Taking Stock: Market Views From the Go-Anywhere Team

A fog of uncertainty—in Europe, in Washington, DC and across investment markets—has investors feeling perplexed. Many are sitting idle in cash or retreating to US Treasury bonds or other so-called "safe" investments. But such a strategy may well come at the cost of lost opportunity. Members of the go-anywhere BlackRock Global Allocation team offer insight into the opportunities and challenges facing investors today:

• Despite a slowdown in the developed world, emerging markets are bolstering the global economy.
• Stocks, although volatile, are the most attractive asset class today and worth investor attention.
• Bonds, particularly many developed market government bonds, currently provide negative real yields, offering investors no return on an after-inflation basis.
• A highly diversified, multi-asset portfolio can be a solid foundation for an investment plan, offering broad market exposure while leaving the burden of navigating today's uncertainty to professional investors.

How would you characterize the current investment environment?

This is one of the toughest environments we have seen in our decades of investing. It's characterized by two very unusual factors. First, we have very low nominal (pre-inflation) interest rates. With nominal rates at such unappetizing levels, real (after-inflation) yields are even less appealing. That means the possibility of making a profit after inflation is very slim. Where it is a possibility, those bonds are selling at quite a premium.

The second big factor that we believe complicates today's environment is extreme policy uncertainty—specifically, the uncertainty around the kinds of fiscal and monetary policies that governments have used aggressively since the 2008-2009 financial crisis. This has implications for risk assets, such as stocks. Quite literally, it takes just a few words one way or another from a central banker to swing asset prices dramatically. It can be a lot for investors to navigate.

In the US, there are serious questions about the Federal Reserve's actions. Will the Fed engage in further quantitative easing? What form might it take? When might it occur? These questions are very important to financial asset prices, but no one knows the answers. What we do know is that the Fed has shown itself to be willing to take significant and aggressive action, but also that those actions are relatively unpredictable. The same can be said of the European Central Bank (ECB). In addition to the Fed and the ECB, there's uncertainty about fiscal policy in the US and about how Europe will deal with the fundamentals underlying the crisis there. And finally, it remains to be seen how Chinese leaders will deal with both the slowdown in that economy and the potential for increased inflation because of rising food prices. So this is a highly unusual environment and one where it takes just a few words one way or another from a central banker to swing asset prices dramatically.

Are you finding opportunity in this environment?

We'll preface this by saying we are blessed with tremendous flexibility in our investment mandate and a team of more than 40 dedicated professionals committed to digging deep in search of opportunities. So, the short answer is yes, we are finding opportunities.

Current opportunities are much more prevalent in stocks than in bonds. Ideally, we are looking for companies that offer products/services that can transcend the "macro noise" and demonstrate a high level of pricing power. As value investors, we are also highly focused on price, and the dislocations in the marketplace in recent years have presented some interesting valuations.

While the data shows investors flocking into fixed income, we actually see very little intermediate or long-term value in sovereign bonds anywhere in the world. Real yields are negative in the US and the UK, and at the shorter end of the yield curves in countries like Germany, Switzerland, Denmark, Austria and the Netherlands, nominal yields are negative. Essentially, investors are paying these governments to hold their money.

What is your strategy then in fixed income?

In general, we have spent a great deal of time making sure we have good liquidity in our bond portfolio and that the bonds we own are either bonds that we are willing to hold to maturity or bonds that are amongst the most liquid available. This is based on our view that it will be difficult to exit fixed income when the tide turns, liquidity dries up and the bond bear market gets under way in earnest.

We're just not bond bulls. If you consider the 10-year Treasury yield (currently at roughly 1.7%) versus CPI inflation readings of 1.5%-2.5% over the past few years, you're making nothing after inflation and taxes. There's also tremendous interest rate risk (when rates do eventually rise, bond prices will fall), not to mention a government that hasn't been able to balance a budget for three years and has an increasing dependence on foreign financing. Given all of this, you might expect bonds to be cheap, but in fact they are expensive compared to stocks. Stock valuations versus bonds are actually the cheapest they've been since the early 1950s. In the current environment, your dollar simply buys you more dividends, more earnings, more cash flow and more book value in stocks than in bonds.

Are you worried at all that stock valuations are getting extended?

Our problem with stock valuations is not the "P" in P/E (price/ earnings ratio), but the "E." The main reason for this is that profit margins are very high right now—so high that the likelihood of future profit growth is going to be somewhat muted, not just in the current cycle, but potentially for an extended period of time. Part of the reason is that aggressive policy to invigorate the economy has also stimulated corporate profits. So, the question we ask ourselves is:

Where do we go from here? The path of least resistance is obviously down. That said, even after adjusting profits down to a level more in line with historic experience, stocks still look very, very cheap compared to bonds.

