This Year’s Most Disappointing Asset Class

High Yield Bonds

2015 has been a year when few asset classes performed well and many did poorly. Commodities fell by almost 30% and emerging market stocks and bonds both suffered double-digit declines. But while the travails of these asset classes are nothing new—all three also lost ground in 2014—one asset class experienced a complete reversal of fortune. High yield bonds have lost more than 5% of their value this year, their first down year since the financial crisis in 2008. That arguably makes high yield bonds this year’s most disappointing asset class.

What’s caused high yield bonds so much pain recently? High yield’s strong performance over the previous 6 years is partly to blame. The strong performance for the asset class drove down the spread—the difference between the yield on high yield bonds and the yield on treasury bonds—to less than 3.5% by the middle of 2014. That’s far below the average spread of almost 6% during the past 15 years. The small spread meant there was less cushion if some companies that issue high yield bonds started to struggle, which is what happened when the prices of energy commodities collapsed.

The Federal Reserve’s decision to start raising interest rates also played a part. The low interest rates that have persisted since the financial crisis made it easier for companies to roll over their existing debt or raise more money to keep afloat. But as interest rates begin to rise, the number of companies that are forced to default on their debt could rise as well.

In recent weeks the collapse of some high yield bond funds added further fuel to the high yield fire.  The most prominent was the Third Avenue Focused Credit Fund, which had to shut down following losses and a subsequent wave of redemption requests from its clients. This turmoil spooked investors and forced the fund to sell its holdings, both of which further pushed down high yield bond prices.

Whether high yield bonds can rebound from their disappointing year will depend on a few factors. The Fed isn’t likely to raise interest rates very far or very fast, but continued economic growth could prompt a handful of small interest rate hikes in 2016. The result would likely be a higher default rate for high yield bonds, although this could be partly tempered by the stronger economy. And if commodity prices don’t bounce back, the energy portion of the high yield market will continue to be hit especially hard.

The good news for investors is that because of high yield’s struggles in the past year, the spread over the yield on treasury bonds is up to almost 7%. The higher spread suggests that a sizable increase in defaults is already incorporated in bond prices. If the rise in defaults turns out to be less severe than expected, high yield’s 2015 performance will look like an anomaly rather than the start of a trend.

Drilling Down for Bargains After Oil’s Decline

Oil Rig

Stocks have suffered lately, with year-to-date returns for U.S. equities once again negative. The most recent driver of the sell-off, and accompanying volatility, hasn’t been fears of a Federal Reserve (Fed) rate hike, but rather collapsing oil prices and the implications for energy-related debt.

Paying less at the pump might seem like a good thing for consumers, but the recent drop in crude prices has reinforced fears over slow economic growth and deflation, placing pressure on a range of asset classes related to energy.

According to Bloomberg data, amid concerns over energy issuers in the high yield market, high-yield spreads continued to widen last week. The fall in oil is also putting more pressure on already battered emerging market oil-exporting currencies, including those of Mexico, Russia and Columbia. Finally, and not surprisingly, any company in the energy space is feeling pressure. This includes not only oil production and service stocks, but also Master Limited Partnerships (MLPs).

However, while market sentiment has certainly turned more negative lately, many investors are wondering if it’s time to start bottom fishing, especially with regards to beaten-up energy assets.

Considerations for Energy Sector Stocks

My take: Though I would remain cautious toward the commodity and believe energy-related names are likely to come under more short-term pressure, I do see longer-term opportunities for those with little or no exposure to energy stocks.

The near-term risk for investors is that, regardless of the particulars of the business model, any stock even tangentially related to oil or energy is being thrashed. This is likely to continue to the extent oil prices have more downside. In fact, given the abundance of supply and bulging inventories, I’d be hesitant to call a bottom in oil prices.

While I believe that oil supply and demand will start to balance toward the middle of next year, absent a supply disruption from the Middle East or a much sharper deceleration in U.S. production, the simple truth is that there’s still too much oil supply relative to demand.

