Why We Stay Pro-risk
The path for further gains in risk assets looks to have narrowed after a long run higher, but we reaffirm our tactical pro-risk stance – supported by a broadening global restart and ongoing negative real interest rates – even as the path for further gains in risk assets looks to have narrowed after a long run higher.
Narrowing path
Markets have been jittery amid focus on China’s regulatory clampdown and the prospect of the Federal Reserve tapering its asset purchases. We believe the path for further gains in risk assets has narrowed after an extended run higher, warranting a selective approach, but we reaffirm our tactical pro-risk stance. In the context of very small client allocations to Chinese assets, we are dipping our toes in the asset class by shifting our view to a modest overweight.
Reinforcing the new nominal
The new nominal stands
U.S. policy rate path vs. past cycles
Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute, Federal Reserve, with data from Refinitiv Datastream , September 2021. Notes: The red dot show the median federal funds rate expectation published by the Federal Open Market Committee, a committee within the Fed that sets the federal funds rate. The lines show past rate hiking cycles since 1994 and our estimates for the path of U.S. interest rates. The paths are shown relative to the point at which the first hike took place, which is indicated by quarter 0. The Fed median dot plot comes from the September 2021 Summary of Economic Projections (SEP). Since the SEP projections show only the end of year forecast for the federal funds rate we reflect the uncertainty by showing end of year dots rather than a continuous line. We believe the Fed will start its next hiking cycle in the first half of 2023.
The Fed has signalled it is gearing to start tapering around the year end. It appears reluctant to admit its inflation mandate has been met, and this reinforces our new nominal theme –or a more muted response to higher inflation from central banks than in the past, a positive for risk assets. See the chart for past rate hike cycles and our estimate. Despite ongoing risk around the fallout from the regulatory clampdown, we are dipping a toe in Chinese equities by moving our tactical view from neutral at midyear to a modest overweight. This call is partly rooted in our expectation for incremental near-term easing via three policy levers –monetary, fiscal and regulatory –with growth slowdown likely having reached a level that policy makers cannot ignore. We see Q4 growth likely dropping to 3% range from Q1’s 18%. We believe the significant repricing –Chinese equities underperforming U.S. peers by more than 30 percentage points so far this year -and a rise in equity risk premia in Chinese equities are overdone, especially with a 6-12 month horizon. Investors are compensated for risk at current valuations in our view, but we favor a quality bias.
Selectively pro-risk
Our strategic view on China already takes into account that the country is unmistakably on a path toward greater state involvement with social and political objectives taking primacy over economic ones –leading to greater risks and the need for a new investment lens. But context is everything: Our allocations to Chinese assets remain orders of magnitude lower than those to developed market assets. To justify currently very small client allocations to China would imply a view that the market will become essentially un-investable despite its growing importance.
We are also upgrading emerging market (EM) local-currency debt to modestly overweight. We do not see the Fed’s tapering leading to an EM tantrum given the higher real yields and improved external balances. EM local-currency debt also offers attractive valuations and coupon income in a world starved for yield. We prefer EM local-currency debt because of its lower duration than EM dollar debt, in line with the significant underweight to U.S. Treasuries, and the steep local yield curves that bring attractive term premium.
In addition, we believe much of the early tightening cycle in many EM economies is behind us, and this lends support to EM local-currency debt.
These two modest upgrades don’t mean that we have become more pro-risk tactically. In fact we see a narrowing path for risk assets to push higher, and there could be bouts of volatility along the way as markets are prone to over-reaction after an extended bull run in risk assets. Yet over a 6-12 months horizon we still see broadening restart and the new nominal supporting risk assets.
We stay overweight on European equities as we see the region continuing to benefit from the broadening restart. We are still underweight U.S. Treasuries, as we see only a gradual rise in yields even with the Fed poised to make a taper announcement in November, and we prefer Treasury Inflation-Protected Securities over nominal bonds for portfolio duration exposure, especially after the recent pullback. We are also underweight global investment grade credit as we see little room for further yield compression. Implementation of asset views will differ across investor types and geographies, depending on objectives, constraints and regulation.