BlackRock Investment InstItute

a DIsaPPeaRInG act IMPACT OF TIGHTER FINANCIAL CONDITIONS

MAy 2014

[ 2 ] a D I s a P P e a R I n G a c t

The opinions expressed are as of May 2014 and may change as subsequent conditions vary.

A Disappearing ActPlentiful money at near-zero cost has been the mood music of markets since the financial crisis. The result of this government-sponsored largesse? Suppressed volatility, greater risk taking and a potential misallocation of capital.

What happens to markets when financial conditions tighten and risks of a liquidity disappearing act pick up? We gathered a group of 80 BlackRock investment professionals to debate this. Our main conclusions:

} Financial conditions have been the dominant driver of asset price returns since 2009—especially in fixed income. Central bank policy has aimed to shift portfolios into riskier assets. Easy financial conditions are pushing pension funds, wealthy individuals and other investors into look-alike yield-seeking trades.

} The longer monetary policy suppresses uncertainty and underpins valuations, the bigger the eventual break. Recent sell-offs in biotech and other favored sectors could be a preview of more volatile times ahead.

} Economies have grown more rate sensitive because debt levels are rising. G20 countries have racked up an additional $40 trillion in debt since August 2007. Household deleveraging has been more than offset by an explosion in sovereign debt. A rise in real economic activity typically helps fix the problem—but can be bad news for financial markets.

} Many investors are buying corporate bonds and other credit instruments at paltry and declining yields that offer decreasing compensation for risks: rising leverage and temporary bouts of illiquidity in the event of a market downturn. Any crunch would be exacerbated by sparse inventories of corporate bonds at broker-dealers—and their reluctance to take on risk.

} Equity and credit markets are joined at the hip. Cheap debt has led companies to extend maturities, raising the share and stability of cash flows accruing to equity holders. Equities are essentially long-dated options on cash flows. The higher the option’s price, the more sensitive it is to minor changes in rates.

} Liquidity measures are increasingly correlated with the VIX, the benchmark U.S. equity volatility index. Like it or not, the world is hostage to U.S. financial conditions—and this includes emerging markets (EM). Their smaller financial systems, links to the U.S. dollar and dependency on external financing magnify the impact of swings in capital flows.

} The U.S. Federal Reserve is unlikely to raise rates until 2015 at the earliest, we believe, but volatility is set to rise from trough levels as the quantity of its stimulus wanes. This means portfolios today are more risky than they appear.

} Investors have to weigh the risk of getting caught out versus the risk of leaving the party too soon. yet going against the crowd is difficult.

} Timing is everything—but predicting the exact timing of market turning points is tough. History suggests rising spread volatility, a spike in dispersion of U.S. high yield returns from record low levels or an acceleration in U.S. wage inflation would be canaries in the coal mine.

Russ KoesterichBlackRock’s Global Chief Investment Strategist

Nigel BoltonChief Investment Officer, BlackRock International Fundamental Equity

Ewen Cameron WattChief Investment Strategist, BlackRock Investment Institute

Supurna VedbratCo-Head of the BlackRock Market Structure and Electronic Trading Team

Rick RiederChief Investment Officer, BlackRock Fundamental Fixed Income

Peter FisherSenior Director, BlackRock Investment Institute

B l a c k R o c k I n v e s t m e n t I n s t I t u t e [ 3 ]

In tHe DRIveR’s seat key market Drivers over the next six months

loW meDIum HIGH

Financial conditions

valuations

volatility

Sources: Federal Reserve banks, Bloomberg and BlackRock Investment Institute, April 2014. Note: The lines show five-year rolling correlations of monthly observations of various financial stress/conditions indexes with the VIX.

FIXateD on tHe vIX Financial conditions correlation With the vIX, 1999–2014

1

-0.4

-0.2

0

0.2

0.4

0.6

0.8Kansas Fed

St. Louis Fed

Chicago Fed

Goldman Sachs

Cleveland Fed

CO

RR

ELA

TIO

N

1999 2001 2003 2005 2007 2009 20142011

} live another Day: Market risks are tilted to the downside. Better to dial down risk and accept some underperformance today than to get badly hurt later?

} upside Hedges: Buying downside protection is expensive and often an imperfect hedge. Position defensively and buy (cheaper) options on the upside.