The outlook for Middle East supply remains undimmed, despite growing geopolitical risks. The Organization of the Petroleum Exporting Countries (OPEC) is unable to even set a production target, and Saudi Arabia and Iraq are producing record amounts of oil. Even a country like Libya, with no functioning national government, has dramatically increased production in recent months.

Making matters worse, non-OPEC oil production has remained resilient. In an attempt to generate much needed revenue, Russia is pumping a record amount of oil. In the U.S., while production has pulled back from the spring peak, production cuts have been modest thanks to improving efficiency. The number of U.S. rigs is down more than 60 percent from its 2014 peak, but U.S. domestic production is off by less than 5 percent, according to data accessible via Bloomberg.

Nor is a surge in demand likely to quickly rescue oil markets. For 2016, global demand growth is estimated to fall to 1.2 million barrels per day (bpd) from 1.8 million bpd this year, as data via Bloomberg show. It will take time to balance out oil markets, assuming we don’t see a more meaningful disruption in supply or a spike in demand, which is unlikely given the sluggish pace of global growth.

However, while an imminent V-shaped recovery in physical oil looks unlikely, some of the stocks in this sector may still represent a good long-term opportunity, especially considering that energy-sector valuations are now the cheapest we’ve seen in decades, according to data accessible via Bloomberg. There are two places in particular investors underweight the energy sector may want to start looking to add positions: U.S. drillers levered to low cost production sites and midstream MLPs.

1. U.S. DRILLERS LEVERED TO LOW COST PRODUCTION SITES

The cratering in oil prices is hurting any and all energy companies, but I believe those with lower production costs, such as Exploration & Production companies focused in the Permian Basin in west Texas, are better positioned to ride out a period of depressed oil prices.

2. MIDSTREAM MLPS

While MLPs aren’t immune to the energy market, as evidenced by the recent 75 percent dividend cut by Kinder Morgan, many MLP businesses are focused on natural gas storage and pipelines. These midstream businesses are less exposed to the daily fluctuation in oil prices.

The bottom line: While the energy sector comes with considerable near-term downside, the key for the long term is selectivity and a focus on those names best positioned to survive, or even thrive, in what may be a prolonged period of low energy prices.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

iS-17395

4 Simple Actions to Consider After Fed Liftoff

Eagle

We finally have liftoff. This week, after months of anticipation, the Federal Reserve (Fed) initiated its first rate hike in nearly a decade, raising the Fed Funds Rate by 25 basis points (bps).

Why not a bigger blast off? The Fed has made it clear that rate “normalization” will happen gradually, meaning rates will likely remain below historical averages for the foreseeable future. But while it may take years to get back to a 4 to 5 percent Fed Funds rate, higher rates are on their way.

The good news for investors is that just a few simple actions can help you prepare your bond and equity portfolios for this new rising rate environment. In the wake of the Fed’s decision, here are four such moves you may want to consider.

1. Consider Your Duration

While longer-duration bonds can provide portfolio diversification benefits, shortening the duration of your bond portfolio can potentially help manage losses due to rising interest rates.

Remember, duration is a measure of a bond’s sensitivity to interest rate changes. The longer the duration, the more a bond’s price is impacted. When interest rates change, a bond’s price will change in the opposite direction by a corresponding amount. For example, if a bond’s duration is 5 years and interest rates rise 1 percent, you can expect the bond’s price to fall by approximately 5 percent. Therefore, bonds with higher duration generally have greater price volatility and the potential for losses when rates rise.

2. Focus on Credit

Instead of owning only Treasuries, you may want to focus on adding credit exposure. Credit exposure adds credit risk (the risk that the issuer won’t pay you back) to a portfolio, but it mitigates some interest rate risk. In addition, investors are compensated for taking more credit risk with higher yields, so increasing exposure to higher quality credit risk may enhance income and offset potential price declines due to rising rates.

