Our Outlook For The Second Quarter

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by: Richard Turnill
Summary

The path for risk assets to grind higher has narrowed, in our view. We are moderately risk-on but see opportunity to take profits and rebalance.

Economic data painted a mixed picture of global growth trends. The 10-year U.S. government bond yield fell to a 15-month low.

Markets expect this week's U.S. jobs report to show nonfarm payrolls growth rebounded in March from a nearly 18-month low in February.

Where are risk assets headed after a strong first quarter? We see a repeat as unlikely and a narrower path for a grind higher. The global economy must remain strong enough to quell recession fears but weak enough to keep policymakers on hold, we believe. We are moderately pro-risk, with a penchant to rebalance toward quality.

Chart of the week
Performance of selected assets during U.S. late-cycle quarters, 1988-2019

Performance of selected assets during U.S. late-cycle quarters, 1988-2019

The figures shown relate to past performance and are not a reliable indicator of current or future results. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, with data from Thomson Reuters, March 2019. Notes: We looked at asset returns in each quarter since 1988 that fell during a late-cycle period. We identify such periods via a "cluster analysis" that groups together time periods where economic series behaved in similar ways. Variables considered include measures of economic slack, wage and price inflation, the monetary policy stance and the growth of private sector leverage. The dots show mean returns over the time period. The bars show the 10th to 90th percentile range. Indexes used are the MSCI World and Emerging Markets indexes, and the Bloomberg Barclays U.S. Government, U.S. Corporate and U.S. High Yield indexes. Index returns do not reflect any management fees, transaction costs or expenses.

A key theme from our latest investment outlook: growth slowdown. We see further decelerations in both economic and earnings growth ahead, with pressure on historically high corporate profit margins. Yet we are also increasingly confident that the global economy can remain in late-cycle throughout 2019. How do markets typically fare during late-cycle periods? Global equities produced quarterly returns above the full-cycle historical average, edging out fixed income, according to our analysis. Yet there was wide dispersion and pronounced downside around these averages, particularly in emerging market equities. Within fixed income, U.S. Treasuries modestly outperformed riskier credit sectors. See the chart above.

A new theme and a Chinese rebound

We introduce a new investment theme this quarter: patient policymakers. It reflects the Federal Reserve's dovish pivot - and a similar emphasis on patience among other developed market central banks. China has moved to easier credit and fiscal policies, but with greater caution than in the 2015-2016 downturn. The supportive stance of global policymakers should underpin both equities and bonds. Yet the strength of the year-to-date rally across markets looks fragile and hard to replicate, and we believe market expectations of U.S. monetary policy are now overly dovish. This is where our third theme, balancing risk and reward, takes on new importance. Signs of a more pronounced growth slowdown or new trade disputes have the potential to stoke uncertainty. A rapid rise in asset valuations and plunge in volatility point to creeping market complacency, but fund flows and market positioning are far from euphoric. These crosscurrents lead us to favor a selective approach to risk-taking in the second quarter. We see quality assets, including U.S. Treasuries, as an important source of portfolio resilience.

China plays a pivotal role in our views on the global economy, markets and geopolitics. We are increasingly confident that Chinese growth is likely to reaccelerate from the second quarter onward, thanks to easing fiscal and monetary policies. Improving Chinese activity should benefit global growth, especially in Asia and Europe, and could also boost global capex. We see potential for a U.S.-China trade deal to address the bilateral trade gap and market access, but caution that U.S.-China tensions, particularly over tech dominance, are likely here to stay. A potential flare-up between the U.S. and Europe over U.S. auto tariffs also merits concern.

Bottom line: We remain modestly overweight stocks versus bonds, but favor trimming exposures that have notched particularly strong returns so far this year. Our preferred regions remain the U.S. and emerging markets. We favor quality equities in sectors that can sustain earnings growth even in a slowing economic environment, such as selected health care and tech firms. In bonds, we focus on income, including emerging market debt, but also see an important role for U.S. Treasuries as portfolio shock absorbers.

Week in Review

  • Global economic data painted a mixed picture. Consumer confidence in both the U.S. and Germany fell, but Germany's Ifo business climate index exceeded expectations. U.S. consumer spending in January was softer than expected while core inflation eased. The 10-year U.S. government bond yield fell to a 15-month low.
  • Some emerging market currencies experienced turbulence. The Turkish lira's wild swings extended into a second week ahead of local elections. The Brazilian real dropped to a five-month low against the U.S. dollar on concerns that President Jair Bolsonaro's signature pension reform might be stalling. The Argentine peso hit a record low against the dollar on growth worries.
  • The UK Parliament rejected Prime Minister Theresa May's Brexit deal for a third time. We see growing likelihood of further delays to the Brexit process. The U.S. and China resumed trade talks, though few details emerged.