} Real Diversity: Correlations between stocks and bonds are set to rise, we believe, increasing portfolio risk. Consider alternative investments.

so What Do I Do With my money?®

FIGURING OUT FINANCIAL CONDITIONSFinancial conditions are a broad measure of how accommodative or restrictive the overall financial environment is. Economic activity requires financing—and cheap credit fosters investment and growth (and encourages asset price appreciation or bubbles).

An arms race has broken out between regional Fed branches and investment banks to find the ultimate gauge of U.S. financial conditions. Inputs include policy rates, bond spreads, equity valuations and measures of interbank stress.

These indexes tend to move in near lockstep. Moreover, they have had a very high (and rising) correlation with the VIX index of equity market volatility. See the chart below.

The correlation does not apply to U.S. metrics only. The MSCI World Index has become increasingly correlated (negatively) with the VIX since the late 1990s. Rising global integration means countries are importing U.S. financial conditions.

Our research suggests the VIX, in turn, has a tight relationship with high yield credit spreads. So keep an eye on the U.S. credit cycle. Companies have been gearing up to buy back shares and increase their return on equity (ROE)—at the expense of future growth opportunities and financial stability.

Just how much do financial conditions matter? Our answer: a lot—at least in the near term. We identified financial conditions as the key swing factor for markets over the next six months at our recent gathering. See the table above.

There are some subtleties to this answer:

} time Horizon: The shorter an investor’s time frame, the more financial conditions matter. Valuation dominates equity returns in the long run, especially over periods of five years or more. See Risk and Resilience of September 2013 for details.

} asset class: The thirst for income has pushed yields to record lows, making bond prices more sensitive to rate swings than in the past. Equities are typically less exposed to financial conditions, yet this may be less true today. Stocks are essentially long-dated options on cash flows. The higher the price of this option, the more sensitive it becomes to minor changes in discount rates.

} causation: The why of a change in financial conditions matters. Consider the difference between a yield spike caused by a) a blockbuster U.S. jobs report (good) or b) mass redemptions by bond fund holders (bad).

} magnitude: In crowded trades, even small shifts in financial conditions can cause big waves.

} Debt load: Economies are debt-laden—and, therefore, sensitive to changes in financial conditions. G20 countries have racked up an additional $40 trillion in debt since August 2007 (excluding financial debt), according to data from Bank for International Settlements. An explosion of sovereign debt has dwarfed a gentle decline in household debt. The resulting debt overhang is a slow-burning issue. It is profound—but not urgent.

[ 4 ] a D I s a P P e a R I n G a c t

Sources: Thomson Reuters and BlackRock Investment Institute, April 2014. Notes: Equity volatility is represented by the Chicago Board Options Exchange’s VIX index; bond volatility is Merrill Lynch’s MOVE index (U.S. Treasuries). Delinquency rate includes commercial and industrial loans.

DancInG to tHe same Beat u.s. volatility and High Yield metrics, 2000–2014

VIX

LEVE

L (E

QU

ITIE

S) M

OVE

IND

EX (B

ON

DS

)

0

20

40

60

Bond Volatility

High Yield Spread

Equity Volatility

DelinquencyRate

80 250

50

100

150

200

2000 2004 2008 2012 2014

SP

RE

AD R

ATE

0

5

10

15

20% 4%

0

1

2

3

VOLATILITY DAMPENERyears of extraordinary monetary easing by central banks have dampened volatility and fostered increased risk taking. Equity and bond market (implied) volatility have slumped close to pre-crisis lows. Other indicators of financial stress are dancing to the same beat. U.S. corporate delinquency rates are at record lows—and high yield bond spreads are at their lowest level since 2007. See the chart below.

The effects of years of monetary stimulus are most apparent in credit markets. The prolonged period of low real rates has sparked a thirst for yield, encouraging greater leverage and pushing investors into riskier and more illiquid assets.

Current fixed income valuations offer little margin of safety against the risk of higher inflation or a spike in interest rates. It takes a yield uptick of just 14 basis points to trigger a price decline that would wipe out a year’s worth of income on German government bonds, our analysis shows. Also consider that 81% of the global fixed income universe (including high yield and hard currency EM debt) currently yields below 4%, according to our research.

