Q2 2023
Taking stock
Market views from BlackRock Fundamental Equities
Between stocks and a hard place. The first quarter packed a full gamut
of investor emotion, as early cheer gave way to fears over stubbornly high
inflation and fallout from Fed rate hikes. As Q2 begins, we see:
Equities maintaining
their long-term
appeal
Returns increasingly
driven by stock
specifics
A need to
emphasize quality
and stability
Tony DeSpirito
Chief Investment Officer,
U.S. Fundamental Equities
”
An early-year stock rally fueled by hopes of a Fed pause proved short-lived. The first
spoiler ― hotter-than-expected inflation data ― was followed by signs that rate
hikes are having an economic impact as cracks emerged in the banking system. The
two counterforces make the Fed’s job more complicated as it becomes increasingly
clear that taming inflation might not only incite recession but could also rock
financial stability. We remain selective in taking risk as macro factors continue to
drive sentiment, but we do expect company specifics to grab the reins as the driver
of returns once greater clarity emerges around inflation and the economy. Despite
the uncertainties, investors should not lose sight of equities’ enduring role in a wellbalanced portfolio. We advocate a near-term focus on resilience via quality stocks,
which historically have outperformed both the broad market and bonds in the one
to three years after the Fed stops hiking rates, as shown below.
Macro conditions are
driving daily market
moves, but individual
stock fundamentals
historically dictate
long-term investor
outcomes.
”
Quality readying to lead?
Average returns after Fed hiking cycle ends, 1984-2021
90%
83%
60
30
57%
49%
26%
33%
17%
32%
24%
12%
0
1 year
2 years
3 years
● Quality stocks ● All equities ● Bonds
Source: BlackRock Fundamental Equities, with data from the Board of Governors of the Federal Reserve System and Bloomberg, calculated from Aug. 31, 1984-Dec. 31, 2021.
Returns are calculated from the month when the Fed stops raising rates for peak rates periods in 1984, 1989, 1995, 2000, 2006 and 2018. All equities represented by the
Russell 1000 Index and bonds by the Bloomberg U.S. Aggregate Index. “Quality” is defined as the top quintile of stocks ranked in the Russell 1000 Index using a proprietary
research screen that assesses companies on 13 “quality” metrics. Past performance is not indicative of current or future results. Indexes are unmanaged. It is not possible
to invest directly in an index.
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Sticking with stocks
In a historically rare occurrence, both stocks and bonds delivered negative returns in 2022. The consensus view is that
bonds now offer the best opportunity to invest at attractive prices since the global financial crisis (GFC). Yet stocks
continue to play a critical role in a long-term investment plan and their “expensiveness” is partly a question of time horizon.
Perspective on price and performance
When it comes to price, starting point is critical to
investment outcomes. That entry point is the most
attractive it’s been in over a decade for bonds, setting up
an appealing tactical opportunity for many investors.
Fund managers are seemingly seizing the moment, as
Bank of America’s Global Fund Manager survey from
February showed stock allocations are more than two
standard deviations below their long-run average while
bond allocations are higher than usual.
But the argument evolves as you extend the investing time
horizon. A look at the equity risk premium (ERP) across
nearly seven decades of data indicates current pricing is a
fairly balanced proposition between the two assets ― with
equities historically offering better long-term returns.
The ERP is a gauge of the relative risk-reward in stocks
versus bonds, measuring stocks’ excess earnings yield
over the “risk-free” rate. The ERP dropped recently after
being abnormally elevated for 13 years as Treasury
yields hovered near historic lows. Yet the S&P 500’s
current ERP of 1.71% is still above the 1.62% average
since the index’s inception in 1957, as shown below.
This suggests that stock pricing relative to bonds is still
slightly better than historical averages.
When it comes to performance, stocks have held the
upper hand. Equities entail greater risk for their potential
greater reward and are broadly expected to outperform
bonds, which have lower volatility, over time. As the chart
below shows, equities have even provided a more favorable
performance outcome over shorter time frames, besting
bonds 68% of the time over one-year holding periods.
An equity edge across time horizons
Percent of time stocks have outperformed bonds, 1957-2022
80%
60
73%
68%
71%
77%
40
20
0
1 year
3 years
5 years
Holding period
10 years
Source: BlackRock Fundamental Equities, with data from the Robert Shiller database,
as of Dec. 31, 2022. Stocks represented by the S&P 500 Index and bonds by the
10-year U.S. Treasury. The analysis looks at total return and calculates the percent of
times stocks provided a greater cumulative return than bonds for each holding period.
Past performance is not indicative of current or future results. Indexes are
unmanaged. It is not possible to invest directly in an index.
