PDF U.S. iSHARES INVESTMENT STRATEGY AUTUMN 2019 ...

INVESTMENT DIRECTIONS

Winter 2019

Pressure drop

Our reference to the classic Toots and the Maytals song comes as we see a de-escalation in trade tensions with China, diminishing risks of a no-deal Brexit and few signs that the record U.S. economic expansion is ending or reversing. Still, persistent trade uncertainty is denting business confidence and spending, particularly the longer-term risk of an unravelling of the global supply chain. Our take on the major investor themes for the weeks ahead:

U.S. equities: Sector steering

Defensive sectors have outperformed cyclicals this year against a backdrop of slowing growth and falling interest rates. However, we expect central bank easing could provide a floor for growth in the coming months. Among cyclicals, we remain constructive on technology, while we prefer less rate-sensitive sectors such as healthcare among defensives.

Developed markets: Winter of our discontent?

Trade uncertainties and slowing growth have taken a toll on developed world stocks outside the United States. But not all DMs are created equal, and there are signs that the global growth slowdown has hit bottom, while central bank easing could help. We are neutral on Europe and underweight Japan.

Emerging markets: China's mixed outlook

A temporary trade truce with the United States provided some optimism around China over the last month. However, China's growth slowdown has become more pronounced. Investors may want to consider EM ex-China exposures to hedge out the risks associated with a Chinese slowdown and any potential negative trade news.

Fixed income: Seeking defense in credit

U.S. government bond yields have responded to geopolitical risks over the past few months both ways, which underscores bonds' important role as a diversifier. Meanwhile, investment grade credit continues to lead sectoral performance, supported by easing financial conditions, a still-growing domestic backdrop and investors seeking high-quality yield. An up-inquality approach may allay fears over potential downgrades.

Chris Dhanraj Head, U.S. iShares Investment Strategy

Contributors Grant Dechert Jasmine Fan Elizabeth Grenfell Thomas Logan

Stephen Laipply Head of U.S. Fixed Income iShares

Patrick Nolan Portfolio strategist with the BlackRock Portfolio Solutions Team

Sara Shores Head of investment strategy for the Factor-Based Strategy Group

Editor David Kurapka

Factors: Value, the comeback king?

We remain in an unfavorable environment for value, given slower growth and the return of "lower-for-longer" interest rates. Still, our outlook for value has improved and now stands at a neutral position as relative valuations appear quite cheap. Our outlooks for minimum volatility and quality have similarly improved.



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Overview

Investors have favored defensive sectors this year. While we do prefer lesscyclical exposures, we're cautious on chasing ratesensitive sectors from here given stretched positioning and instead prefer tech and healthcare amid a moderately pro-risk position within U.S. equities.

CONSIDER

?? iShares U.S. Technology ETF (IYW)

?? iShares Exponential Technologies ETF (XT)

?? iShares U.S. Healthcare ETF (IYH)

?? iShares Global Healthcare ETF (IXJ)

U.S. equities

Sector steering

Key points

?? Defensive sectors' moment. Defensive equity sectors have outperformed their cyclical counterparts this year as global growth continues to decelerate, central banks ease policy and interest rates fall in lockstep.

?? A consensus trade? However, equity market pricing, sentiment and positioning suggest these trends are largely baked in, while the prospect of a subsequent rebound in growth due to easier financial conditions remains modestly underpriced, in our view.

?? Easing provides a floor. We expect easier financial conditions to provide a floor under global growth in the coming months. Among cyclicals, we remain constructive on technology. Among defensives, we prefer less rate-sensitive sectors such as healthcare.

Market pulse

Interest rates are driving equities and sector leadership within those markets. As central banks eased policy in response to weaker global growth, U.S. equity market leadership has taken on a decidedly defensive and ratesensitive tone this year. Lingering U.S.-China trade policy uncertainty has only amplified this trend. Not surprisingly, amid the slowdown, defensives have outperformed cyclicals, and global ETP flows across U.S. equity sectors suggest investors are highly positioned toward weaker growth and lower rates.

