The stars aligned almost perfectly for risk assets during 2017, but the period ahead will likely be more challenging, the world’s largest asset manager says.
“[The year] 2017 will be a tough act to follow. We believe investors will still be compensated for taking risk in 2018 – but [will] receive lower rewards,” the BlackRock Investment Institute notes in its Global Investment Outlook 2018.
Over the past year, valuations have increased, market volatility has remained muted and many perceived risks have not materialised, but this means markets are more susceptible to short-term corrections, it says.
According to Bloomberg data, the S&P 500 has returned about 19.7% in the year to date, the Nasdaq 29.3% and the Dow Jones Industrial Index 25.1%.
“The risk premia on all financial assets has declined. Our measure of the US equity risk premium – one gauge of equities’ expected return over government debt – has fallen since the global financial crisis.
“We believe overall market returns will be more muted as a result, making selectivity key. We prefer to take risk in equities, particularly non-US stocks. We believe structurally low interest rates mean equity multiples can stay higher than in the past,” BlackRock says.
Broadly speaking, the firm is of the view that stable global economic growth, subdued inflation and low interest rates should support the performance of risk assets, but warns that investors should taper their return expectations.
While cheerful equity and credit markets might suggest that investors are high-spirited, BlackRock says its analysis does not point to excessive exuberance. Even with stock markets continuously testing highs, its US “risk ratio” – which measures the extent to which shareholders are bidding up the value of risk assets relative to seeming safe havens such as cash and government bonds – does not show the same warning signs it did just prior to the dotcom crash or global financial crisis.
Corporate profitability supported earnings growth over the past year. According to Thomson Reuters, all major regions increased earnings faster than 10%, the strongest expansion since the recovery after the global financial crisis.
Although BlackRock expects 2018 to be another good year, it does not anticipate a repeat of 2017. The favourable economic and earnings environment should support equities although more expensive valuations could weigh on performance. While US corporate tax cuts will support US earnings, the effect will vary across sectors and companies.
“Equities in Japan, the only major region to see multiple contraction in 2017, look well positioned.”
With regard to developed market stocks, BlackRock prefers the technology and financial sectors.
During 2017, emerging market equities managed to end years of underperformance relative to its developed market equals.
“We believe they can run higher. Companies have reduced wasteful investments, and our math finds free-cash-flow yield for non-financials exceeds that of developed markets for the first time since 2007. Return on equity is finally improving and valuations are rising,” BlackRock notes.
The fund manager believes there is room for a continued rerating in emerging markets in 2018 and sees reform progress in major markets as a positive. There is also more than enough room for investors to increase their exposure to emerging markets.
“We see the greatest opportunities in emerging market Asia but note positive progress in Brazil and Argentina. We do not see moderate Fed tightening or US dollar gains harming the investment case.”
The Fed is expected to raise interest rates three times at projected increments of 25 basis points in 2018.
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