Financial markets are caught in an uneasy equilibrium as the second half of 2018 gets underway. The U.S. is leading the global expansion and powering corporate earnings, but the macro outlook is becoming more uncertain in the face of trade disputes and rising rates.

Market sentiment has shifted markedly since last year as a result. 2017 was a year of upside growth surprises and muted inflation—and unusually low volatility. That set the stage for out sized risk-adjusted returns across markets. Fast forward to 2018: Sentiment on many of these key market drivers has shifted. The Market moods graphic below tells the story.

The growth picture is still bright overall. Inflation risks look more two-way, and financial conditions are tightening as U.S. rates rise. The big change in 2018: a rise in macro uncertainty. How dark is the mood? Not nearly as bad as 2015, as the graphic seeks to capture.

Against this backdrop, we have updated the three investment themes we see shaping economies and markets in 2018. Here’s a look at the refreshed themes, which we describe in more detail in our new Global Investment Outlook Midyear 2018.

Theme 1: Wider range of growth outcomes

We see steady global growth ahead—but global growth is becoming uneven and has a broader set of possible outcomes. The U.S. is the growth engine, propelled by fiscal stimulus. We see positive spillover effects, especially to emerging markets (EM). Economic growth boosts corporate earnings. Yet the risks are two-sided: U.S. stimulus could accelerate capex and lift potential growth—or trade wars and/or inflation driven overheating could incite a downshift. The market’s adjustment to these higher levels of uncertainty will be a key theme for the remainder of 2018, we believe, and is already being mirrored in higher risk premia across asset classes.

Theme 2: Tighter financial conditions

Rising interest rates, less-easy monetary policy and a strengthening U.S. dollar are tightening financial conditions, with ripple effects across markets. Tighter funding conditions have played a role in this year’s EM hardships − including Argentina and Turkey, countries with big external financing needs. Further gains in the U.S. dollar could cause more pain, including for global banks that rely on dollar funding. Higher U.S. short-term rates mean renewed competition for capital and less need to stretch for yield when (dollar-based) investors can get above-inflation returns in short-term “risk-free” debt.

Theme 3: Greater portfolio resilience

Bouts of volatility this year underscore the need for portfolio resilience. Think of the VIX tantrum in February, 2018 tied to leveraged short positions in equity volatility, the explosive selloff in Italian government bonds, and the tech sector suffering a brief shake-out of popular long positions. How to make portfolios more resilient? We advocate shortening duration in fixed income, going up-in-quality across equities and credit, and increasing diversification.

Market views

We remain pro-risk but have tempered that stance given the uneasy equilibrium we see between rising macro uncertainty and strong earnings. We prefer U.S. equities over other regions. We still see momentum equities outperforming, and prefer quality exposures over value. In fixed income, we favor short-term bonds in the U.S. and take an up-in-quality stance in credit. Rising risk premia have created value in some EM assets. We like selected private credit and real assets for diversification. We see sustainable investing adding long-term resilience to portfolios. Read more on the investment and economic outlook in our full Global Investment Outlook Midyear 2018.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

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