Yet we see 2019's easier financial conditions laying the groundwork for a modest, subsequent growth rebound in the first quarter of 2020. We remain cautious on cyclicals overall given late-cycle concerns and geopolitical risks; however, we continue to favor tech amid unmatched and stable earnings growth. We're also cautious on chasing rate-sensitive equity sectors, such as utilities, consumer staples and real estate, at current levels given heavy positioning and very dovish Federal Reserve pricing. Instead, we prefer less rate-sensitive defensive expressions, such as healthcare, a potential guard against a possible further slowdown with less sensitivity to rate movements.

A common theme across tech and healthcare is stronger organic earnings growth with less macro sensitivity--both to economic growth and rates. We expect tech to continue outperforming cyclicals, while we expect healthcare to recover from the weakness year-to-date (YTD) and outperform other defensive sectors as this year's rapid decline in rates abates.

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10-year U.S. Treasury yield (%)

Figure 1: Tech climb continues, healthcare has cheapened versus other defensive exposures

120

0

115

0.5

Relative equity returns

110

1

105

1.5

100

2

95

2.5

90

3

85 2017

2018

3.5 2019

Rate-sensitive Tech Healthcare 10-year U.S. Treasury

Source: Refinitiv Datastream, as of October 24, 2019. Note: Rate-sensitive, tech and healthcare total returns are shown relative to the S&P 500, based on the S&P 500 Consumer Staples Index, the S&P 500 Utilities Index, the S&P 500 Real Estate Index, the S&P 500 Technology Index and the S&P 500 Healthcare Index. Rate-sensitive is an equal-weighted average of the utilities, real estate, and consumer staples indexes. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

A tale of flows

Global ETP flows have exhibited a clear risk-off tone this year, with bonds outpacing equities and defensive leadership within both equities (i.e., defensives over cyclicals) and fixed income (i.e., rates over credit) as well. In the United States, flows are clearly skewed toward defensive exposures that benefit from lower interest rates.

Utilities, consumer staples and real estate are the only sectors to see positive ETP flows over the past year, each typically a strong beneficiary of lower rates. In contrast, global ETP flows to cyclical sectors are negative across the board, while financial sector ETP flows, the prime beneficiary of higher rates, are deeply negative.

Equity investors are expressing views on rates, and the trend in global ETP flows shows investors have been adding to these rate-sensitive expressions throughout the year. While we do prefer less cyclical exposures, we're cautious on chasing rate-sensitive sectors from here given stretched positioning.

Figure 2: A preference for defensives

Utilities

Consumer staples Real estate

Technology Consumer discretionary

Healthcare Energy

Industrials Materials Financials

-2% -8% -10% -16% -20% -20% -26%

-40%

-20

0

11%

31% 25%

20

40

Trailing 1-year flows, % of AUM

Source: BlackRock, Markit, as of October 24, 2019. Note: Chart measures all globally listed ETP flows to U.S. sectorfocused ETPs over the past 12 months as a percent of AUM.

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Overview

Trade uncertainties and slowing growth have taken a toll on developed world ex-U.S. stocks. But not all DMs are created equal; those with less exposure to trade with China have enjoyed stronger flows and returns than those with relatively high exposure. We are neutral on Europe and underweight Japan.

CONSIDER

?? iShares MSCI Eurozone ETF (EZU)

?? iShares Core MSCI Europe ETF (IEUR)

?? iShares MSCI Canada ETF (EWC)

?? iShares MSCI France ETF (EWQ)

?? iShares MSCI United Kingdom ETF (EWU)

Developed market equities

Winter of our discontent?

Key points

?? Under pressure. Developed world (DM) ex-U.S. stocks have come under pressure in 2019 amid rising protectionism and slowing growth. However, not all DMs are created equal.

?? We upgraded European equities to neutral this year. The accommodative shift by the European Central Bank (ECB) should support the region amid its challenging macro backdrop. Trade disputes and a slowdown in China pose downside risks.

