Investors are flocking to 'quality' in the stock market as the economic cycle nears peak growth, BlackRock says

• Investors are pouring money into profitable companies with strong balance sheets and low debt, says BlackRock.
• Quality stocks will benefit investors as the US economy heads toward the peak of economic growth this year, the firm says.
• Quality ETFs have taken in more than $3 billion after outflows of $2.4 billion in Q1.

Investors are increasingly putting more money into so-called quality stocks as they prepare to meet what's likely to be the height of economic growth this year, according to BlackRock.

So far in the third quarter, $2 billion has poured into quality exchange-traded funds after they absorbed $1.3 billion in the second quarter, the firm said in a note Tuesday. Those mark reversals from outflows of $2.4 billion in the first quarter, which was the first quarter of net outflows for quality since 2015.

BlackRock defines quality stocks as those of companies with strong balance sheets, profitable earnings, and low debt. That group was shunned by investors earlier in 2021 as they chased inexpensive value shares and cyclical stocks that are closely linked with prospects of economic growth, with the economy in recovery mode from the devastating COVID-19 pandemic.

"While investments that benefit from broad-based growth, such as cyclical and value sectors, still have room to run, we think it is time to add quality stocks to the portfolio - or those companies that will benefit once peak growth has passed," said Gargi Chaudhuri, head of iShares investment strategy for the Americas, at BlackRock.

Chaudhuri said Bloomberg consensus estimates point to a peak in the third quarter of 7.1% in US economic growth adjusted for inflation. The economy expanded by 6.5% in the second quarter, much slower than expectations of 8.4% in a Bloomberg survey of economists. The consensus estimates call for growth of 5% in the fourth quarter and 3.5% in the first quarter of 2022.

Meanwhile, other economic indicators are signaling a peak, she said. Business activity as tracked by IHS Markit's US Composite PMI came in at 59.7 in July following readings above 60 in the prior three months. US core durable goods orders rose by 0.3% month over month in June, less than rates logged in March through May.

"The robust restart will continue to support cyclical, value-oriented companies, but financial markets are anticipatory, and we think that some of the early-cycle investment opportunities may have already played out, especially in the US," said Chaudhuri.

Value ETFs have logged "modest" outflows of $700 million in the third quarter after inflows during the first and second quarters of $5 billion and $4.1 billion, respectively.

BlackRock said it favors a "barbell" approach to equities by pairing value with quality for investors to have exposure to companies that should be set to perform in a mid-cycle environment. The firm recommended taking that approach through the iShares MSCI Intl Value Factor ETF and the iShares MSCI USA Quality Factor ETF. BlackRock runs iShares ETFs.

The Value Factor ETF aims to track international, developed large- and mid-cap stocks with value characteristics and relatively lower valuations. The USA Quality Factor ETF tracks US large- and mid-cap stocks that are identified through three fundamental variables: return on equity, earnings variability and debt-to-equity.

BlackRock said it's also seen a quality bias emerge within fixed-income ETFs, with flows into US government bonds hitting $5.2 billion in the second quarter after first-quarter outflows of $1.2 billion.