Global markets, as illustrated by the indices in the graph below, delivered returns that we believe were lower than overall investor expectations. Then the COVID-19 pandemic hit the global economy, which we believe put an end to the 10-year bull market. In general, global equity markets have now started to recover, but the pandemic introduced and even exacerbated challenges that we expect to subdue financial market returns over the next five years.
Our outlook suggests that there are multiple trends in place that may drive the equity and fixed income markets during the next five years. We expect economic actors may be dealing with the pandemic fallout amid calls for more resilient business and economic models. Tensions between the U.S. and China may remain high, leading to a less efficient world trading system. That, combined with central banks’ potential actions, may lead to higher levels of potential inflation.
Global Agg. is the Bloomberg Barclays Global Aggregate Total Return Index and is a measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
U.S. Agg. Bond is the Bloomberg Barclays U.S. Aggregate Total Return and is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the U.S. bond market.
Europe Agg. Bond is the Bloomberg Barclays Euro Aggregate Bond Index and is a broad-based flagship benchmark that measures the investment grade, euro-denominated, fixed-rate bond market, including treasuries, government-related, corporate and securitized issues.
GLOBAL HIGH YIELD
Global High Yield is the Bloomberg Barclays Global High Yield Total Return Index and a multi-currency flagship measure of the global high yield debt market.
Global Equities is the MSCI World Index captures large and mid cap representation across 23 Developed Markets (DM) countries. With 1,601 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
U.S. Equities is the MSCI U.S. Broad Market Index captures broad U.S. equity coverage. The index includes 2,969 constituents across large, mid, small and micro capitalizations, representing about 99% of the U.S. equity universe.
Europe Equities is the MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe. With 435 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe.
EMERGING MARKET EQUITIES
Emerging Market Equities is the MSCI Emerging Market Equities Index captures large and mid cap representation across 26 Emerging Markets (EM) countries. With 1,383 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
We believe companies may prioritize stability over profitability by re-routing their supply chains, moving production inside their home countries, and building healthier balance sheets. After the stimulus-induced surge, global growth may settle at low levels.
In our opinion, the controversial Modern Monetary Theory (MMT)1 — which may advocate for greater coordination between monetary and fiscal policy — is, in reality, already being applied. In our opinion, this evolution has given central banks (recently viewed as ineffective) a big new toolkit.
We believe inflation faces a test from many of this year’s themes — notably Retooling Global Growth; One World, Two Systems and Massive Monetary Toolkit — but the effects of slow growth, technology and automation may keep inflation at or below central bank targets.
We believe that last year’s Irreconcilable Differences theme is evolving to where the U.S. and China may learn to live on the same planet with their opposing views on economic policy. Collaboration may not be absent, but may not be optimal either — leading to inefficiencies.
We believe that capitalism must evolve. Business leaders, the ultra-wealthy and politicians representing those left behind may find a way to forge a new capitalism that works better for all.
In our opinion, the pandemic took focus off climate-related issues, but the risks have not gone away. In some cases, they have intensified. Post-pandemic economic rebuilding may force leaders to re-engage with climate risk — a headwind for some industries but a tailwind for others.
EQUITIES | FIXED INCOME | REAL ASSETS
We expect a mix of elevated valuations, slow global growth, lower profit margins and broader focus on stakeholders versus just shareholders may subdue returns. Emerging markets, which we believe may continue to reflect attractive valuations but also may add a measure of uncertainty, may slightly outpace developed markets.
In our opinion, low but steady interest rates could translate into low but positive returns over the next five years. High yield fixed income stands out as a potential alternative to global equities with its potential for higher yield, and what we believe will be higher expected total return.
We believe the possible permanent impairment of retail and office properties may hurt global real estate, while natural resources may struggle through subdued global demand. Listed infrastructure may stand out as a potentially higher-yield, lower-risk asset class in what many investors may feel is a higher-risk world.
QLC | QDEF
The pandemic has acted as an accelerant for both geopolitical tensions and technological disruption. U.S.-China tensions have resurfaced and technology utilization is increasing by C-suites and consumers alike. Working from home has been embraced and e-commerce delivery has taken another big step forward. We believe the ramifications will last beyond the pandemic. The accelerated decline of brick-and-mortar retail caused the loss of millions of jobs — many of which we suggest may never be coming back. Also, we believe that industries must “retool” to stabilize business models by moving production out of China and closer to home. This both reduces dependence on China and ensures access to necessary supplies. Our analysis suggests that this could temper long-term global economic growth.
For investors who desire to both invest in the U.S. market to potentially take advantage of this expected trend and are looking to enhance the risk-adjusted performance of their large-cap stock2 allocations, we believe there may be some advantages to investing in a multi-factor3 dividend strategy like that utilized in the FlexShares U.S. Quality Large Cap Index Fund (QLC).
We think investors who are looking to take a defensive position while potentially utilizing stock dividends as another source of return in their equity portfolios, may want to consider the FlexShares Quality Dividend Defensive Index Fund (QDEF).
BNDC | HYGV
Our feeling is that a closer link between monetary and fiscal policy may be in order to deal with potentially ongoing low inflation. While not technically coordinated, the simultaneous reduction of interest rates to zero and massive increase in central banks’ balance sheets has allowed government deficit financing at massive size and at minimal interest costs. Effectively, the highly debated Modern Monetary Theory (MMT) — the idea that monetary policy should serve as fiscal policy’s wallet (through money printing), enabling political leaders to combat recessions — is already at work, whether officials want to call it MMT or not.
