Reasons To Embrace Risk

Key points

• We believe the synchronized and sustained economic expansion and low-yield environment bode well for risk assets.
• German bunds helped drive global government bond yields up for a second week on prospects of reduced monetary stimulus.
• Soft loan growth, relatively weak trading volumes and a flattening yield curve lowered U.S. bank earnings expectations.

The global economy is chugging along, with the eurozone perking up even as inflation remains subdued. In a low-yield environment, we believe this bodes well for risk assets.

U.S. equity market valuation, 1988-2017

Sources: BlackRock Investment Institute, with data from MSCI and Thomson Reuters, June 2017.
Notes: U.S. equities are represented by the MSCI U.S. Equity Index. Absolute valuation is based on the earnings yield (the inverse of the 12-month forward price/earnings ratio). Valuation relative to bonds is based on the earnings yield minus the U.S. real bond yield (10-year U.S. Treasury yield minus U.S. core CPI inflation). Valuations are shown in percentiles. For example, the current U.S. absolute earnings yield is in the 18th percentile. This means the earnings yield has been equal to or lower than that level 18% of the time since 1988.

We look at the earnings yield of U.S. equities - the implied yield in earnings estimates that makes potential returns comparable to bond yields. U.S. equities look expensive on this basis, as shown by the blue line in the chart. But compared with historically low bond yields (green line), U.S. equities still look cheap.

Rethinking returns

We see the world in a synchronized and sustained economic expansion, as detailed in our Global investment outlook: Midyear 2017. Eurozone's growth has accelerated, and we believe any near-term worries on China are likely overstated. Yet overall we see an environment of structurally lower growth and interest rates. This suggests comparing today's valuation metrics to past levels may not be as useful of a guide to future returns as in previous cycles.

The current U.S. economic cycle has been unusually long, sparking fears that it is ready to die of old age. We compared this cycle with previous ones, based on estimates of economic slack, and found it has room to run. One consequence: A benign economic environment tends to go hand in hand with low market volatility. We see risks of policy missteps as the Federal Reserve plans to wind down its balance sheet and the European Central Bank looks to transition towards smaller asset purchases. A sharp rise in bond yields could undercut risk assets, but we expect both central banks will communicate clearly and proceed with caution.

Bottom line: We believe investors are being paid to take risk, and prefer equities over fixed income. We like European, Japanese and emerging market shares, as well as the momentum factor. We are negative on major government bonds and prefer inflation-linked debt.

Week in review

• Government bond yields shot up for a second week, led by German bunds. Poor eurozone sovereign auctions added to a sell-off already underway on expectations for unwinding of central bank stimulus.
• U.S. June payrolls rose more than expected, but wage growth disappointed. The data should allow the Fed to push ahead with balance sheet normalization, as its June meeting minutes suggested last week.
• North Korea tested its first intercontinental ballistic missile. Further military escalation may strain U.S.-China relations over different approaches to North Korea's growing nuclear threat.

Global snapshot

Weekly and 12-month performance of selected assets

Equities	Week	YTD	12 Months	Div. Yield
U.S. Large Caps	0.1%	8.3%	15.6%	2.0%
U.S. Small Caps	0.1%	5.0%	24.9%	1.2%
Non-U.S. World	-0.5%	13.6%	21.4%	3.1%
Non-U.S. Developed	-0.5%	13.3%	21.6%	3.3%
Japan	-1.7%	8.1%	17.1%	2.1%
Emerging	-0.6%	17.7%	24.0%	2.6%
Asia ex-Japan	-0.6%	22.0%	26.0%	2.4%

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Bonds	Week	YTD	12 Months	Yield
U.S. Treasuries	-0.5%	1.4%	-3.4%	2.4%
U.S. TIPS	-0.6%	0.3%	-2.3%	2.3%
U.S. Investment Grade	-0.4%	3.4%	0.7%	3.3%
U.S. High Yield	-0.2%	4.7%	11.4%	5.8%
U.S. Municipals	-0.2%	3.4%	-0.9%	2.3%
Non-U.S. Developed	-1.1%	5.0%	-5.4%	0.9%
Emerging Market $ Bonds	-0.9%	5.2%	4.0%	5.5%

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Commodities	Week	YTD	12 Months	Level
Brent Crude Oil	-2.5%	-17.8%	0.7%	$46.7
Gold	-2.3%	5.7%	-10.9%	$1,212.5
Copper	-1.8%	5.3%	24.3%	$5,828.0

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Currencies	Week	YTD	12 Months	Level
Euro/USD	-0.2%	8.4%	3.1%	1.14
USD/Yen	1.4%	-2.6%	13.0%	113.92
Pound/USD	-1.0%	4.5%	-0.1%	1.29

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Source: Bloomberg. As of July 7, 2017.
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

This post originally appeared on the BlackRock Blog.