BEACh BALLInvestors are essentially writing options on illiquidity—at paltry yields that increasingly are not enough to compensate them for the associated risks. Many are venturing into illiquid areas such as leveraged loans—bundled into liquid vehicles such as mutual funds that are subject to daily redemptions.

What happens when the tide of global monetary policy turns? As the Fed scales back its bond purchases, global liquidity is tightening for the first time in years.

Emerging markets are particularly vulnerable, due to their smaller financial systems, their ties to the U.S. dollar and dependence on capital flows. A stronger dollar (a likely result of tightening U.S. liquidity) typically hurts EM assets, as detailed in What’s Developing of April 2013. Resulting EM currency slides are painful but also necessary economic adjustments, as discussed in Emerging Markets on Trial of February 2014.

Any financial shock waves could be amplified in increasingly illiquid corporate bond markets. Banks and dealers have been withdrawing from market making due to new regulations that require them to hold more capital. This has contributed to decreased liquidity for all but newly issued corporate bonds, as discussed in Setting New Standards of May 2013.

We expect volatility to rise as the Fed gears up for its first rate hike since 2006. The Fed has promised to keep rates low for a long time—but this pledge could be overtaken by events.

Picture being in a swimming pool where Fed Chair Janet yellen is holding a beach ball of tightening financial conditions under water, right under your face. “Don’t worry,” she says. “I’m holding the beach ball. I can hold it for much longer than you think.”

you might ask: “How much longer?” yellen’s response: “Longer than you think.”

A beach ball may not appear threatening—but it could surprise when it suddenly pops out of the water, especially if the pool’s surface has been placid.

To be sure, financial conditions are more than just policy rates. Quantity (of monetary stimulus) and investor sentiment often matter more than rate levels. Three examples:

1. The Fed funds rate stood at 5.5% in late 1999, yet financial conditions were pretty loose. Long-term yields were low, credit spreads tight and equity valuations high.

2. The Fed started tightening in 2004—but financial conditions loosened dramatically in the years leading up to the financial crisis of 2008–2009.

3. By early 2009, the Fed funds rate was near zero, yet financial conditions were tight. Credit spreads were very wide, the dollar strong and equity valuations depressed.

B l a c k R o c k I n v e s t m e n t I n s t I t u t e [ 5 ]

Source: BlackRock Investment Institute, April 2014. Notes: Chart shows cumulative return to momentum factor in the BlackRock equity model. Grey lines represent one standard deviation moves.

RunaWaY tRaIn Returns to Global equity momentum, 2013–2014

6%

Momentum Returns

1 Standard Deviation (SD)

2 SD

CU

MU

LATI

VE R

ETU

RN

4

2

0

Apr 2013 Jun Aug Oct Dec Feb 2014 Apr

Sources: Thomson Reuters and BlackRock Investment Institute, April 2014. Note: The dots show the total return and annualized weekly volatility since the start of 2013.

Recent RePoRt caRDs asset Performance and volatilty, 2013–2014

U.S. Biotech

U.S. Small Cap

Developed Equities

Global High Yield

Global Investment Grade

U.S. 10-Year EM Equities

Copper Gold

EM Debt

NasdaqS&P 500

S&P Buyback Index

RE

TUR

N S

INC

E 2

013

VOLATILITY

60%

40

20

0

-20

0 5 10 15 25%20

Italy 10-Year

Closing time is near in the pub. The Fed is ringing the bell, and this induces awkward behavior. Patrons down as many beers as possible before they get kicked out (pile into U.S. small caps!). What happens when the pub finally closes? The karaoke bar down the road is still open for business (long Japanese equities!) and so are some Mediterranean joints (buy European peripheral assets!).

Global money flows in exchange traded funds (ETFs) show these trends, with Europe-focused ETFs (up a net $11.9 billion) and Japanese funds (up $11.6 billion) holding their momentum through April, whereas flows into U.S. equities tapered off, analysis of our ETF database shows.

The tide can turn very quickly. Case in point: the recent reversal in momentum trades. Betting on yesterday’s winners had been a very profitable trade over the past year. Returns on the global equity momentum factor were two standard deviations above average (around the 95th percentile) in early 2014, our research shows. See the chart above.

yet this year has started off like a San Francisco cable car: shuddering stops and jolts over hilly terrain. Growth stocks such as U.S. biotechs (a top performer in the past year; see the chart on the right) took it on the chin.

