With downside risks rising, more volatility looms for global markets: BlackRock

Jul 12th, 2016 | By | Category: ETF and Index News

BlackRock Investment Institute’s Mid-Year 2016 Global Investment Outlook

With downside risks rising, more volatility looms for global markets: BlackRock

Richard Turnill, BlackRock Global Chief Investment Strategist.

More volatility looms for the global markets, torn between anxiety over the fallout of the UK’s vote to exit the European Union (Brexit) and the prospect of a strengthening U.S. economy, according to the 2016 Mid-Year Global Investment Outlook from BlackRock Investment Institute (BII). BlackRock is the parent of exchange-traded fund provider iShares.

The Mid-Year Outlook provides an update on the Institute’s main economic and market assumptions and asset views for 2016 – a year now marked by geopolitical uncertainties.

“Downside risks to global growth point to a U.S. Federal Reserve on hold — and reinforce our view of low global interest rates for long,” said Richard Turnill, BlackRock Global Chief Investment Strategist. “A potential surprise: a rally in risk assets prompted by investors shifting out of cash and low-yielding assets in search of higher returns.”

Trimming Expectations for Global Growth

The global economy is “limping along,” with the U.S. holding up, and Chinese growth, commodities and EM currencies stabilizing, according to the BII. The BII has trimmed its expectations for global growth and, in particular, sees a risk of a UK recession and expects downgrades to an already poor growth outlook in the eurozone as Brexit uncertainty weighs on sentiment.

Headline inflation is set to rise from depressed levels globally if oil prices stabilize at current levels. The BII sees the U.S. leading any reflationary trend, driven by price increases in the services sector and moderate wage growth. Signs of U.S. reflation could boost risk sentiment, yet would also carry risks: Most asset prices would suffer if the Fed were seen to fall behind the curve on inflation, the BII believes.

Asset Relationships Breaking Down

Volatility soared when the UK voted to exit the EU, with the VIX index of U.S. equity market volatility spiking to near 2016 highs, the BII notes. At the same time, long-held relationships among various asset classes appear to be breaking down, with implications for portfolio hedges.

“Betting on yesterday’s winners rising (or losers falling) further — the momentum trade — has gotten a lease on life amid low growth and easy monetary policies,” said Turnill. “We see volatility driving more investment flows into our favorite assets: high-grade credit, quality equities and dividend growers.”

The impact of monetary policy divergence on asset prices appeared to be waning, and countries have limited firepower left in their monetary arsenals, the BII says. “Fiscal stimulus and structural reforms need to take over from monetary policy to foster growth, we believe, yet fractious politics complicate things,” the BII says. “For example, in the eurozone, Germany does not want to boost spending while it perceives others as unwilling to reform.”

A More Challenging Hunt for Yield

The hunt for yield is getting more challenging for investors. “Bonds yielding 3% or more are going the way of the dodo,” the BII says, with slow global growth, negative interest rates policies, quantitative easing, and a flight to quality amid elevated global risks pushing yields even lower.

“Investors who want higher returns must take on greater risk — by increasing leverage or moving into riskier asset classes, which, in turn, propels valuations of risk assets higher,” said Turnill. “Future market returns will likely be lower than in recent history. This argues for a more active approach to investing.”

The BII has turned more positive on most fixed income due to elevated geopolitical risks and easy monetary policy in a low-growth world. Holding quality government bonds such as U.S. Treasuries makes sense as a portfolio hedge against “risk-off” episodes — and for investors seeking to match liabilities. Negative-yielding sovereigns such as German government bonds come with a hefty price tag, however, the BII notes.

On the credit side, the BII sees investment grade corporate debt as attractive in a world hungry for yield. U.S. high yield spreads could widen as risk and illiquidity premia rise with the post-Brexit economic uncertainty, but any sell-offs could create buying opportunities.

Corporate bond purchases by the ECB are underpinning European credit markets, the BII notes. “We expect the ECB to buy €4-5 billion of corporate debt per month in the primary market this year, roughly 15% of estimated monthly issuance, and an additional €1 billion per month in secondary markets,” the BII says. “This is especially supportive of higher-quality investment grade debt — the target of the ECB’s buying.”

Pick-Up in Earnings Would Support More Bullish Equity View

The BII is cautious on equities, particularly European stocks, due to negative risk sentiment, elevated valuations and poor earnings growth. U.S. earnings have been flat for a year now, Japanese earnings growth has turned negative, and EM earnings are showing only tentative signs of recovery. Uncertainty around the shape of the UK’s relations with the EU could further crimp European earnings.

“What would make us more bullish? “A pick-up in earnings growth, or a shift toward fiscal expansion and structural reform,” said Turnill. “We prefer quality equities and dividend growers in the current low-rate environment. An added bonus for dividend growers: We see them outperforming when the Fed eventually raises rates.”

“Warming Up” to Emerging Markets

The BII is “warming up” to emerging markets (EM) assets, thanks to structural reforms in some countries and a strong demand from investors fleeing negative rates.

An expected hiatus in Fed rate rises bodes well for beaten down EM assets. In addition, the cyclical challenges that led to poor EM returns in recent years are now reversing. In particular, the BII likes hard-currency EM debt for income in a yield-hungry world.

“Portfolio flows into EM assets have resumed — with room for upside because most investors are still underweight the asset class,” the BII says.

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