Industry Updates

Are clouds gathering for ETF investors in H2?

Opportunities remain in emerging markets and fixed income

Theo Andrew

City night skyline emerging markets

Investors buoyed by the rally of both stocks and bonds so far in 2023 might be looking to go on the defensive in H2, with asset managers anticipating a volatile finish to the year.

Many investors have expressed puzzlement in a market characterised by two opposing narratives in the first half of 2023, with a slowdown in global manufacturing and March’s banking turmoil set against a robust labour market and only slightly cooling inflation.

Meanwhile, the Federal Reserve has hiked interest rates to above 5%, a level not seen since 2007, and, despite a pause in June, are widely anticipated to continue rising in the second half of the year.

Economists surveyed by Bloomberg are predicting US inflation figures, published later today, will likely fall from 4% in June to 3.1%, the lowest rate since March 2021.

However, the all-important Consumer Price Index (CPI) – which strips out volatile energy and food sectors – is likely to fall only slightly from 5.3% to 5%, leading many to believe rate rises could resume.

It is also leading many to predict an uncertain few months with quality dividend-paying stocks, emerging markets and short-duration fixed income tipped to generate performance in H2.

A new regime

According to BlackRock, greater volatility will bring “divergent security performance” to the broader market, requiring investors to take a more granular approach in eyeing opportunities.

In its 2023 midyear outlook, Jean Boivin, head of the BlackRock Investment Institute (BII), said slowing growth and sticky inflation in major economies underpins its preference for emerging markets and income, with a tilt towards quality in developed markets.

“We implement an overweight to artificial intelligence as a mega force. Our tilt toward quality already captures AI beneficiaries,” he wrote. 

“We get granular to achieve portfolio breadth: We like Japanese equities within developed market stocks. We prefer emerging market equities and local emerging market debt (EMD). For income, we prefer short-dated US Treasuries, US mortgage-backed securities and high-grade credit.”

Karen Ward, chief market strategist for EMEA at JP Morgan Asset Management (JPMAM), agreed quality would help buffer equity portfolios from volatility ahead, with a recession “still more likely than not”.

“Amid heightened uncertainty, our highest conviction view within equities is that markets will reward companies with stronger quality credentials such as robust balance sheets and management teams with deep experience through multiple cycles,” she said.

Ward added emerging markets – which would traditionally fair badly in economic downturns – could also offer opportunities, with emerging market stocks trading at a 30% discount to developed markets on a 12-month forward earnings basis.

Opportunities in fixed income

As investors may be looking to go on the defence, certain areas of fixed income are looking increasingly more attractive, even with the Fed expected to raise rates.

Gargi Pal Chaudhuri, head of iShares investment strategy Americas at BlackRock, suggested investors could still consider stepping into high-quality, medium-term fixed income with a maturity of three to seven years.

“The Bloomberg US Aggregate Bond index now yields close to 4.7% and has a duration (or sensitivity to interest rates) of 6.3 years,” she said. “Even if the Fed were to raise rates higher than current market expectations, the carry earned from higher coupons could be sufficient to counter losses realized by rising rates.”

Meanwhile, emerging market local currency bonds are offering an attractive yield of 7.7% on a weighted average coupon of 5.9%, according to Bloomberg.

“Emerging market central banks may be able to start easing soon after a two-year hiking cycle that will benefit allocations to local currency EMD,” Chaudhuri added.

“We also believe that the US dollar likely hit a cycle peak in Q4 2022, and outside of a global hard landing scenario that could trigger demand for safe havens, emerging market currencies seem primed to maintain their value versus the US dollar in the second half of 2023.”

The asset class proved popular among European investors last quarter, with the iShares J.P. Morgan EM Local Govt Bond UCITS ETF (SEML) and the BNP Paribas Easy JPM ESG EMU Government Bond IG 1-3Y UCITS ETF (BNJPGTC) recording inflows of $1.2bn and $1.1bn, respectively, according to data from ETFbook.