A relative view of valuations
Equity risk premium for U.S. stocks, 1957-2023
8
Stocks more
attractive
4
Average = 1.62%
0
Bonds more
attractive
-4
1959
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
2007
2011
2015
2019
2023
Source: BlackRock Fundamental Equities, with data from Robert Shiller, Standard & Poor’s and Refinitiv, March 1, 2023. The equity risk premium is calculated using the S&P 500
earnings yield and subtracting the 10-Year Treasury Constant Maturity Rate. It is not possible to invest directly in an index.
Emphasizing resilience
With recession a looming concern, investors understandably gravitate to the lower-risk asset. But equities are a critical
long-term growth engine and can be built into portfolios with a focus on resilience. We believe this is best achieved
through active selection with an emphasis on “quality” characteristics.
What is quality?
“Quality” in investing can be a subjective term. We apply a
comprehensive metric comprising 13 factors that offer a
broad, quantitative measure of quality. Among them are
profitability, earnings stability, free cash flow generation,
use of leverage and capital allocation. Our quality metric
2
has tended to outperform in down markets, and 2022
was among its best years since 1977. We believe this
outperformance could continue in 2023 given a historical
late-cycle advantage for quality, attractive relative
valuations and a history of outperformance in the years
following the conclusion of Fed hiking cycles, as shown
on page 1.
Taking stock | Market views from BlackRock Fundamental Equities
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Actively keying in on quality
Building quality into an equity portfolio can be achieved in various ways, across both growth and value disciplines.
Our Fundamental Equities portfolio management teams are adding quality through stock selection that emphasizes:
More return with less volatility
1. Earnings compounders
In the short run, macroeconomic influences can have an
outsized impact on stock returns. This has been painfully
evident in the past year amid high inflation and Fed rate
hikes. Yet companies’ underlying fundamentals are
responsible for the lion’s share of stock returns across
time, as illustrated below.
We seek companies that can maintain their earnings growth
throughout market cycles. Those that compound their
earnings by reinvesting them into revenue growth, margin
improvement or share count reduction are effectively
compounding returns to shareholders. We look for solid
balance sheets and positive free cash flow (essentially a
buffer against any shortfalls) as additional key signposts.
Fundamentals dictate long-term returns
25%
21.9%
22.3%
20
15
16.3%
15.3%
13.2%
12.3%
10
10.8%
9.4%
5
0
S&P 500 Index sources of total return, 1988-2022
Dividend
growers and
initiators
4000
Cumulative total return (%)
Return and risk by dividend category, 1978-2022
S&P 500
Index
Non-dividend
payers
Dividend
cutters and
eliminators
● Return ● Risk (standard deviation)
3000
Source: BlackRock Fundamental Equities, with data from Refinitiv, as of Dec. 31, 2022.
Figures shown are annualized. Data for the S&P 500 Index is equal-weighted, meaning
all companies are allocated at equal proportion. The other categories are subsets of the
index based on their dividend strategy. Risk is represented by the standard deviation of
returns. Past performance is not indicative of current or future results. Indexes
are unmanaged. It is not possible to invest directly in an index.
2000
1000
0
3. Stability sectors
-1000
1990
1998
2006
2014
2022
● Dividends ● Earnings growth ● Change in valuation multiple
● Total return
Source: BlackRock, with data from Refinitiv, Feb. 28, 1988-Dec. 30, 2022. Chart shows
the cumulative total return of the S&P 500 Index attributable to EPS growth, dividend
yield and change in valuation multiple, referencing Refinitiv IBES Global Aggregates for
index-level earnings estimates. Shown for illustrative purposes only. Past performance
is not indicative of current or future results. Indexes are unmanaged. It is not
possible to invest directly in an index.
2. Dividend growers
Dividend-paying stocks have outperformed nondividend payers over the long term with less volatility,
but companies that grow their dividends stand out most,
as shown at the upper right. Statistically, a company’s
record of and commitment to paying a dividend has
instilled a measure of resilience. We find their
managements are loath to cut a dividend and send a
negative signal to the market, so dividend growers tend to
be well-run companies built to weather diverse markets.
Stocks with a history of dividend growth also have tended
to fare better in a rising-rate environment versus the
highest-yielding stocks (essentially “bond proxies”) that
tend to follow bond prices down as rates rise.
Healthcare was a favored stability sector across our
global Fundamental Equities platform last year and
remains so today. Company earnings in the healthcare
sector have historically proved to be recession resilient,
and we would expect that precedent to hold in the
next recession. This is important in a year in which
stock performance is more likely to be driven by
earnings, versus last year when returns were driven by
multiple contraction.
Pricing for healthcare stocks is compelling, with valuations
below the market average. Other defensive sectors such as
consumer staples and utilities were bid up in price last
year as investors sought stability and their valuations still
sit at or above the broad market. Healthcare also boasts a
long-term tailwind as aging populations and increasing
health-related needs worldwide set the stage for attractive
growth prospects across the sector.
We see each of the above expressions of quality
gaining in importance in 2023 as return outcomes
rely less on broad market moves and more on
individual selection.
3
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