BlackRock: Leaning further into cyclicality

By BlackRock Investment Institute

The UK has led the developed world in the pace of its vaccine rollout, with the euro area set to catch up after a slower start. Vaccine rollouts and fiscal spending are paving the way for an accelerated global restart, reflected in a recent rise in real rates. This supports a broadening of the cyclical tilt in our tactical views, with our recent debut of a UK equities overweight and upgrading euro equities to neutral.

Chart of the week

Estimated equity risk premia in selected markets, February 2021

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. You cannot invest directly in an index. Sources: BlackRock Investment Institute and Refinitiv Datastream, data as of Feb. 26, 2021. Notes: The chart shows the estimated equity risk premia and historical ranges since December 1997 for selected equity markets, represented by MSCI U SA, MSCI UK, MSCI Europe (euro), and MSCI Emerging Markets Indexes. We calculate the equity risk premium based on our expectations for nominal interest rates and the implied cost of capital for respective equity markets.

UK and euro area stocks lagged the global market in 2020. UK stocks, skewed toward sectors that typically fare poorly during cyclical downturns and weighed down by Brexit uncertainties, were the worst performer among developed market (DM) peers. With the risk of a no-deal Brexit lifted and the UK leading the vaccine rollout among DMs, we see a broad activity restart in the summer. Unprecedented UK fiscal support – which the government plans to keep in place – has helped to minimize long-term economic scarring, reinforcing our positive view on this market. We see the euro area restart lagging that of the UK or U.S. by a few months, given its slower-than-expected vaccine rollout, but this leaves room for a catch-up. In addition to the positive macro backdrop, we see valuations in these two markets as supportive, based on our estimates of the equity risk premium, our preferred valuation gauge that accounts for changes in the risk-free rate. See the chart above.

We expect a vaccine-led reopening to enable activity to return to pre-Covid levels by late 2021 or early 2022 in the euro area and the UK, with a well of pent-up demand fueling spending, especially in services. Activity data last week were stronger than expected, suggesting services have not been as severely hit as by the initial lockdowns as in 2020. We see ongoing fiscal support for the most affected households and sectors, and expect central banks to keep financial conditions easy. We expect the ECB to likely reiterate such a commitment at this week’s policy meeting, pushing back against higher bond yields.

Recent earnings suggest an improving outlook for European and UK companies. More European companies have beat earnings expectations in the fourth quarter of 2020 than ever – albeit versus moderate expectations – accompanied by an improving margin picture. Cyclical exposures such as materials and energy have posted the strongest upward earnings revisions, lending additional support.

Rising government bond yields recently have put pressure on equities. Yet we see UK and European equities relatively well placed in this environment, as our research shows equity prices are typically less sensitive to rising rates when valuations are low, or the ERP is high. More broadly, we don’t see rising nominal yields as a source of worry as long as our new nominal theme holds, with a more muted central bank response against inflation than in the past – and monetary authorities leaning against any excessively rapid increases in real yields. The recent increase in real yields, in our view, reflects expectations for a stronger economic restart and underpins the recent broadening of our pro-cyclical stance.

The bottom line

We have broadened our pro-cyclical stance over the tactical horizon as we expect a rapid activity restart later this year and into 2022. As a result we are overweight UK equities and have upgraded euro area equities to neutral. We also recently downgraded euro area peripheral bonds to neutral, as yield spreads have narrowed. Overall, we prefer equities over credit over the tactical horizon given the relatively more attractive valuations in equities. European companies have also made strides in the shift towards sustainability, positioning them well for the transition to a zero-carbon economy that we see as a key driver of asset returns over the strategic horizon.

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