With US monetary policy turning, fundamentals such as productivity and earnings growth are poised to regain prominence as drivers of investment return – with some key indicators “flashing red,” according to BlackRock (NYSE: BLK) Investment Institute’s (BII) mid-year 2015 investment outlook.
The mid-year outlook, “Nearing Normal”, provides an update on BII’s main economic assumptions and top investment ideas for 2015, a year so far characterised by divergence in global central bank monetary policy and asset prices.
The “red signals” BII highlights include flagging productivity, which affects growth rates; monetary policy; and, ultimately, corporate margins.
“Heady valuations in some markets and uncertainty over the pace of Fed tightening argue for caution and selectivity in countries, sectors and securities,” said Ewen Cameron Watt, global chief investment strategist for BlackRock.
“We balance this with the sense that bull markets often last a lot longer than expected, and the associated risk of missing out on gains.”
Today’s richly valued assets include government bonds which are hovering near record prices, BII notes.
“Valuations of developed equities are average, with the U.S. market the outlier,” said Mr Cameron Watt.
“Bond and currency volatilities have already risen, and we expect equity volatility to follow. This would challenge traditional bond-equity diversification.
“European markets have been troubled by the situation in Greece. This obscures more important issues in the second half including low productivity and challenged margins on one side of the coin and soaring M&A on the other,” said Mr Cameron Watt.
Markets anticipating end to zero interest rates
BII expects the US Federal Reserve to raise short term rates in the fall, and the Bank of England to follow suit in November or February 2016. Monetary policy remains easier elsewhere with the European Central Bank (ECB) expected to maintain its asset purchasing until September 2016, the Bank of Japan continuing with its quantitative easing (QE) program and the People’s Bank of China delivering increased domestic stimulus.
“It is premature to call an end to global QE,” BII notes, but “worth thinking about as markets tend to front-run events”, suggesting that investor focus will soon turn from central bank policy to other investment fundamentals.
An awakening for global bond markets
Market trepidation about the first Fed hike in nine years is awakening global fixed income markets lulled into complacency by years of near-zero rates and regular doses of quantitative easing, notes BII.
How will bond markets react when the Fed begins to normalise rates?
“A September rate hike would likely hit short-maturity bonds,” said Russ Koesterich, global chief investment strategist for BlackRock.
“Yet, any rise in long-term rates should be subdued by yield-hungry buyers.”
Across the eurozone, the “largesse” of the European Central Bank has driven a collapse in bond yields.
“Although formerly high-yielding nations such as Spain no longer offer much absolute value, opportunities do remain, such as long-dated sovereign debt of Portugal and subordinated bank debt,” added Mr Koesterich.
“Similar dynamics will play out in Japan and Australia, with central banks keeping monetary policy loose. We are relatively optimistic about Japan due to improved wages and job conditions, lower energy prices, possible postponement of a further sales tax hike, and sustained low rates thanks to Quantitative and Qualitative Easing (QQE).
“In Australia, we expect the central bank to resume easing towards end of year and bonds will outperform those in the US,” said Joel Kim, head of Asia Pacific fixed income for BlackRock.
Rising rates will threaten some stocks and benefit others
Overall, equities look reasonably valued relative to bonds, though BII cautions against “richly valued US equities”, particularly ahead of a rising rate environment in the US.
“The impact of rising rates will threaten US dividend-paying, low-volatility sectors such as utilities, real estate investment trusts and consumer staples, while benefiting banks as loan growth tends to rise in tandem,” said Mr Koesterich.
Whilst European equities are no longer cheap, earnings forecasts are finally on the rise.
“Thank the weak euro, loose credit conditions engineered by the ECB’s bond purchases and signs of loan growth,” said Mr Koesterich.
In Asia, BII favors Japanese equities, with the weak yen boosting earnings estimates, and increasing dividends and buybacks providing extra support.
More broadly, “Asian equities away from Japan are at the cusp of a long run higher, based on good value, easing financial conditions and reform momentum to liberalize economies such as India and China. We prefer Hong Kong-listed Chinese equities, or H-shares,” said Chris Hall, BlackRock’s co-head of Asian equity research.
Emerging markets in better shape; dispersion set to rise
Past Fed tightening cycles have sparked emerging market debt crises, yet emerging markets are in better shape these days, with less external debt, deeper financial markets and more dry powder for stimulus, BII notes.
“Emerging market stocks look reasonable, but are not screaming buys. Where they look cheap it is often for good reasons,” said Mr Cameron Watt.
“Key risks in the emerging markets include anemic growth in exports and falling productivity. We prefer hard currency over most local bonds, as we see the US dollar rising against many EM currencies, and prefer countries with reform momentum and falling inflation,” he added.
“Asian countries broadly meet the same criteria, with reduced vulnerabilities, positive reform momentum and inflation generally below expectations. We expect Asian bond markets to be less vulnerable as a result, which gives Asian central banks the flexibility to diverge from the US Fed.
“On currencies, China is going to retain a stable policy for now, while there is no need for Asian currencies to depreciate in order to synchronize growth between Asian and developing markets. We retain a modest preference for Asian hard currency over local currency debt,” added Mr Kim.
Source: BlackRock Investment Institute