3. Shift to Cyclical Sectors

It’s important to remember that when rates rise, it’s not just bonds that are affected. Equities are affected too. Higher rates mean that borrowing money becomes more expensive, so it’s harder for businesses and consumers to finance everyday needs. As such, traditionally defensive sectors, like utilities and telecommunications, typically become increasingly vulnerable in a rising rate environment due to their existing large debt positions. At the same time, higher rates generally are a sign of an improving economy, boosting the case for adding exposure to cyclical sectors, which have tended to outperform when the economy is strong.

I prefer to get cyclical exposure through two sectors: U.S. technology and U.S. financials (excluding rate-sensitive REITs). With their large cash reserves, U.S. mature tech companies are much less vulnerable to rising rates than companies in more debt-laden sectors mentioned above. In addition, tech sector revenues may increase if economic growth continues to expand and consumers and businesses spend more. Meanwhile, for some financial institutions, like banks, rising rates could mean higher profits, as net interest margins may increase.

4. Seek New Sources of Income

You may also want to take a look at your dividend strategies when interest rates rise. Although traditional high dividend payers (think the utilities and telecom sectors) have performed strongly in recent years, they’ve become quite expensive by most valuation metrics. And the previously low interest rate environment paved the way for many of these defensive businesses to load up on debt to expand their operations, while continuing to pay high dividends to investors. As such, many of these companies will likely come under pressure when rates rise.

In contrast, dividend growth stocks have historically demonstrated less interest rate sensitivity and may be an attractive way to maintain yield in a rising rate environment. In contrast to high dividend payers, they tend to be more reasonably valued and have more potential to sustainably grow dividends over time.

So, although rates are expected to moderately increase, you can prepare your portfolio now for a rising rate environment by considering simple actions such as these. These simple steps may help to insulate your investments while also capturing new opportunities. Learn more about these four strategies for rising rates, and the exchange traded funds (ETFs) that can help you put them into action, at iShares.com/iThinking.

Funds, such as the iShares Floating Rate Bond ETF (FLOT), the iShares Short Maturity Bond ETF (NEAR) and the iShares 1-3 Year Credit Bond ETF (CSJ), can provide credit exposure with short duration. Meanwhile, the iShares U.S. Technology ETF (IYW), the iShares U.S. Financial Services ETF (IYG) and the iShares Core Dividend Growth ETF (DGRO), can provide exposure to the U.S. technology sector, the U.S. financials ex-REITs sector and dividend growers, respectively.

Heidi Richardson is a Global Investment Strategist at BlackRock. She is also Head of Investment Strategy for U.S. iShares.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.

NEAR is an actively managed fund and does not seek to replicate the performance of a specified index. Actively managed funds may have higher portfolio turnover than index funds.

Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market. Technology companies may be subject to severe competition and product obsolescence.

There is no guarantee that any fund will pay dividends.

This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

This document contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

iS-17397

The Consumer Discretionary Sector’s Recent Success

Consumer Discretionary

While the US stock market overall is back where it started the year, the consumer discretionary sector has gained about 10%. That makes this sector, comprised of companies that sell “non-essential” products to consumers (and therefore includes retailers, carmakers, and media companies, among others), the top-performing stock market sector so far in 2015. Will consumer discretionary stocks be able to build on their gains and continue outperforming the rest of the stock market? Answering that question requires understanding what’s driven the sector’s recent success.

Much of the sector’s gains are likely the result of the fairly strong economic environment. The Bureau of Labor Statistics estimates that the US economy added 211,000 jobs in November, the 62nd straight month of job growth. The unemployment rate has fallen to 5%, half the peak level it reached in late 2009 in the aftermath of the global financial crisis.

