Investors should be attempting to make their portfolios more resilient by focusing on lower-risk exposures such as quality in the current market environment, according to analysts at iShares. 
The ETF provider, which is owned by asset management giant BlackRock, has outlined the broad themes that it expects to be in play throughout the final quarter of 2018. In its outlook, the group focuses on the impact of varying growth outcomes, tighter financial conditions and the need for portfolio resilience.
Wei Li, head of investment strategy for BlackRock ETF and index investments EMEA, said: “The steady global expansion is rolling on, underpinned by above-trend US growth. Yet the drivers of growth are changing and the range of potential economic outcomes is widening as the cycle matures.
“Stimulus-fuelled surprises could boost growth and risk assets, but escalating trade disputes create downside risks. Gradual increases in US rates are tightening financial conditions globally, contributing to bouts of volatility and sharply depreciating emerging market currencies. This argues for a greater focus on building portfolio resilience, via quality and other lower-risk exposures.”
Theme 1: Wider range of growth outcomes
Analysts at iShares believe that the global economy has the potential to grow at above-trend levels – although they do warn that the range of potential macro outcomes that could emerge is widening as we head in to 2019.
Real year-on-year GDP growth by country group
Source: IMF’s World Economic Outlook, October 2018. Note: Grey area denotes projections
“We continue to see steady global growth ahead, but the outlook is clouded by persistent and elevated uncertainties. Above-trend US growth is underpinning G7 growth and a rise in US fiscal spending into year-end will provide further fuel, yet this also increases the risk of economic overheating,” Li said.
“The fiscal expansion is set against a backdrop of rising US rates that – although steady and well-telegraphed – may stoke worries about waning monetary stimulus. Continuing trade tensions add to uncertainty and, on the whole, economists have become more divided on the two-year outlook compared with last year.”
Within this theme, iShares said it prefers emerging market equities over the developed world, despite their significant underperformance in 2018-to-date.
Indeed, its analysts argued that the emerging market sell-off has simply made valuations more attractive, as they are traded at a discount to US equities of around 28 per cent yet have strong fundamentals such as low public sector leverage, limited external funding needs and flexible exchange rates.
In addition, the firm has a preference for Asian equities within emerging markets, especially India thanks to its long-term structural reforms and China because of near-term policy easing.
However, the US remains iShares’ preferred region for developed market equity exposure as the group sees the potential for stronger earnings growth and the chance of a surprise rise in economic growth. It also argues that the US economy is at a late-cycle expansionary stage, creating a preference for technology exposure and the momentum investing approach.
When it comes to European equities, iShares is underweight and is likely to remain so until it sees cheaper valuations and better economic growth. The passive investment house is also neutral on Japan, saying “the market’s value orientation is a challenge without a clear growth catalyst”.
Theme 2: Tighter financial conditions
The second theme highlighted by iShares is the risk that comes with tighter financial conditions, following an extended period when markets have grown used to easy money.
Performance of currencies vs US dollar over 2018
Source: FE Analytics
“Tighter financial conditions have partly played out through a stronger US dollar this year. This has exacerbated the troubles of the most vulnerable emerging market economies. Alongside trade frictions, the dollar’s path remains key for emerging markets,” Li said.
“Higher US interest rates are also adding to the emerging market stress by creating competition for capital: investors can now receive decent returns in US short-term bonds without having to take major credit and duration risk.”
The firm pointed out that emerging market debt has been heavily sold in 2018, particularly in a small number of “problem countries”, and it is currently neutral towards the asset class. However, it added that emerging market debt seems to be nearing a point at which the buy signal will becoming “compelling”.
Floating-rate notes and inflation-linked bonds are also considered under this theme. According to iShares, floating-rates notes – which act as a hedge against the tail risk of the US economy being overheated – look attractive given the Federal Reserve’s rate-hike plan; inflation-linked bonds could also help increase portfolio resilience given expected rises in core CPI inflation in the final quarter of 2018.
Theme 3: Greater portfolio resilience
Addressing iShares’ third and final theme for the quarter, Li noted that volatility has returned to markets in 2018 and investors have already faced several sell-offs, making portfolio resilience essential in this environment.
“As US rates have risen and the returns from US short-term bonds have become more appealing, investors have reset their return expectations for riskier assets – especially emerging market equities and bonds,” she said.
“This re-pricing has sparked market volatility, reinforcing our view that it is important to build greater resilience into portfolios through quality exposures across equities and credit. We believe equity investors are broadly compensated for growing risks but advocate a greater focus on fortifying portfolios amid macro uncertainty.”
Performance of equity indices in 2018
Source: FE Analytics
For defending portfolios iShares’ analysts prefer the quality factor, suggesting a focus on stocks with solid balance sheets, high returns on equity and other strong fundamentals. However, it added: “We believe bond proxies may not provide the safety net that investors have come to expect.”
In keeping with a tilt to quality, the group also likes US Treasuries as a diversifier. It has a preference for short maturities over longer ones, noting that higher yields here offer more of a cushion to rising interest rates than they have in much of the recent past.
Another way to add resilience to portfolios is through alternative assets that have a low correlation to both global equity and bond markets.
“Despite its lacklustre performance so far this year, linked to US dollar strength, we find that gold is an effective diversifier over the long run and benefits from perceived safe-haven status, providing a potential hedge against geopolitical uncertainty,” iShares said.
The group also pointed out that broader commodities tend to have good diversification characteristics and can offer a hedge against inflation. However, it did concede that exposure to energy and global growth trends can lead to a slightly higher correlation to equities.