As Stimulus Curtails, Fundamentals Will Re-Emerge as Key Drivers of Portfolio Returns

Some indicators “flashing red” Lagging productivity, heady asset valuations

Equities “reasonably valued” relative to bonds Stocks in Europe and Japan favored

Emerging markets buffered against impact of Fed tightening

With U.S. monetary policy turning, fundamentals such as productivity and earnings growth are poised to regain prominence as drivers of investment return - with some key indicators "flashing red," according to BlackRock (NYSE:BLK) Investment Institute's (BII) mid-year 2015 investment outlook.

The mid-year outlook, "Nearing Normal," provides an update on BII’s main economic assumptions and top investment ideas for 2015, a year so far characterized by divergence in global central bank monetary policy and asset prices.

The “red signals” BII highlights include flagging productivity, which affects growth rates, monetary policy and, ultimately, corporate margins. "Heady valuations in some markets and uncertainty over the pace of Fed tightening argue for caution and selectivity in countries, sectors and securities," said Ewen Cameron Watt, Global Chief Investment Strategist for BlackRock. "We balance this with the sense that bull markets often last a lot longer than expected, and the associated risk of missing out on gains."

Today's richly valued assets include government bonds which are hovering near record prices, BII notes. "Valuations of developed equities are average, with the U.S. market the outlier," said Cameron Watt. “Bond and currency volatilities have already risen, and we expect equity volatility to follow. This would challenge traditional bond-equity diversification."

“European markets have been troubled by the situation in Greece. This obscures more important issues in the second half including low productivity and challenged margins on one side of the coin and soaring M&A on the other,” said Cameron Watt.

Markets anticipating end to zero interest rates

BII expects the U.S. Federal Reserve to raise short term rates in the fall, and the Bank of England to follow suit in November or February 2016. Monetary policy remains easier elsewhere with the European Central Bank (ECB) expected to maintain its asset purchasing until September 2016, the Bank of Japan continuing with its quantitative easing (QE) program and the People's Bank of China delivering increased domestic stimulus.

"It is premature to call an end to global QE," BII notes, but "worth thinking about as markets tend to front-run events," suggesting that investor focus will soon turn from central bank policy to other investment fundamentals.

An awakening for global bond markets

Market trepidation about the first Fed hike in nine years is awakening global fixed income markets lulled into complacency by years of near-zero rates and regular doses of quantitative easing, notes BII.

How will bond markets react when the Fed begins to normalize rates? "A September rate hike would likely hit short-maturity bonds," said Russ Koesterich, Global Chief Investment Strategist for BlackRock. "Yet, any rise in long-term rates should be subdued by yield-hungry buyers."

Across the eurozone, the "largesse" of the European Central Bank has driven a collapse in bond yields. “Although formerly high-yielding nations such as Spain no longer offer much absolute value, opportunities do remain, such as long-dated sovereign debt of Portugal and subordinated bank debt,” added Koesterich.

Rising rates will threaten some stocks and benefit others

Overall, equities look reasonably valued relative to bonds, though BII cautions against “richly valued U.S. equities", particularly ahead of a rising rate environment in the U.S. “The impact of rising rates will threaten U.S. dividend-paying, low-volatility sectors such as utilities, real estate investment trusts and consumer staples, while benefiting banks as loan growth tends to rise in tandem,” said Koesterich.

Whilst European equities are no longer cheap, earnings forecasts are finally on the rise. "Thank the weak euro, loose credit conditions engineered by the ECB’s bond purchases and signs of loan growth," said Koesterich.

In Asia, BII favors Japanese equities, with the weak yen boosting earnings estimates, and increasing dividends and buybacks providing extra support.

More broadly, "Asian equities away from Japan are at the cusp of a long run higher, based on good value, easing financial conditions and reform momentum to liberalize economies such as India and China," said Cameron Watt. “The recent rally in Chinese domestic small and mid-cap pushed valuations into bubble territory. Accordingly, we prefer Hong Kong-listed Chinese equities, or H-shares.”

Emerging markets in better shape; dispersion set to rise

Past Fed tightening cycles have sparked emerging market debt crises, yet emerging markets are in better shape these days, with less external debt, deeper financial markets and more dry powder for stimulus, BII notes.

"Emerging market stocks look reasonable, but are not screaming buys. Where they look cheap it is often for good reasons," said Cameron Watt. "Key risks in the emerging markets include anemic growth in exports and falling productivity. We prefer hard currency over most local bonds, as we see the U.S. dollar rising against many EM currencies, and prefer countries with reform momentum and falling inflation,” he added.

BII’s investment ideas for the second half of 2015

  • BII favors U.S. credit (high yield, mortgages and even investment grade bonds) over government debt.
  • In the Eurozone, BII likes QE-supported subordinated bank debt and selected long-maturity peripheral bonds.
  • In the U.S. equity market, BII prefers cyclical sectors such as consumer discretionary, technology and financials over “bond proxies” (utilities and consumer staples).
  • BII likes equities in Europe (particularly banks) and Japan (financials and exporters), based on weak local currencies and monetary stimulus.
  • BII favors emerging market equities in countries with reform momentum or monetary easing, particularly Asia.
  • BII prefers hard currency emerging market bonds over most local bonds and prefers countries with reform momentum and falling inflation such as India, China and Mexico.

About BlackRock

BlackRock is a leader in investment management, risk management and advisory services for institutional and retail clients worldwide. At March 31, 2015, BlackRock’s AUM was $4.774 trillion. BlackRock helps clients meet their goals and overcome challenges with a range of products that include separate accounts, mutual funds, iShares® (exchange-traded funds), and other pooled investment vehicles. BlackRock also offers risk management, advisory and enterprise investment system services to a broad base of institutional investors through BlackRock Solutions®. Headquartered in New York City, as of March 31, 2015, the firm had approximately 12,300 employees in more than 30 countries and a major presence in key global markets, including North and South America, Europe, Asia, Australia and the Middle East and Africa. For additional information, please visit the Company’s website at www.blackrock.com | Twitter: @blackrock_news | Blog: www.blackrockblog.com | LinkedIn: www.linkedin.com/company/blackrock

About BlackRock Investment Institute

The BlackRock Investment Institute leverages the firm’s expertise across asset classes, client groups and regions. The Institute’s goal is to produce information that makes BlackRock’s portfolio managers better investors and helps deliver positive investment results for clients.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2015 and may change as subsequent conditions vary. The information and opinions contained in this are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are no necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain ‘forward-looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that nay forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

Investment involves risk including possible loss or principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. The information provided here I neither tax nor legal advice. Investor should speak to their tax professional for specific information regarding their tax situation.

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Media:BlackRockJessica Greaney, 212-810-5498Jessica.greaney@blackrock.comorPaige Hofman, 212-810-3368Paige.hofman@blackrock.com

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