Global snapshot

Weekly and 12-month performance of selected assets

Equities Week (%) YTD(%) 12 Months (%) Div. Yield
U.S. Large Caps 1.2% 13.7% 9.5% 2.0%
U.S. Small Caps 2.3% 14.6% 2.1% 1.6%
Non-U.S.World 0.0% 10.4% -3.6% 3.2%
Non-U.S.Developed 0.0% 10.1% -3.1% 3.4%
Japan -1.4% 6.8% -6.8% 2.4%
Emerging -0.1% 10.0% -6.9% 2.7%
Asia ex-Japan -0.1% 11.4% -4.8% 2.5%
Bonds Week (%) YTD (%) 12 Months (%) Yield (%)
U.S. Treasuries 0.4% 2.1% 4.2% 2.4%
U.S. TIPS 0.1% 3.2% 2.7% 2.6%
U.S. Investment Grade 0.5% 5.1% 4.9% 3.6%
U.S. High Yield 0.3% 7.3% 5.9% 6.4%
U.S. Municipals 0.4% 2.9% 5.4% 2.3%
Non-U.S. Developed -0.5% 1.5% -4.1% 0.7%
EM & Bonds 0.3% 7.0% 4.2% 6.0%
Commodities Week YTD (%) 12 Months Level
Brent Crude Oil 2.0% 27.1% -2.7% $68.39
Gold -1.6% 0.7% -2.5% $1,292
Copper 2.7% 8.7% -3.5% $6,483
Currencies Week YTD (%) 12 Months Level
Euro/USD -0.8% -2.2% -8.8% 1.12
USD/Yen 0.8% 1.2% 4.2% 110.86
Pound/USD -1.4% 2.1% -7.0% 1.30

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index.
Source: Thomson Reuters DataStream. As of March 29, 2019.
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 JPMorgan 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.

Week Ahead

Date: Event
April 1 U.S. retail sales; global manufacturing Purchasing Managers' Index (PMI)
April 3 Chinese Vice Premier Liu He visits the U.S. for trade talks; U.S. non-manufacturing PMI
April 4 German industrial orders
April 5 U.S. jobs

This week's U.S. employment data will offer clues about the health of the labor market - and the overall economy. Markets are keen to learn if February's weak nonfarm payrolls growth - the slowest since September 2017 - was a one-off or the start of a downtrend. Consensus estimates point to a rebound in the March data. This would confirm ongoing strength in the labor market and potentially ease growth worries caused by a recent raft of mixed global economic data.

Asset class views

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

Asset Class View Comments
Equities U.S. icon-up A slowing but still growing economy underlies our positive view. We prefer quality companies with strong balance sheets in a late-cycle environment. Health care and technology are among our favored sectors.
Europe icon-down Weak economic momentum and political risks are challenges to earnings growth. A value bias makes Europe less attractive without a clear catalyst for value outperformance. We prefer higher-quality, globally oriented firms.
Japan icon-neutral Cheap valuations are supportive, along with shareholder-friendly corporate behavior, central bank stock buying and political stability. Earnings uncertainty is a key risk.
EM icon-up Economic reforms and policy stimulus support EM stocks. Improved consumption and economic activity from Chinese stimulus could help offset any trade-related weakness. We see the greatest opportunities in EM Asia.
Asia ex-Japan icon-up The economic backdrop is encouraging, with near-term resilience in China and solid corporate earnings. We like selected Southeast Asian markets but recognize a worse-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.
Fixed Income U.S. government bonds icon-neutral We are cautious on U.S. Treasury valuations after the recent rally, but still see them as portfolio diversifiers given their negative correlation with equities. We expect a gradual steepening of the yield curve, driven by still-solid U.S. growth, a Fed willing to tolerate inflation overshoots - and a potential shift in the Fed's balance sheet toward shorter-term maturities. This supports two- to five-year maturities and inflation-protected securities.
U.S. municipals icon-up We see coupon-like returns amid a benign interest rate backdrop and favorable supply-demand dynamics. New issuance is lagging the total amount of debt that is called, refunded or matures. The tax overhaul has made munis' tax-exempt status more attractive in many U.S. states, driving inflows.
U.S. credit icon-neutral A still-growing economy, reduced macro volatility and a decline in issuance support credit markets. Conservative corporate behavior - including lower mergers and acquisitions volume and a focus on balance sheet strength - also help. We favor BBBs and prefer bonds over loans in high yield.
European sovereigns icon-down Low yields, European political risks, and the potential for a market reassessment of easy ECB policy or pessimistic euro area growth expectations all make us wary on European sovereigns, particularly peripherals. Yet any further deterioration in U.S.-European trade tensions could push yields lower.
European credit icon-down "Low for longer" ECB policy should reduce market volatility and support credit as a source of income. European bank balance sheets have improved after years of repair, underpinning fundamentals. Yet valuations are rich after a dramatic rally. We prefer high yield credits, supported by muted issuance and strong inflows.
EM debt icon-neutral Prospects for a Chinese growth turnaround and a pause in U.S. dollar strength support both local- and hard-currency markets. Valuations are attractive despite the recent rally, with limited issuance adding to positives. Risks include worsening U.S.-China relations and slower global growth.
Asia fixed income icon-neutral A focus on quality is prudent in credit. We favor investment grade in India, China, and parts of the Middle East, and high yield in Indonesia. We are cautious on Chinese government debt despite its inclusion in global indexes from April. We see rising funding needs outstripping foreign inflows.
Other Commodities and currencies * A reversal of recent oversupply is likely to underpin oil prices. Any relaxation in trade tensions could boost industrial metal prices. We are neutral on the U.S. dollar. It has perceived "safe-haven" appeal but gains could be limited by a high valuation and a narrowing growth gap with the rest of the world.

* Given the breadth of this category, we do not offer a consolidated view.

This post originally appeared on the BlackRock Blog.