The FlexShares Core Select Bond Fund (BNDC) uses what we believe are cost effective and efficient exchange-traded funds (ETFs) to construct an actively managed bond fund that is managed by institutional fixed-income managers at Northern Trust, the adviser of the FlexShares funds. The managers of the fund are attempting to provide a diversified, core fixed-income portfolio within the fund that balances total return and income, while pursuing price stability and diversification away from equities.
Our analysis suggests that fixed income high yield securities may face some challenges from the slow economic growth environment, but could remain attractive to investors due to the global search for yield which may keep interest rates lower and potentially make it easier for companies to service and roll over debt. Consequently, investors may want to consider the FlexShares High Yield Value-Scored Bond Index Fund (HYGV) which uses a multi-factor approach to select and weight securities, which we believe offers the potential for improved diversification and income generation.
TDTT | TDTF | GUNR | NFRA
Our opinion is that if ever there was a time that inflation may rise, this may be it. In response to the pandemic, trillions of dollars of fiscal and monetary stimulus has been pumped into the system. For now, fiscal stimulus has only partially replaced lost economic demand and monetary stimulus has mostly stayed in the financial markets. However, some fear that, once the economy regains traction, all of this money in the system will push inflation beyond investors’ comfort zone. Adding to this concern, we expect companies to prioritize resiliency over efficiency, potentially leading to a higher cost of production. Also, central bankers likely will allow “somewhat higher” inflation to make up for a decade of low inflation.
For investors that believe inflation may increase, then we believe that the FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (TDTT) and the FlexShares iBoxx 5-Year Target Duration TIPS Index Fund (TDTF) may provide them with the inflation-hedging attributes of TIPS.
Investors may also want to consider investing in global real asset equity ETFs such as the FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR) and the FlexShares STOXX Global Broad Infrastructure Index Fund (NFRA). GUNR focuses on the upstream portion of the natural resources supply chain while we believe that NFRA may provide exposure to new and evolving players in the infrastructure space.
Tensions between the U.S. and China are as high as they have been in decades. But we do not believe the current feud will move out of the economic realm — the stakes are too high. In fact, we believe tensions will reduce to a constant simmer as an “agree-to-disagree” dynamic takes hold. Both will hold onto their own “systems” and maintain distrust of each other. The biggest loser here will be globalization, which may continue to decline. Other countries and multi-national companies may be forced to either pick a side or straddle the middle ground, potentially leading to lost economic opportunity (potentially slowing economic growth) and/or economic inefficiencies.
Investing in low volatility stocks is often used as a defensive strategy by investors who want to participate in some of the market’s growth while potentially reducing their downside risk. Investors who see this trend as potentially adding increasing levels of volatility into the markets may want to consider the FlexShares U.S. Quality Low Volatility Index Fund (QLV) which is designed to provide exposure to U.S.-based companies that possess lower overall absolute volatility and that also exhibit financial strength and stability, which we believe are quality characteristics.
In many cases today, minimal investment capital is needed to launch companies, which may require relatively few employees to keep operations going. For instance, Netflix and Intel have a similar market cap and yet Intel employs over 12 times as many workers —110,000 vs. 8,600. Meanwhile, the benefit of multiple competitors is less clear. Should Amazon be broken up? Its scale is what enables it to be the low-cost provider.
While there is no guarantee that past performance will be repeated, some investors may want to pursue potential growth opportunities that have may have been historically seen in small-cap and value stocks.4 Investors may want to take advantage of the historic growth opportunities through the FlexShares Morningstar U.S. Market Factor Tilt Index Fund (TILT), which is designed to provide broad equity market exposure with a tilt toward small-cap and value stocks.
ESG | ESGG
We believe that the biggest threat for financial markets and equity returns concerns investors potential anticipation of the future negative impact of climate change. Particularly vulnerable are natural resource and emerging market stocks. Relatively fragile economies could be especially sensitive to climate-related regulation as they are still in early stages of maturation, which generally comes with higher carbon emissions. Investors likely will start to look at climate risk with more urgency as the pandemic has made investors more sensitive to how large non-financial events can hurt returns.
Investors who want to stay ahead of this trend may want to consider the FlexShares STOXX U.S. ESG Impact Index Fund (ESG) and the FlexShares STOXX Global ESG Impact Index Fund (ESGG). Both of these ETFs seek enhanced risk return characteristics relative to broad large-cap equity markets. Our research indicates it is prudent to evaluate the impact of KPIs on a sector-by-sector basis. By focusing on the ESG criteria, our research has shown that these KPIs may be most material in specific sectors/ industries. The funds are designed to target companies within those sectors/ industries that exhibit positive historical risk and return.
FIND OUT MORE
The FlexShares approach to investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of any of the ETFs discussed in this report in greater depth or find out more about the index methodology behind them please don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383).
DEFINITION OF TERMS1. Modern Monetary Theory (MMT) is a macroeconomic theory that, for countries with complete control over their own currency, government spending cannot be thought of like a household budget. Instead of thinking of taxes as income and government spending as expenses in a checkbook, MMT proponents say that fiscal policy is merely a representation of how much money the government is putting into the economy or taking out.