sheets, our research suggests. This favours an active approach to investing, we believe. Market neutral strategies may benefit,” Turnill, Boivin and Rosenberg concluded.
“We see volatility and dispersion rising to normalised levels as the Fed lifts rates and markets pay more attention to lurking tail risks. This creates opportunities for security selection, but also a need to diversify. Investors can no longer rely on a rising tide lifting all boats. Security selection is crucial as dispersion re-emerges in asset markets.”