The lesson: It does not take much to cause changes in sector leadership when positioning is crowded and valuations stretched. (And it is key to appreciate the importance of changing sector weights in the traditional equity style boxes of growth and value, as detailed in A Matter of Style of February 2014.)

So what could derail the momentum train?

} Rising U.S. wage inflation. This could prompt markets to re-evaluate expectations that the Fed will not raise interest rates until the first half of 2015. Inflation could come sooner than many expect, given tighter labor markets and rising industrial activity. The last time U.S. capacity utilization was at today’s level of 79%, inflation was 3.5%, roughly two percentage points above its current reading.

} Increasing U.S. credit spread volatility or signs the corporate default cycle is turning for the worse.

} Hard evidence China’s economy is slowing more than expected or that its financial system is gumming up.

} An overdose of leverage. So far, increasing corporate leverage has boosted returns, with the S&P Buyback Index a notable outperformer. See the chart below. Companies are borrowing and using the proceeds (as well as cash) to make acquisitions or buy back shares. Consider IBM repurchased $8 billion of its shares in the first quarter, yet generated just $600 million of free cash flow.

Optimists urge us to consider what could go right:

} China and Japan have revealed very ambitious reform agendas. Some of the plans might actually get done, yielding growth that is not discounted by markets yet.

} The landscape looks eerily like 1994: Financial conditions are loose, growth is good enough and the Fed is ready to pounce after years of easy money. Rate hikes did not spoil the party in 1994—and a bull market in stocks took off.

[ 6 ] a D I s a P P e a R I n G a c t

Sources: IMF, Bank of America Merrill Lynch and BlackRock Investment Institute, April 2014. Note: CLOs are collateralized loan obligations.

DeBt Fest u.s. High Yield Bond and loan Issuance, 2007–2013

$400

Leveraged Loans

BIL

LIO

NS

0

100

200

300

2007 2008 2009 2010 2011 2012 2013

Not RatedCCCBBBHigh Yield Bonds:

CLOs

Sources: Thomson Reuters and BlackRock Investment Institute, April 2014. Notes: Earnings yield is calculated as the inverse of the 12-month forward price/earnings ratio of the S&P 500. Cost of debt is based on the yield of the Barclays U.S. Corporate Investment Grade Index.

JoIneD at tHe HIP u.s. equities earnings Yield vs. cost of Debt, 1985–2014

12%

8

4

Earnings Yield

Cost of Debt

0

1985 1989 1993 1997 2000 2005 20142009

FROTh WATChThere are innumerable gauges of market froth. We like to focus on the credit markets—and believe they will likely foreshadow the next stage of this market cycle. The reasons?

} Fixed income—and especially credit—has been the biggest beneficiary of easy financial conditions. It is also where valuations appear most vulnerable.

} Credit markets have been subsidizing equity holders by helping companies refinance easily at low cost.

Issuance of high yield bonds and leveraged loans rose to record highs in 2013. Origination of collateralized loan obligations (CLOs) was closing in on record 2007 levels. See the chart below.

The average quality of high yield bond issuance today is higher than it was in 2007, with CCC-rated bonds making up a smaller share of the total. Other measures tell a different story. “Covenant-lite” loans with lower protections for lenders make up almost 70% of new issuance in the leveraged loan market today, compared with a peak of 38% before the 2008 crisis, Deutsche Bank data show.

yet the underlying economics of credit markets are strong. The prolonged period of low rates has enabled companies to refinance cheaply and push out debt maturities. This means they are better equipped to weather a storm without defaulting. The greatest risk for credit markets appears to be a big upward move in the risk-free rate (U.S. Treasuries) rather than in the risky rate (spreads), we believe.

How about equity markets? Bulls and bears have their (many) pet indicators. Two sides of the equation we look at:

} Pro: Credit and equity markets are joined at the hip. A decline in the cost of debt historically has translated into declining earnings yields (or higher equity valuations). See the chart above. Cheaper corporate borrowing costs have boosted the size and stability of cash flows accruing to equity holders. This suggests equity valuations could move higher yet—as long as financing costs stay low (a big if).

