Tighter financial conditions and elevated worries about the impact of heightened U.S.-China trade tensions are spooking investors–and have helped spark this month’s equity pullback. We retain a preference for selective risk-taking, even as the recent market moves reinforce our call for building greater resilience into portfolios.
Higher interest rates are one of the key contributors to tighter financial conditions this year. Market expectations for future Federal Reserve rate hikes have adjusted upward and are now consistent with our outlook for around three rate rises over the next 12 months. The result: Higher yields on short-term bonds making for greater competition for capital. This is contributing to falling equity prices–mirrored by rising earnings yields–and rising bond yields. The recent move higher in bond yields has been driven by higher real rates–not inflation expectations. See the light blue and green shaded areas in the chart above. A rise in the term premium, the additional return investors demand for holding longer-term debt, has contributed. Investors have reset their return requirements across asset classes, given heightened uncertainty and rising short-term yields. This repricing has escalated since the start of October.
Part of the recent equity market drop was due to jitters about an intensification of the U.S.-China trade conflict. Some global companies cited trade concerns last week, fueling investor uncertainty about the sustainability of the growth and earnings outlook. Our gauge of overall geopolitical risk has dipped in the past few weeks, but U.S.-China trade tensions are high and we see trade tensions as the biggest global threat to the U.S.-led expansion. Our BlackRock GPS growth indicators point to robust global growth with low inflation–and do not show trade tensions hampering economic activity. However, the negative threat posed by trade protectionism could yet feed through due to highly globally integrated corporate value chains. Third-quarter earnings season will be key to watch in this respect.
Last week’s decline in the MSCI World Index was the index’s second-largest weekly drop in 2018, although global equities remain in positive territory year-to-date. Equity markets have seen a sharp rotation in leadership, with momentum shares under-performing after a stretch of strong gains. We believe the bulk of the recent selling pressure has been driven by hedge funds unwinding popular crowded positions–especially in technology and growth names. The rise in 10-year U.S. Treasury yields at the start of last week came after Fed officials’ hawkish commentary pushed up market expectations for the path of U.S. policy rates. The rise in market yields has been driven by higher real rates and a higher term premium, often associated with increased uncertainty.
We still see corporate earnings supported by sustained above-trend global growth, and retain our preference for equities over fixed income. But we reiterate our call to focus on portfolio resilience. Companies that disappoint on third-quarter earnings and fourth-quarter guidance risk being acutely punished. We like quality exposures within equities and prefer the U.S. within developed markets due to earnings resilience and stronger balance sheets. In fixed income, we favor short-end bonds but are starting to see opportunities further out on the yield curve in the U.S. and Europe. Over the long term, the rise in yields should eventually point to higher returns across asset classes. Yet we see good reasons why risks will stay elevated or increase further in the short term, pressuring returns.