We expect US-led reflation – rising nominal growth, wages and inflation – to accelerate, and see fiscal expansion gradually replacing monetary policy as a growth and market driver around the world.
Reflation
We see the prospect of US fiscal expansion amplifying expectations for higher yields and a steepening yield curve. We also see steeper curves in the eurozone after the European Central Bank (ECB) gave itself more room to buy short-term paper as part of an extension of its bond buying programme, yet we see the Bank of Japan’s (BOJ) target to keep 10-year yields near zero limiting moves there.
We believe we have seen the low in bond yields after a 35-year decline − barring any big shock in growth or broader market conditions.
Positioning for a reflationary world
Expectations for global reflation are driving a rotation into cyclicals within equities and sharpening our focus on inflation-linked securities in fixed income.
US equities: Rising earnings estimates could be supportive for broad US equities, but high valuations and a spike in flows following the US election may warrant a selective approach. We see a steeper US yield curve and the prospect of loosening regulation as positive for US financials and other value equities.
- iShares S&P 500 Financials Sector UCITS ETF (IUFS)
- iShares Edge MSCI USA Value Factor UCITS ETF (IUVL)
Inflation-linked bonds: US inflation expectations have bounced back from depressed levels, pointing to inflation settling at around 2.5 per cent in the medium term, in our view. We have a long-term preference for inflation-protected securities but see short-term risks as markets appear to have gotten ahead of themselves.
Credit: Prospects for higher economic growth and inflation favour US corporate credit. Credit market valuations look decent by historical standards, with the exception of high yield. Quality high yield, however, including in Europe, could offer some cushion against rising rates; shorter duration or interest rate-hedged credit products could help reduce interest rate risk.
- iShares $ Corp Bond Interest Rate Hedged UCITS ETF Dist (LQDH)
- iShares $ Short Duration Corp Bond UCITS ETF (SDIG)
- iShares Fallen Angels High Yield Corp Bond UCITS ETF (WING)
- iShares € Corp Bond BBB-BB UCITS ETF EUR Dist (IEBB)
Low returns ahead
Subdued economic growth and still low rates take a toll on prospective asset returns, in our view. Our capital market assumptions point to particularly poor five-year returns on government bonds. However, we believe investors are still being rewarded for moving up the risk spectrum into equities, credit and alternative asset classes. Moving longer in duration, however, seems unlikely to be rewarded given the onset of a cyclical recovery and rise in bond yields in a structurally low-rate environment.
Growth in a low return environment
Structural factors such as ageing societies and weak productivity growth have led to a drop in potential economic growth. We believe these factors limit how high real yields can go.
Emerging market assets: A stronger dollar and potential anti-trade policies pose risks to both emerging market (EM) debt and equities, but such risks look broadly priced in. EM debt yields remain attractive versus US Treasuries and a revival in earning expectations — alongside improved fundamentals and reasonable valuations — may provide support for EM equities, despite external headwinds. Financial sector reform and rising current account surpluses are encouraging for EM Asia, in particular.
- iShares Core MSCI EM IMI UCITS ETF (EIMI)
- iShares MSCI EM Asia UCITS ETF (CEMA)
- iShares J.P. Morgan $ EM Bond UCITS ETF (IEMB)
Japanese equities: Renewed yen weakness, improving global growth, and more shareholder-friendly behaviour could be positive for Japanese equities in 2017.
Eurozone equities: A weaker euro could help export-driven segments of European markets, particularly cyclical sectors which may also benefit from higher global growth momentum and a reflationary-driven pullback in ECB accommodation. The busy political calendar ahead, however, may need to be factored in to any investment decision related to eurozone assets.
Diversification getting harder
The old rules of diversification no longer appear to be working. Long-held relationships between asset classes have broken down dramatically at times as rising yields have led to a shakeup across asset classes. Bond prices are no longer moving as reliably in the opposite direction of equity prices. Similarly, asset pairs that have historically moved in near lockstep − US equities and oil, for example − have become less correlated. Traditional methods of portfolio diversification, which use historical correlations and returns to derive an optimum asset mix, may be less effective.
Diversification amid correlation chaos
A more unstable relationship between bonds and equities challenges traditional diversification techniques.
Cash equivalents: Investors who are building up cash positions as a means to provide a buffer against cross-asset risk-off episodes could consider ultrashort duration bonds as a way to pick up a little additional yield (while rates remain low). Low risk does not mean risk free — investors choosing to put cash to work in ultrashort bonds are taking on additional credit risk and exposing themselves to volatility.
Commodities: When traditional portfolio diversification methods are less effective, it seems inevitable that alternative asset classes gain focus. Gold may have sold off somewhat dramatically following Trump’s victory — but it did so at a time when US equities hit record highs. We believe gold may still prove to be an important portfolio diversification tool for those investors with longer time horizons. Expectations of higher infrastructure spending in the US could benefit commodities more broadly.
Wei Li is iShares EMEA head of investment strategy
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any financial instrument or product or to adopt any investment strategy.
*World’s leading ETF provider: Based on over 800 ETPs and more than $1.2 trillion in AUM globally, BlackRock Global ETP Landscape as at 30 November 2016. Trusted to manage more money than any other investment firm: Based on $5.14 trillion in AUM globally, BlackRock as of 31 December 2016.