Our biggest concern about stocks relates to the sheer degree of uncertainty that exists in the current environment. So, while we believe stocks are the most attractive asset class, they are also the most volatile. On the whole, this has caused us to trim some of our equity exposure. Optimistically though, this means we have more dry powder to jump on opportunities as they present themselves.

And where are you finding these opportunities in world stock markets?

We've found great value in Japan and Asia ex-Japan. While the US is not expensive compared to its historic averages, Japan is as cheap as it's ever been. Japan is home to many best-in-class businesses that make goods people and industries around the world generally want. Many investors have dismissed its potential, and that means valuations are attractive. International investing involves its own set of risks, including the possibility of substantial volatility, but we believe gaining that exposure through a professionally managed solution can help manage for those risks.

Sectorwise, we like energy, which is an area with global appeal. While oil prices have come down sharply, we don't believe oil stocks ever reflected $100+ oil. And as we look out over the course of the next five years, we expect to see a consistent increase in demand for energy from the emerging markets, which are just beginning to tap the energy markets. As this continues, we anticipate it will be difficult to find new supplies of energy at prices any lower than today. We also find plentiful opportunities in materials, healthcare, telecommunications and information technology.

Is the slowdown in economic growth a headwind for global stocks?

There's really no problem with growth in the world. Emerging economies are doing fine, creating wealth, jobs and income, and they have money to spend. The trouble is in the developed markets—the United States, Europe and, to some degree, Japan. The problem in these places is debt. In the US, debt-to- GDP ran up to 370% and now we're dealing with the hangover from that party. That hangover is what led to the aggressive government policies we mentioned earlier. The US government has borrowed and spent a lot of money to stimulate the economy. A household running its income statement like the US government would be spending $1.50 for every $1.00 taken in. It's simply unsustainable.

Emerging economies are the drivers of growth today, heralding a profound change in the world economy. In addition to the oil example we noted earlier, with China and India just getting started in terms of fulfilling their needs, China auto sales provide another striking example. Ten years ago, the Chinese were buying 200,000 cars a month. They are now buying 1.5 million cars per month, a 7.5-fold increase. Many are owning cars for the first time. The implications go well beyond the auto industry. This newfound mobility means profound change in the world economy and increased competition for limited resources.

So, the world economy is not endangered. It's simply different. The pie charts below illustrate the contribution of different regions of the world to global gross domestic product (GDP) versus how their stock markets are represented in terms of market capitalization. The emerging economies contribute far more to global GDP (nearly 50%) than is represented by their stock markets (14%). We believe these percentages will converge over the long-term, meaning there's ample scope for growth in emerging stock markets. We're able to adjust for this in our portfolio. That's a meaningful advantage for investors who do not have the expertise and resources to do the type of analysis required to capitalize on these far-off opportunities.

Given your broad scope, how do you begin to narrow down the investment universe?

It's a daunting challenge, but it's also a great luxury because very few investment managers have the flexibility to go wherever the opportunities are. Unlike most asset allocation funds, we're not only top-down (making decisions based on which asset classes, sectors and geographies look attractive), we're also, importantly and differently from most, bottom-up. This means we're looking for individual securities that can outperform their markets. Our team is constantly looking for those individual securities that validate the top-down view and give us greater conviction that we have the right investment view of the world.

What differentiates the Global Allocation Fund among its peers?

It's a good question, because there are a lot of products right now that say they do what we do. But we believe our team is unique and unlike any other in the industry. It's a key differentiating factor. We have more than 40 dedicated professionals, and many have worked together for 10 years or more. Our investors are undistracted from the job of investing, thanks to a robust support structure. We have a transaction center, information system specialists, an independent risk team, and the list goes on. BlackRock has made a tremendous investment in the Global Allocation Team, and that ultimately benefits our clients.

We also have staying power. There are 116 funds in our Lipper category right now, most of them introduced after the 2008 financial crisis when the benefits of diversification gained increased attention. This compares to just 16 funds in 1999; and you might be surprised to know that 11 of those funds are gone now. That tells us there are a lot of casualties in the mutual fund business and it's important to choose wisely.

Most importantly, we've been able to deliver on our commitment to our investors for more than 23 years. The BlackRock Global Allocation Fund was created to serve as a core holding for a broad range of clients, to deliver competitive returns, but with less risk than the typical equity-only fund. We never dreamed we would outperform the equity market by as much as we have over the long term, with one-third less risk.*

Over time, we've competed with a lot of strategies that had hotter quarters or hotter years than we did. That's not what we're about. We aim to grow wealth over time. Our goal is to help satisfy our shareholders' most basic investment needs—to send kids to college, to pay for retirement. We have achieved our mandate, not for one, three or five years, but for over 23 years, and we believe we are well positioned to continue delivering on those goals.

 

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* Equity market represented by the FTSE World Index; risk is measured by standard deviation.

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 those of the portfolio managers profiled as of November 26, 2012, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. The BlackRock Global Allocation Fund is actively managed, and its holdings and portfolio characteristics are subject to change.

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 two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.

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