3 Themes That Will Shape Markets This Quarter

by: Richard Turnill

jodie_johnson / Shutterstock

jodie_johnson/Shutterstock

Fears of a global recession hit markets hard at the start of the year. Yet the anxiety has waned.

What's in store for the quarter ahead? My colleagues and I provide a roadmap in our new BlackRock Investment Institute publication "Global Investment Outlook: Q2 2016." Our outlook centers around three key themes likely to shape financial markets in the second quarter.

Theme 1: Low returns ahead

We are living in a low-return world. A long period of low rates have encouraged investors to assume greater risk in the stretch for yield, inflating asset prices. Ongoing quantitative easing (QE) and negative interest rate policies are only continuing this trend.

Higher valuations today typically mean lower returns in the future. For example, BlackRock's five-year "Capital Market Assumptions" for future returns of various asset classes are near post-crisis lows. But it's important to remember we are in a low-return, but not no-return, environment. This poses a dilemma for investors: Accept lower returns or dial up risk by taking more equity, credit and interest rate exposure.

Theme 2: Monetary policy divergence is slowing

Monetary policy divergence has been a clear market theme since 2014, sparking a persistent appreciation in the U.S. dollar. Expectations of a Federal Reserve (Fed) liftoff contrasted with further easing measures from the European Central Bank and the Bank of Japan, and this has been reflected in the diverging path of two-year bond yields.

However, the era of ever-widening policy divergence through interest rates is likely behind us. We believe future divergence will be more subtle. The Eurozone and Japan are reaching the limits of negative rates, with further divergence likely to be driven by incremental QE in Europe and Japan as well the trajectories of U.S. growth and rate increases.

The market implications: A slower expected pace of Fed tightening is pausing the dollar's rise, and this bodes well for risk assets and emerging markets in particular. The dollar will likely only resume its uptrend once markets start pricing in faster Fed rate increases.

Theme 3: Volatility and dispersion

Markets today are characterized by a lot of "me-too" trades. Popular trades have included overweighting the U.S. dollar and underweighting emerging market and commodity assets. We see two problems with this picture. First, many of these trades are highly correlated. This means portfolios may be riskier than they appear. Second, monetary policy normalization is likely to increase volatility. Volatility and dispersion tend to rise late in monetary policy cycles when central banks start raising rates and shrinking their balance sheets, our research suggests.

This raises the risk of rapid momentum reversals and shifts in market leadership going forward. We are already starting to see the gap between winners and losers widen again. Cross-sectional dispersion in global equities - a measure of the variation in returns across individual securities - recently reached its highest level in four years, according to our analysis. Other asset classes are displaying similar trends.

We see volatility and dispersion rising to normalized levels as the Fed lifts rates and markets pay more attention to lurking tail risks. These risks include the downside ones of a Chinese yuan devaluation and a U.K. exit from the European Union, as well as the upside risks of an emerging market rebound or a moderate rise in inflation expectations on improving growth prospects.

The investing takeaway of this third theme: Investors can no longer rely on a rising tide lifting all boats. Security selection is crucial as dispersion re-emerges in asset markets.

Read more about these themes, and our views across asset classes, in the full BlackRock Global Investment Outlook.

This post originally appeared on the BlackRock Blog'.