What’s in store for the second half? Around 90 BlackRock portfolio managers and executives recently gathered to discuss the question. We had vigorous debates about the outlook for reflation, emerging markets (EM) and financials, but we did agree on the three themes likely to shape markets for the remainder of 2016 and other key views.
Theme 1: Low rates and low returns
We are living in a low-return world, with future market returns likely to be lower than in recent history. The hunt for yield is getting more challenging. More than 70% of the bonds in developed-market government bond indexes today have yields of 1% or lower, as the chart below shows. Falling yields are dragging down projected returns across the capital markets. This means investors who want higher returns must consider taking on greater risk — by increasing leverage or moving into riskier asset classes. This, in turn, propels valuations of risk assets higher, at the expense of lower projected returns in the future.
Theme 2: Policy limits
Monetary policy has been a key driver of asset prices — but its effectiveness looks to be waning. Countries have limited firepower left in their monetary arsenals. Policy rates are low, many balance sheets are bloated and some countries are near full employment. We see the Federal Reserve’s (Fed’s) interest rate hikes being put on hold for now amid lackluster growth and economic uncertainty, while the European Central Bank (ECB) looks to be running into diminishing returns from negative rates.
Fiscal stimulus and structural reforms need to take over from monetary policy to foster growth, we believe. There has arguably never been a better time for governments to finance infrastructure spending. Interest expense is low despite high debt levels. Yet this is not a quick fix. High-quality fiscal spending takes time to scale up. And fractious politics complicate things, so we are not holding our breath.
Theme 3: Volatility
We see more volatility ahead as Brexit-related anxiety weighs on economies in Europe and the business cycle matures. Volatility soared when the United Kingdom voted to exit the European Union (EU), with the VIX index of U.S. equity market volatility spiking to near 2016 highs, as Bloomberg data shows. Yet realized equity volatility outside the United States has been bubbling below the surface, and currency volatility has spiked to near five-year highs, as reflected in the J.P. Morgan’s VXY index of G-7 currency volatility.
At the same time, long-held relationships appear to be breaking down. For example, the dollar has started to correlate positively with global equities on a two-year rolling basis, reversing a long-standing negative correlation. This means it no longer consistently rallies in equity market selloffs — notwithstanding the recent risk-off period. This argues for greater diversification in portfolio hedges.
Our other key views?
Risks. We see geopolitical uncertainties and a renewed rise in the U.S. dollar as near-term risks, and populism as a medium-term challenge for trade, growth and markets. A potential surprise: A rally in risk assets prompted by investors shifting out of cash and low-yielding assets in search of higher returns.