Investors are grappling with an unusually wide range of potential economic outcomes beyond the post-pandemic restart, reflected in frequent shifts in equity market leadership and volatile bond yields. We stick to the anchor of our three key investment themes – and a broad strategic preference for equities over bonds in our updated long-term return assumptions. A more granular approach could help better capture these themes and provide diversification in portfolios, in our view.
Our three investment themes are the new nominal, or a more muted central bank policy response to higher inflation than in the past, China stands out as a distinct asset class and global growth engine, and the journey to net zero. We advance our portfolio construction tool kit in two ways to reflect a more granular approach: One, we take explicit views across the yield curve; two, in equities we use sectors as the unit of analysis to inform our regional views. Rising earnings growth expectations and low interest rates have helped offset the impact of higher equity prices on our overall expected long-term returns. We’ve witnessed diverging earnings expectations across regions and sectors during the pandemic. Some sectors in the U.S., such as IT, materials and communications, have dramatically eclipsed their pre-pandemic earnings estimates. See the chart. In Europe, earnings estimates still lag pre-Covid levels in some areas but the earnings revision ratio – the ratio of the number of stocks with corporate earnings upgrades to those with downgrades – has been rising sharply, supporting our recent tactical upgrade of European equities to overweight.
Forward-looking estimates may not come to pass. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, July 2021. Notes: The chart shows 12-month forward earnings for the selected sectors within the MSCI USA and MSCI EMU indexes relative to their pre-Covid trend. Respective MSCI sector indexes are used as proxies. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index.
We believe a sectoral approach to asset allocation in equities will allow investors to better tap into structural themes that are being turbocharged by the pandemic, such as sustainability. Climate change and the green transition will likely affect all assets, but it will be most pronounced at the sector rather than broad market level, in our view. Some sectors may benefit from being aligned with the green transition, as solution providers or by being less exposed to transition risks, including tech and healthcare. Others such as energy and utilities may face longer-term challenges even if restart dynamics brighten their near-term appeal. Just to be clear: These are broad sectoral views – and some individual companies within sectors may buck these trends, creating opportunities for differentiation.
We maintain high conviction in our new nominal theme that implies low real yields – a positive for risk assets. The fall in long-dated yields through the second quarter – a reversal from the climb earlier in the year – has further eroded our expected long-run returns across government bonds and credit. Yet we believe the interest rate environment lends itself to more granularity because the new nominal is effectively all about varying views across different parts of the yield curve. We expect short-term yields to likely stay low as central banks keep policy accommodative, yet see longer-term yields gradually rising on the back of higher medium-term inflation and a revival of term premia (the compensation investors demand for holding riskier longer-term bonds). As a result we expect the yield curve to be steeper in five years than the market is currently pricing. The implication? A preference for shorter-dated nominal government bonds over longer maturities within our overall strategic underweight on the asset class.
The bottom line: We prefer equities to credit and government bonds in strategic portfolios, and see the need for a more granular approach. In fixed income, we prefer inflation-linked bonds to nominal government bonds due to our medium-term inflation expectations and the diminished diversification role of nominal bonds. The lower for longer rate environment also boosts the appeal of private markets for eligible investors, in our view. We also still see a strong strategic case for Chinese assets – especially government bonds – even after allowing for sizable uncertainties, in large part because we believe even a “neutral” strategic allocation to China is significantly higher than current index weights and modest client allocations to Chinese assets. We recognize that precise implementation of more granular views in practice can differ widely among different types of investors.