Financial markets are in an uneasy equilibrium. We see sustained U.S.-led global expansion as our base case, but note rising uncertainty around the economic outlook and tightening financial conditions globally. We favor equities over fixed income, but prefer to reduce some portfolio risk in today’s environment. We focus on our highest-conviction equity markets (the U.S. and emerging markets)–and have downgraded Europe (to underweight) and Japan (to neutral).

Rising macro uncertainty–primarily tied to global trade disputes and their potential impact on growth–and tighter financial conditions magnify the importance of portfolio resilience. This is a major theme in our 2018 Mid-year global investment outlook. We see European equities as vulnerable to risks–both global and local. Sentiment already has turned. Investors have yanked money out of European equity funds for 17 straight weeks. See the chart above. Our BlackRock Geopolitical Risk Indicator suggests markets may still not be paying enough attention to the risk of European fragmentation.

Getting selective

Sustained U.S.-led global economic growth is our base case – supported by our BlackRock GPS.  Yet the range of possibilities for the economic outlook has widened: On the upside, U.S. fiscal stimulus could lift capital expenditures and potential growth. On the downside, trade wars and overheating risks. We do not see trade disputes derailing the global expansion for now, but tensions are likely to get worse before they get better. This could hit investor sentiment and business confidence, prompting companies to defer or cancel investments. There are also home-grown risks in Europe. An anti-establishment, euro-skeptic Italian government and renewed tensions over immigration have raised long-run risks for the European Union (EU)’s future. A non-committal outcome at the most recent summit of EU leaders gives us little confidence that a crisis would be handled well. In Japan, ongoing improvements in corporate governance and profitability are encouraging, but we see no near-term catalyst to propel relative equity outperformance.

Our call for portfolio resilience leads us to prefer U.S. equities–with unmatched earnings growth–over other regions. We still like EM equities, especially EM Asia–but are becoming more selective amid rising trade risks, tightening financial conditions and a stronger dollar. We see valuations in EM stocks as compelling after the recent selloff. EM earnings growth is still supported by global expansion, sustained growth in China and a well-telegraphed path of Federal Reserve tightening.

Globally, we look to quality companies–those able to generate and grow free cash flow–as a way to build the right defense in equities. We now prefer quality to value, and also like the momentum factor. In a portfolio context, we favor reallocating some funds to U.S. equities, and (for U.S. dollar investors) shifting some equity risk to short-duration U.S. Treasuries and investment grade credit. These exposures may also look attractive to global investors (such as euro-based ones) with a favorable view on the U.S. dollar.

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

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