There are three key themes that investors need to stay ahead of over the coming months: a growth slowdown, the move towards neutral interest rates and balancing risk with reward.
This is the view of analysts at iShares, the passive investment business of asset management giant BlackRock. In its outlook for 2019, iShares highlighted how these three themes should affect portfolio positioning after a challenging year for risk assets.
In the first theme – growth slowdown – the analysts expect to see a slowing in global growth and corporate earnings in 2019, with the US economy entering a late-cycle phase.
This means they are anticipating US GDP growth stabilising, albeit at a much higher level than other regions. Growth in the eurozone is subdued and analysis by BlackRock suggests it is at risk of further downside surprises; growth in Japan remains “tepid” while China is likely to see a mild slowdown amid its fiscal and monetary stimulus.
Relative performance of quality and min vol equity indices over MSCI World, and equity volatility, 2013-2018
Source: BlackRock, with data from Bloomberg, December 2018
“Our expectations for a global slowdown lead us to favour a quality bias, and a more broadly defensive bias, in portfolios. We look for quality companies that have high levels of cash on their balance sheets, sustainable free cash flow and the ability to grow independently of the economic cycle,” iShares’ outlook said.
“We believe companies with these characteristics can provide better ballast than traditional bond proxies: firms that grow earnings per share may offer more protection than those with high – but potentially unsustainable – dividend yields.”
The report added that quality appears to as a stronger defensive hedge than minimum volatility strategies, as shown in the above chart, although both have outperformed the global equities over the past five years.
Within equities, iShares prefers the US healthcare sector for quality exposure as the economy moves into late-cycle territory. US healthcare has above-average free cash flow estimates and is traditionally less sensitive to economic growth, while valuations remain attractive when compared with other defensive sectors.
When it comes to fixed income, a quality stance can be established through US and European investment grade debt. Investment grade is preferred over high yield debt, as the latter may be more susceptible to a growth slowdown.
The second investment theme highlighted by iShares is ‘nearing neutral’, or the impact on markets of the move away from the ultra-loose monetary policy that was implemented after the global financial crisis.
Analysts at the passive investment house noted that the US yield curve flattened in 2018 as financial conditions tightened over the course of 2018, with the Federal Reserve hiking rates on four occasions.
Although a flattening yield curve is often seen as a sign of a looming recession, iShares added that monetary conditions remain relatively loose, offering some support to the near-term growth outlook. It added that the US neutral interest rate – or the rate at which monetary policy neither restricts nor stimulates growth – is currently around 3.5 per cent.
Convergence of US Treasury 2yr and 10yr yields, November 2013 – November 2018
Source: BlackRock, with data from Bloomberg, December 2018
Meanwhile, Fed chair Jerome Powell suggested in November that US rates were approaching neutral. The central bank’s policy is likely to become more data dependent because of this, so iShares expects the central bank to take a more cautious approach and possibly pausing in its quarterly rate hike path for 2019.
“With increasing uncertainty over the path of US rates, we favour inflation linkers, floating-rate bonds and short duration. These tend to provide an effective hedge against rate moves and can help investors to build portfolio resilience,” the firm’s outlook added.
The final theme being watched by iShares is the balance between risk and reward. Its analysts argue that rising volatility and late-cycle market conditions mean investors have to pay more attention to portfolio resilience, without becoming obsessed with defence and still ensuring selective risk exposure to meet long-term goals.
Last year saw VIX index, which measures US equity market volatility and is known as Wall Street’s fear gauge, traded at an average of 15.9; this is almost double the level averaged in 2017, when markets went through a period of historic calm.
Analysts at iShares expect macro uncertainty and equity volatility continuing into 2019, which should reinforce the need for portfolio resilience and more defensive positioning.
“But building portfolio resilience is about more than just dialling down risk and requires that investors maintain sufficient exposure to meet their long-term goals. Taking a barbell approach can pay off, as the macro environment calls for increased selectivity in risk coupled with a defensive core,” they added.
“Resilience can be built in other ways too: paying attention to investor positioning can help to flag potentially crowded trades. In the volatility episodes we have seen this year, investors have heavily sold crowded positions.
“Diversification is an important aspect of portfolio resilience and can provide a layer of protection in volatile market conditions. We prefer to diversify with commodities, which traditionally have a low correlation to equity markets. Our analysis shows that this correlation decreases over time, further enhancing the diversification benefits over a longer time horizon.”
As well as a thematic analysis, iShares’ 2019 outlook assess markets on a geographic basis.
The group’s analysts expect US economic fundamentals to remain strong into 2019 – noting that there is an important distinction between slower growth and contraction – and have an overweight stance on US equities.
Performance of indices over 5yrs
Source: FE Analytics
It also has a positive view on emerging market equities, arguing that there is potential for a rebound in the asset class after its underperformance over the past year. However, selective exposure is recommended and iShares prefers emerging Asia, especially China and India, because of strong current account fundamentals.
The firm has a more neutral stance on Japan. It said yen appreciation is a perpetual risk, especially in times of heightened global volatility, as investors tend to move towards it as a safe haven asset, but notes positives in the country’s shareholder-friendly corporate behaviour, solid earnings and stimulus by the Bank of Japan.
However, iShares has an underweight towards Europe as it sees limited growth prospects for the region. Inflation remains weak and European companies’ earnings growth is significantly behind that of their US peers, while Brexit and Italy’s continuing friction with the European Commission over its proposed budget only add to worries.