At the same time, declining commodity prices have helped keep the inflation rate subdued. The oil price in particular has declined dramatically since the middle of 2014, with the price of crude oil recently nearing an 11-year low. The combination of a strengthening jobs market and low commodity prices has helped put more money in consumers’ wallets and provided a boost to companies in the consumer discretionary sector.

Beyond broad economic factors, a sizable amount of the sector’s success this year can be traced to one company: Amazon. The online retailer is now the largest company in the sector (it accounts for more than 10% of the SPDR Consumer Discretionary ETF) and its stock has gained more than 110% this year. Though some of Amazon’s success has come at the expense of other retail companies, it’s likely that without Amazon’s surge the consumer discretionary sector’s 2015 performance would have been much closer to that of the overall stock market.

So how long will the dual trends of a growing economy and Amazon’s soaring stock price last? The jobs market could weaken slightly as the Federal Reserve starts raising interest rates, but as we’ve noted in the past the Fed is unlikely to raise rates very far or very fast. And amid a supply glut commodity prices don’t seem likely to rebound strongly in the near future, providing continued support for consumer spending. In other words, the economic environment could remain favorable for consumer stocks for a while.

Amazon’s stock, however, isn’t likely to continue giving the overall consumer discretionary sector a massive tailwind. The company has a 5-year average price-to-earnings ratio (a comparison of the company’s market value to its profits) of almost 175, a large number for any company but an astronomical one for a company with a market value of over $300 billion. Amazon will have to continue to grow extremely rapidly simply to justify its current stock price, so a repeat of its 2015 performance seems unlikely.

Are You Really Ready to Retire?

Baseball

For most of us, retirement is meant to be the ultimate reward — the sweet icing on the cake of life.

And if you’re within sniffing distance, let’s say 10 years, of what you hope will be a decadent respite, you know the excitement can be mixed with anxiety: Will my savings last throughout my retired years?

To help tip that emotional scale in favor of excitement, there are a few things you can do right now to ease your mind.

1. Envision Where You Want to Be

In order to prepare realistically for retirement, you’ll need to have a sense of how much it will cost you. And that will mean putting a price tag on your goals. We developed a retirement expense worksheet to help you inventory and itemize your likely expenses.

In addition to the necessities, leave yourself room to dream a little. Perhaps you want to see the world? Put it on the list. Even better, use our Define Your Retirement tool to visualize your retirement in just 15 minutes. It asks you to rank activities, identify your preferred living arrangements and provide information related to retirement age, needs and risk factors. With one click, you can send the results to your financial advisor, which can plant the seeds for a lively and realistic conversation about your expectations and retirement readiness.

2. Take Stock of Where You Are

Once you have a vision of what your retirement might look like, see how your current savings measure up to your dreams and ambitions.

By itself, the size of your nest egg says little about your preparedness for retirement. More telling is how much that current savings could provide in annual income in retirement. BlackRock’s CoRI tool can help you assess just that in two easy steps: Input your age (it starts at age 55) and then your total accumulated savings. CoRI will tell you how much that sum could provide for you each year in retirement (assuming retirement at age 65).

It also works in reverse: Input how much money you’d like to have each year in retirement, and CoRI will tell you how much you need to set aside to achieve it. This is often the “a-ha” moment for many savers.

3. Mind, and Close, the Gap

Perhaps you haven’t stashed enough money to fund your retirement vision just yet. Believe me, you’re not alone. The 2015 edition of BlackRock’s Investor Pulse Survey found that people nearing retirement (ages 55-64) have saved an average of $136,200. And while they claim to need $45,500 annually to meet their retirement expectations, that average savings figure of $136,200 would yield them just $9,150 annually. That’s a gap of over $36,000 each year of retirement.*

Of course, most Americans will receive a Social Security check as well. That certainly helps, but does not solve the problem. For an individual, the average annual Social Security payments amount to $16,000, which still leaves an income gap of $20,000 per year in retirement. For a dual-earner household, Social Security payments are providing an average of roughly $25,000 per year — leaving a retirement income gap in the area of $11,000 annually.