?? However, we downgraded Japanese equities to underweight. We believe they are particularly vulnerable to a Chinese slowdown with a Bank of Japan that is still accommodative but policy constrained. Other challenges include a consumption tax increase.

Market pulse

DM economies have exhibited synchronized deceleration throughout 2019. Figure 3 identifies how the Markit DM composite PMI is teetering on the brink of contraction. In several pockets of the DM universe, economies are exhibiting outright recessionary characteristics, too. For example, Germany's September manufacturing PMI fell to the worst reading in more than a decade and the eurozone manufacturing PMI is at a seven-year low. Alongside this weakness, the BlackRock G7 growth GPS--a proprietary measure of where the GDPweighted G7 12-month consensus GDP forecast may stand in three months' time--has moved lower.

Figure 3: BlackRock G7 growth expectations have fallen YTD

57

2.7

Developed market PMI

56

2.5

55

2.3

54 2.1

53

52

1.9

51

1.7

50 2017

2018

Developed market PMI BlackRock G7 growth GPS

1.5 2019

Source: BlackRock, Thomson Reuters, as of October 31, 2019.

BlackRock G7 growth GPS

The key question: Has the global economy struck bottom? Financial conditions would suggest so. The historical relationship between financial conditions and our GPS points to potential for a growth pickup in the coming six months. An effort by global central banks to stretch the cycle is a key tailwind. For example, the European Central Bank announced its highly anticipated economic stimulus package, which included a rate cut, the resumption of quantitative easing (QE), and a two-tier excess liquidity system for banks.

However, protectionism continues to haunt markets. While a perceived easing in U.S.-China trade tensions has boosted sensitive equities, including beaten-down Japanese stocks, we do not see this rotation having staying power. We maintain

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our underweight on Japanese equities: They are particularly vulnerable to a growth slowdown in China, and we see no sustained letup in the protectionist push. Yet the recent rally offers a preview of the potential upside in Japanese equities if trade tensions were to fade substantively and growth to reaccelerate.

A tale of flows

Flows of ETPs have generally reflected slowing growth and heightened global trade tensions. Cumulative ETP flows into DM equity focused products remained in negative territory throughout most of the year. As of the end of October, ETP flows into DM (ex-U.S.) equity focused products are on pace for the worst year since 2016.1

Figure 4: Rebound in DM?

$4,000

DM equity ETF cumulative flow ($mm)

0

-4,000

-8,000

-12,000 12/18

3/19

6/19

Source: BlackRock, as of October 24, 2019. Shows U.S.-listed flows into DM ex-U.S. ETFs.

9/19

Within individual country focused ETFs, there is notable dispersion. Japanese, Hong Kong, and German products saw the most outflows through the year, while Canada-, France- and U.K.-focused products gathered the most inflows.

Figure 5: DM country ETF flows impacted by economic exposure to China and performance in 2019

Rank

Country

Bottom 3 1 2 3

Top 3 1 2 3

Japan Hong Kong

Germany

Canada France United Kingdom

Total trade with China (% of total trade)

28.2% 46.2% 8.6%

6.5% 9.6% 10.5%

YTD ETF flows ($mm)

-6470 -887 -472

1318 442 406

QTD ETF flows ($mm)

618 -14 -74

-1 -172 143

YTD total return (%)

14.0 4.5 15.7

20.7 17.9 13.0

QTD total return (%)

2.6 1.6 5.3

-0.8 1.7 2.6

Source: BlackRock, Thomson Reuters, as of October 24, 2019. Note: Country return information is based on the respective MSCI index for each country. Flows are for U.S.-listed ETFs.

Through there are many differences among these individual countries, two points are particularly noteworthy with respect to their overall YTD popularity. First, the specter of trade wars and a reduction in economic activity in China weighed on economies with a high exposure to the region. The bottom three flow-gathering countries had an average trade with China as a percent of total trade of 28%; the top-three average was 9%. Second, the year-to-date performance differential of the top three flow-gatherers outpaced the bottom three by nearly 6%, on average.

1 Source: BlackRock, Markit, as of October 24, 2019. Notes: Flows are U.S.-listed ETFs.

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