David Gyung
Transcript
In this volatile economic regime, we stay dynamic on a strategic horizon of five years or more to take advantage of valuation-driven opportunities.
While valuations may not always drive short-term results, they are pivotal over the long term.
Our granular approach targets areas we see as having comparatively attractive valuations, like emerging market equity, where we go overweight for the first time since 2020.
1) Emerging market stocks
We see broad emerging market stock valuations as attractive. We look at equity risk premia, one key valuation metric, which shows emerging market equities are at their cheapest relative valuations to develop markets in nearly four years.
We see opportunities in Mexico, India and Saudia Arabia – countries that we see at the cross-current of many mega forces.
2) Developed market bonds
We remain neutral developed market stocks and stay selective, with a preference for Japan.
We’re overweight developed market government bonds for the first time in over four years – notably in short-dated and long-dated bonds outside of the US.
3) Inflation-linked bonds
We still see inflation getting closer to 3% over the long run, which we do not see priced into fixed-income markets. That underpins our strategic preference for inflation-linked bonds.
We prefer emerging markets over developed market equities given relative valuations but stay selective in both. We like inflation-linked bonds in a high-for-longer rate regime.
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We see the new macro regime of greater volatility causing more frequent valuation shifts between asset classes. Valuations may not always drive short-term results but matter long term. Staying dynamic – even on a strategic horizon of five years and longer – creates opportunities to capitalize on these shifts. Getting granular allows us to target areas where we see the most repricing potential, like emerging market (EM) stocks. We go overweight developed market (DM) government bonds.
Relatively cheap
Spread Between EM And DM Equity Risk Premia, 2017-2024 (BlackRock Investment Institute with data from LSEG Datastream, May 2024)
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Index performance does not account for fees.
The chart shows the difference between our estimates of equity risk premium – the excess yield investors receive for the risk of holding stocks over cash – by using a dividend discount model for DM and EM equities.
We’re in a new, more volatile regime where macro risks are elevated and valuations are shifting more quickly. Assessing valuations on a strategic horizon of five years and longer is key for long-term investors, even if short-term performance can be driven by other factors. We get granular to uncover opportunities. In EM equity, we don’t feel prices reflect fair value over a strategic horizon. The difference in equity risk premia – a gauge of the excess yield investors receive for the risk of holding stocks over cash – between EM and DM equities has grown to its widest level in nearly four years, reflecting cheaper relative EM valuations. See the chart. DM government bonds are another area we find opportunities – notably in short-dated DM and long-dated DM bonds excluding the US. We go overweight EM stocks and DM government bonds for the first time in four and five years, respectively.
Under the hood of our strategic overweight to EM stocks, we stay selective. We see broad EM stock valuations as attractive. While China’s structural challenges remain, we consider them largely understood by markets and reflected in valuations. We find opportunities in EMs like Mexico, India and Saudi Arabia that we see at the crosscurrent of many mega forces – structural shifts driving returns now and far in the future. EMs rich in natural resources and supply chain inputs stand to benefit from geopolitical fragmentation, turning them into multi-aligned trading partners. Demographic divergence favors most EMs – where domestic working-age populations are still growing – over DMs with flat or shrinking worker pools.
Staying selective in stocks
We remain neutral DM stocks and stay selective – yet see reasons to like Japanese equities. The long-awaited comeback of inflation in Japan brightens the outlook for corporate profits, as companies can raise prices on products and services, while rising wages are set to support consumer spending. Ongoing corporate reforms aimed at boosting shareholder value also underscore our view. We favor an above-benchmark allocation to Japan over a strategic horizon (for professional investors).
Heightened market sensitivity to economic data releases has driven market volatility so far this year, especially in government bonds. Last week’s US CPI showed inflation slowing as expected – yet, we still see inflation settling closer to 3% over the long term. This is not priced into fixed-income markets, in our view – underpinning our strategic preference for inflation-linked bonds. How inflation and central bank policy evolve from here will vary by region. We expect policy rates to fall more in the UK than the US. This dynamic makes UK government bond yields more attractive than other DM debt. That’s why we like long-dated DM government bonds outside of the US, such as UK gilts. Yet, we keep our preference of short-dated over long-dated maturities across DMs. We’re now overweight DM government bonds overall on a strategic horizon for the first time in five years. In a whole portfolio context, we go underweight investment-grade credit given tight spreads.
Our bottom line
We prefer EM over DM equity given relative valuations but stay selective in both. We like inflation-linked bonds in a high-for-longer rate regime. We now favor DM government bonds over IG credit – driven by our preference for UK gilts.
Market backdrop
US stocks notched fresh 2024 highs last week, while US 10-year Treasury yields fell to around 4.40% – about 35 basis points below this year’s peak. The US CPI met consensus expectations and broke a three-month streak of hotter-than-expected readings. While the data may give the Federal Reserve some comfort that the previous upside surprises were anomalies, we think the Fed needs more evidence of inflation coming down to start cutting policy rates.
We watch Japan inflation data for the Bank of Japan policy implications. We think the BOJ will be slow to tighten policy to support the return of mild inflation and healthy wage growth. Global flash PMIs will provide an update on whether growth momentum is picking up, if slowly, in the euro area and cooling in the US. The US durable goods report will be in focus for another snapshot of how the industrial part of the economy is holding up.