Stocks climb again despite mixed economic picture
Stocks rose for the second consecutive week. In the U.S., the Dow Jones Industrial Average climbed 1.51% to end the week at 16,639, while the S&P 500 Index was up 1.62% to 1,948 and the Nasdaq Composite Index advanced 1.90% to 4,590. Volatility subsided, with a key measure of equity volatility, the VIX Index, closing below 20 for the first time since early January. Meanwhile, riskier bonds like high yield and investment-grade corporates, rose and their spreads — the difference between their yields and that of a comparable-maturity Treasury — tightened slightly. The yield on the benchmark 10-year U.S. Treasury inched up from 1.74% to 1.76% as its price slipped.
Despite an overall positive week for the markets, investors are still contending with a very mixed economic picture. Slow global growth and the accompanying monetary response are keeping interest rates near historic lows. This suggests that finding income will remain a challenge and that investors will still want to focus on areas of the market that offer attractive yields. Along those lines, we continue to like preferred stocks and municipal bonds, but we also see some opportunity in U.S. investment-grade bonds.
A tale of two narratives
Investors may be enjoying a bit of a respite from recent market weakness, but they should be under no illusion: Challenges remain. The economic signals are mixed at best and continue to confirm both the optimists' and pessimists' narratives.
The "glass is half full" camp can point to some encouraging developments from last week. Our preferred leading indicator, the Chicago Fed National Activity Index, ticked higher in January, and current readings are consistent with U.S. economic growth of 2%, or slightly above, over the next few quarters. In addition, there is some evidence that the contraction in manufacturing is starting to abate. Durable goods orders were particularly strong last month. And outside the U.S., European bank lending continues to make progress.
At the same time, the "glass is half empty" crowd can offer evidence that shows growth continues to struggle. Consumer and small business confidence is falling and the February Markit U.S. Services Purchasing Managers Index fell into contraction territory.
Meanwhile, geopolitics is once again adding to the list of things to worry about. A U.K. referendum on European Union (EU) membership is now scheduled for June 23. That announcement, along with news that London Mayor Boris Johnson will support the "leave" campaign, pushed the British pound down to its lowest level versus the dollar since 2009. And as we get into the heart of the U.S. primary season, investors will increasingly be contemplating the economic and financial implications of an unusual, to say the least, U.S. election.
Investors also remain fixated on oil. Crude oil prices managed to rebound last week, but little has changed in terms of the fundamental issue of excess supply. Iran threw cold water on the recent Saudi/Russian agreement to limit production. Although oil prices have risen 25% from their February low, they remain 70% below their 2014 peak, and the collapse in crude is having an impact on oil producers and on lenders. Last week, Moody's downgraded Brazilian debt to junk status and JPMorgan announced it would add $500 million to reserves against its energy portfolio.
Given the murky picture, it should come as no surprise that investor behavior remains somewhat contradictory. Last week witnessed both safe-haven buying — flows into gold and Treasuries — and outflows from U.S. large-cap stocks. At the same time, high yield flows spiked, with $1.2 billion invested in the asset class
Low for really long
Although risky assets have stabilized in recent weeks, bond yields remain near record lows . This is partly due to inexplicably low inflation expectations, with 10-year expectations down 20 basis points (bps) (0.20%) this year, although they have bounced from their February lows. At the same time, real (that is, inflation-adjusted) interest rates are down by half since mid-January. This is not just a U.S. phenomenon; German 10-year yields are down 45 bps, while Japanese 10-year yields have plunged into negative territory.
This is an important development. Even if we see an improvement in the U.S. inflation and growth outlook, we function in a global bond market. As such, ultra-low international bond yields will dampen any rebound in U.S. interest rates. This, in turn, suggests that the quest for reliable, less volatile sources of yield will continue.
For investors in search of yield, we continue to favor U.S. preferred stocks, which have outperformed U.S. large caps by roughly 500 bps year-to-date. We also see opportunities in U.S. investment-grade bonds. While this asset class has not been immune from the year’s selling, returns have remained positive and volatility has been a fraction of what we’ve seen in high yield. Finally, we maintain our preference for municipal bonds. This asset class has proved resilient despite the headlines surrounding Puerto Rico.
Russ Koesterich managing director and BlackRock’s global chief investment strategist, as well as global chief investment strategist for BlackRock’s iShares business.
Finding Yield: Difficult, But Not Impossible
February 29, 2016
Stocks climb again despite mixed economic picture