} con: Today’s valuations may only look fair due to (perhaps unsustainably) high profit margins. Bears cite gauges such as “Tobin’s q,” which measures the ratio between the market value and replacement cost of corporate assets. The U.S. ratio is currently at its highest level since the 2000 tech bubble.

Our bottom line: Equities may look cheap versus bonds—but not on an absolute basis against their own history.

Why do investors often stay on the dance floor too long? Behavioral finance says people would rather stick with the safety of the crowd than risk leaving the party early—and regret missing out on the fun. yet the risks are often asymmetric. The question: Is it better to dial down risk and accept some underperformance today than to get badly burned later?

Protection against a market downturn does not always come cheap (put options are generally more expensive than calls—and this gap has widened since the 2008 financial crisis). Also, it sometimes turns out to be an imperfect hedge. One alternative: marry a defensive portfolio with cheap upside options that would benefit in a bull scenario.

B l a c k R o c k I n v e s t m e n t I n s t I t u t e [ 7 ]

What is the best canary in the coal mine for a rise in the market risk? Our high yield complacency gauge is one candidate. The tool, which measures the dispersion of returns in the high yield market, tends to reverse sharply after hitting trough levels. See the chart on the right.

The measure has been in the bottom quartile for 11 months—and recently hit a record low. Low dispersion means returns are bunched together, with little differentiation between winners and losers. Similar troughs in the past have foretold big market declines. Imagine a raft where all the passengers are sitting on one side. It only takes a small wave to capsize the contraption.

The indicator bottomed ahead of sell-offs triggered by the early 1990s U.S. recession, Russia’s debt default of 1998 and Lehman’s collapse in 2008—although the signal sometimes came a year or two early. (Life as a contrarian can be lonely.) Today’s levels do not necessarily presage another crisis. But they do suggest markets are living on borrowed time. See Squeezing Out More Juice of December 2013 for another “bubble-meter.”

In seaRcH oF a canaRY

Source: BlackRock Investment Institute, April 2014. Note: The BlackRock high yield complacency gauge measures the level of cross-sectional dispersion in the U.S. high yield market.

comPlacencY WatcH BlackRock High Yield complacency Gauge, 1986–2014

RAT

IO

12

8

4

0

1986 1990 1994 1998 2002 2006 2010 2014

Lehman Collapse

Russia Default / LTCM

U.S. Recession

Sources: Thomson Reuters and BlackRock Investment Institute, April 2014. Note: Rolling 90-day correlation of 10-year U.S. Treasury and world equity daily returns.

ReGIme cHanGe?correlation of Global equities and u.s. treasuries, 1985–2014

0.6

1997–2014 Average

CO

RR

ELA

TIO

N

0.4

0.2

0

-0.2

-0.4

-0.6

-0.8

1985 1989 1993 1997 2001 2005 2009 2014

1985–1997 Average

The outsized role of financial conditions as a common driver of valuations across asset classes means average correlations are likely to rise as markets normalize. This would reduce the diversification benefits of owning different asset classes. Global equities and U.S. Treasuries, for example, have been good diversifiers in the new millennium with an average negative correlation of -0.24 (albeit hiding a lot of volatility). See the chart below.

Correlations can change dramatically, both over time and in different market environments, as detailed in Risk and Resilience of September 2013. If bonds and equities were to move in lockstep again, portfolios will suddenly look a lot riskier. This does not preclude diversification benefits in flights to quality: Bonds rallied in early 2014 as equities came under pressure. Genuine diversification, however, starts with a realization that (implied) volatility has been eerily low—and that this is likely to change.

IN SEARCh OF YIELDElevated valuations in financial markets pose challenges for portfolio construction. Consider a European bond investor targeting a 5% annual return. In 2007, the investor could meet this objective through an 88% allocation to (pan-European) government bonds, with just 12% in riskier sectors such as high yield and EM debt, our analysis shows. Today, the investor would need to pour 78% of the portfolio into risker sectors. And today’s portfolio would be more than twice as risky (based on historic volatilities). See Currents: The New Diversification of April 2014 for details.

This hunt for income is likely a long-term quest. Aging populations and low nominal GDP growth are creating a structural bid for yield and are likely to cap any sustained interest rate rises. The longer such an environment persists, the greater the risk of volatility bursts and (temporary) unwinds.

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This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2014 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents.

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