If not cash, then what should investors buy?

If not cash, then what should investors buy?
Markets have rebounded strongly in 2023 leaving investors wondering if they have missed the boat. However, looking underneath the surface reveals a lot of compelling opportunities still exist. These opportunities also come at a time when BlackRock think traditional diversification can make a comeback. This excites BlackRock as multi-asset income managers as it means can seek compelling income and return with improved diversification.Here are a few areas we favor in our multi-asset income portfolios:

1. Undervalued dividend stocks complemented with covered calls

Much ink has been spilled on the concentration of this year’s equity rally, which has been led by a handful of mega-cap tech stocks. What’s gotten much less attention is the potential appeal of other types of equities. Valuations still look very reasonable for dividend stocks. One way to look at this is breaking the equity universe into dividend quintiles, which shows higher yielding stocks are cheap relative to historical valuations and relative to growth stocks (Chart 1). This means the bar to exceed expectations is much lower in these pockets of equity markets, and they should benefit more in the case of a soft landing.Chart 1: Forward P/E by Dividend Quintiles – MSCI USA IndexChart 1: Forward P/E by Dividend Quintiles – MSCI USA IndexSource: Institutional Brokers' Estimate System (IBES) as of 31/08/2023. Forward P/E multiples represented by IBES estimates, reflecting the consensus earnings per share across sell-side analyst estimates. Indexes are unmanaged and one cannot invest directly in an index.That said, BlackRock also want to make sure they have growth exposures in income portfolios, especially given the importance of tech today. One way BlackRock get access is through covered calls. This means BlackRock sells away some upside potential on individual stocks, which they think makes sense considering today’s valuations, and in exchange get a very attractive income stream. As an example, BlackRock can sell a 1-month 6% OTM call option on Microsoft and receive annualized yield of 11.0%.1

2. Select opportunities in higher yielding credit

The current yield profile of the US high yield market continues to offer attractive carry at ~8.3% with a strong fundamental profile for the core of the market.2 However, index levels don’t tell the full story as dispersion continues to sit at elevated levels for this market. In our strategies, BlackRock are avoiding the tails. In other words, BlackRock have less exposure to the very tight names (spreads inside 200 bps) and very distressed names (spreads over 800 bps). BlackRock still think there is a lot of value in between, but investors will need to stay selective.BlackRock also think investors should consider owning a portion in European high yield. Relative to the US, it is a higher quality market on average and USD investors get the added benefit of earning approximately 2% more income when hedging back to US dollars.3 We also don’t anticipate a meaningful spike in defaults.

3. Higher quality, lower duration bonds

Lastly, a rise in short-term rates has led to much more attractive valuations in higher quality fixed income. A couple of areas that stand out to us, especially in BlackRock more conservative portfolios, include short-term investment grade bonds and collateralized loan obligations (CLOs). Even though BlackRock don’t expect a meaningful rise in rates from here, these markets offer compelling yields with minimal duration risk. BlackRock also like having an allocation to agency mortgage-backed securities (MBS), where valuations have become much more compelling. As the below chart shows (Chart 2), these areas have much higher yields today and may provide investors with strong downside protection versus stocks should volatility rise.Chart 2: High quality fixed income offer attractive risk-adjusted yieldsChart 2: High quality fixed income offer attractive risk-adjusted yieldsPast performance is not an indication of future results. It is not possible to invest directly in an index. Yields based on yield to worst. For illustration purposes only. Source: Bloomberg as of 31 August 2023. US Investment Grade bonds represented by the Bloomberg US Corporate Bond Index. US CLO represented by the JPM CLO IG Index. Agency MBS represented by Bloomberg US MBS Index.1 Reference to the company name mentioned herein is for illustrative purpose only and should not be construed as investment advice or investment recommendation of those companies.
2 Source: Bloomberg as of 31 August 2023. Based on the Bloomberg US High Yield Index.
3 Source: Bloomberg as of 31 August 2023. Based on the Bloomberg EUR/USD Hedging Cost Index.
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