Room to run: can cyclicals keep grinding on?

^{By: Karim Chedid, Head of EMEA Investment Strategy for iShares at BlackRock}

Quick read

• As central banks lean against any sharp yield rises, the more muted response of government bond yields to stronger growth and higher inflation leads us to believe that this new nominal regime will last for some time – leaving us tactically pro-risk.
• Given low rates and tight spreads, we prefer to take risk in equities over credit – especially cyclically tilted equities, which may be well positioned to capture the upside from an accelerating activity restart.
• We favour cyclicals – where we still see room to run – as part of a barbell approach to equities that also includes exposure to quality companies.

Our new nominal theme flags a more muted response in nominal government bond yields to rising inflation than in the past. We see stronger growth and negative real yields ahead as the vaccine-led restart accelerates and central banks limit the rise of nominal yields – even as inflation expectations climb.

In our view, the policy revolution in response to COVID implies that real yields will be less responsive to rising inflation risk, suggesting that risk assets will perform better than in past inflationary periods.

Despite being questioned, this narrative has largely unfolded in 2021: the rise in long-term yields has been mainly driven by higher market pricing of inflation, with real yields remaining pinned well in negative territory. This supports our near-term moderately pro-risk stance and our preference for equities over credit, amid low rates and tight spreads. This is especially true of cyclically tilted equities, which we feel look well positioned to benefit from the global restart.

Cyclically tilted

We still see room to run for cyclical exposures, which we favour as part of a barbell approach to equities, alongside quality sectors that could help boost portfolio resilience. Analysts are seeing strong earnings momentum from businesses benefiting from higher economic growth, with real economy cyclicals expected to drive earnings growth through 2022. A pick-up in inflation expectations is also supportive and may allow those cyclically geared companies to pass higher input costs on to their customers.

The financials sector is one area that has been in focus for investors this year, after lagging in 2020. The sector looks attractive against a backdrop of steeper yield curves and is further bolstered by the potential for dividend resumptions – a scenario we see playing out as the year progresses. As the chart on the next page shows, investors have taken note: the US$35 billion added to financial sector exchange traded products (ETPs) globally so far this year is more than double the sector’s total inflows for all of 2020.¹

Value adds

Investors have also been adding a cyclical tilt to portfolios through the value factor, with US$26 billion of inflows into value ETPs since November, including a record US$7.6 billion in March alone – a monthly inflow record for any factor.¹ Value strategies have historically benefited during periods of higher economic growth, such as the one we have started to see playing out. Fiscal stimulus, expansive monetary policy and a robust underlying economy provide fundamental support for value equities. Valuations also remain attractive, in our view, despite recent interest toward value stocks.

1 Source: BlackRock and Markit, as at 22 June 2021. Past flows into global ETPs are not a guide to current or future flows and should not be the sole factor of consideration when selecting a product. Figures are in US dollars, unless stated otherwise.

Chart

Cyclical equity buying inflated by inflation

Cumulative global flows into value, financials and small cap ETPs vs. 10Y US breakevens. January 2020-June 2021

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