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The return of volatility—as valuations and investor complacency remain elevated—will make it vital for investors to consider hedging against downside risk and cut back on certain investments in the new year, finds the BlackRock Investment Institute’s (BII) 2015 Investment Outlook.

BII anticipates divergent monetary policies and growth trends will be key themes of 2015. Financial conditions in the U.S. and U.K. will likely tighten due to a pickup in growth and improving labour markets, and will loosen elsewhere, particularly Japan and Europe.

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Nominal risk-free rates should stay low for the long term. A low-rate environment suggests investors will continue to stretch for yield.

But they must be cautious, as valuations in most markets are rich, and faith in monetary policy underpinning asset prices is high. “Such valuations and a voodoo-like belief in momentum raise the cost of mistakes,” BII notes.

“Pockets of volatility are likely,” says Russ Koesterich, BII’s global chief investment strategist. “It’s key for investors to develop a plan to prepare for a return to a more normal volatility regime.”

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Peter Fisher, senior director of the BlackRock Investment Institute, adds, “Readiness rules in 2015. Equity and fixed income markets could fall in tandem, challenging traditional diversification. Relative value strategies and alternative investments can help.”

BII suggests the following investment tips for 2015.

  1. We like Japanese and European equities due to cheap valuations and monetary boosters. We favor U.S. cyclicals over defensives as the Fed tightens monetary policy.
  2. We prefer credit, such as U.S. high yield and European bank debt over sovereign debt. We like hard-currency EM debt, and favour U.S. Treasuries over other safe-haven bonds.
  3. We like income-paying real assets, such as property and infrastructure, but want to get compensated for being illiquid.
  4. Our contrarian idea: beaten-up natural resources equities as a hedge if U.S. dollar strength fades.

Worldwide: Recovery remains tepid

“Many pro-growth assumptions—rising wages and inflation expectations, a behind-the-curve Fed and an uptick in global growth—did not pan out in 2014,” says the report. “GDP forecasts have had one common thread lately: downward revisions.”

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On the other hand, the ongoing oil price decline, if sustained, could counterbalance the low-growth trend in 2015, giving a boost to growth in most economies. The price fall should dampen headline inflation in the developed world. This could strengthen calls for monetary stimulus in weak economies and help keep a lid on bond yields in stronger ones. Cheap oil could drive up consumer demand.

U.S. poised to accelerate

The U.S. economy is in a cyclical upswing, and is one of the world’s few major economies expected to perform well in 2015. A rising U.S. dollar will likely be the key financial market trend of 2015, bringing a de-facto tightening of global financial conditions because the greenback is still the world’s premier funding currency. European and emerging market companies with U.S. sales could benefit from a strong U.S. dollar.

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“Steady growth in employment, a moderate (yet patchy) housing recovery and rising capital spending (capex) all point to a sustainable recovery,” notes BII, adding it expects the Fed to start tightening monetary policy in 2015. “But only at a gentle pace, likely ending at a historically lower end point than in previous cycles.”

When it comes to the impact of higher rates on U.S. equities, the report notes there is likely to be a big difference between the performance of low-beta stocks (which historically do well when rates are falling) and high-beta stocks (which do best when rates rise, but only when the rise is mild).

Eurozone has rebound potential

The report notes the eurozone’s  growth could yet surprise on the upside, with expectations at rock-bottom and the European Central Bank likely to deliver on market hopes for full QE. This would not mirror the U.S. experience due to lower equity and home ownership rates in Europe, but QE could have a big impact on confidence.

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Even a moderate cyclical rebound would be a booster for European risk assets, BII says, and indeed the bar is low: Greece looks likely to be the fastest-growing eurozone economy in 2015, although it could also be a source of risk with an election likely in early 2015.

Invest in cyclicals such as European auto makers—many companies are trading near 2008/2009 lows—and contrarian investments in beaten-down luxury goods makers and integrated oil majors, advises BII.

Japan moves upward for equities

Japan is “all in” on a high-stakes bet that monetary stimulus will jumpstart the country’s economy, the report says, with the Bank of Japan’s balance sheet now swollen to almost 60% the size of Japan’s GDP.

The Bank of Japan is buying equities as well, a move that—especially when combined with a decision by Japan’s $1.2 trillion Government Pension Investment Fund (GPIF) to more than double its allocation to Japanese and foreign equities—should offer a big boost to equity markets.

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In 2015, “the path of least resistance is likely to be up for Japanese equities and down for the yen,” says BII. Other factors offering support for Japanese stocks include the cheapest valuations in the developed world, and dividends and stock buybacks at the highest level in six years, and poised to climb further.

Emerging markets

Satellites of the Eurozone and Asia will likely import dovish monetary policies from the European Central Bank and Bank of Japan, respectively, and will have room to cut rates to spur growth. Brazil and Russia might have to hike rates to defend their currencies. Others, including Mexico and China, stand to gain from U.S. economic momentum.

What these diverse countries have in common, the BII notes, is that traditional export models are challenged, with export growth essentially flat for the past three years. The reasons are weak global demand from the developed world, and a deceleration in the emerging world’s locomotive—China.

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Emerging market equity valuations are generally cheap, relative to both developed market stocks and their own history, but company selection will remain key, the report suggests.

Originally published on Advisor.ca

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