Whether your situation is more or (hopefully) less severe, there are essentially three broad options for closing the gap: save more, work longer and/or invest differently. In the past, knowing which lever to pull and with what impact was more or less guesswork. Today, working with an experienced financial advisor and the appropriate tools, you can home in on a much more precise plan of action.

We learned in our survey that most Americans (69%) value professional financial advice, even if they don’t always seek it. In fact, just 28% report using a financial advisor right now. It’s an interesting disconnect. I think that’s one more gap worth closing, particularly when it comes to the important task of planning for your hard-earned “just desserts.”

Rob Kron, Managing Director, is the head of Investment and Retirement Education for BlackRock’s U.S. Wealth Advisory group. He provides practical information on topics that are important to every saver and investor of every age.

* Retirement savings and desired income come from Global Investor Pulse Survey (July/August 2015) in median dollars for Americans ages 55-64. Estimated annual retirement income is based on the CoRI 2015 Retirement Index for a pre-retired 55-year-old. CoRI estimates are as of Sept. 21, 2015, and are subject to change over time. Retirement is assumed to begin at age 65. Expected income does not include other sources of income, such as Social Security.

 

This material is provided for educational purposes only and does not constitute investment advice. The information contained herein is based on current tax laws, which may change in the future. BlackRock cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in these materials does not constitute any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice. lackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2015 BlackRock, Inc. All rights reserved. BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

USR-7903

Political Risk Goes Global

Flag Globe

Political risk—the idea that political changes can affect the value of investments—used to be a concern primarily related to emerging markets. There are still plenty of political risks emanating from emerging markets, such as Russia’s military adventurism and China’s territorial disputes in the South China Sea. But in recent years developed markets haven’t been spared as political risk has reared its head around the globe.

The latest example of political risk in developed markets comes from the first round of France’s regional elections earlier this week, in which the far-right National Front party garnered the most votes. The National Front’s success is part of a broader trend in Europe where more extreme political parties have gained popularity in countries ranging from the United Kingdom and Denmark to Austria and Hungary. The continent’s refugee crisis and recent terrorist attacks could further increase support for more extreme parties.

There are other possible political changes that could dramatically affect the value of investments as well. In the UK the government has pledged to hold a national referendum on whether the country should remain in the European Union. The US presidential election next year could alter America’s economic and regulatory policies. And any agreements that result from the ongoing UN climate change conference in Paris have the potential upend the energy sector.

Political risk has already left its mark on investments around the world this year. Greece, which was nearly forced to leave the euro zone after the newly-elected Syriza party initially couldn’t agree to a bailout deal with the country’s European creditors, has one of the world’s worst-performing stock markets so far in 2015. Turkey and Egypt, which have become enmeshed in the Middle East’s geopolitical woes, are also among the world’s worst-performing markets.

Yet simply abandoning international investments to try to avoid political risk is a mistake. The stock market in France, despite multiple large-scale terrorist attacks and the surging popularity of the National Front party, has slightly outperformed the US this year. And given how political risk has flared in Europe, it’s possible that the next market-rattling political risk could be in United States. As political risk goes global, having a portfolio that’s well-diversified internationally is a good way to mitigate the impact.

Time to Favor TIPS?

Bicycle

Over the past several years, investor perceptions of the U.S. economy have changed dramatically. Following several years of consistently disappointing economic growth, few now expect a return to the post-World War II growth norm.

Amid the sluggish economic recovery, investor expectations for future inflation have also moderated, but perhaps by too much. Indeed, current expectations for future inflation may be too complacent, creating a potential opportunity in long-dated Treasury Inflation-Protected Securities (TIPS).

Shifting the Focus to TIPS

Three years ago, according to data accessible via Bloomberg, investors were expecting inflation of roughly 2.5 percent over the course of the next decade. Even as recently as last summer, expectations for long-term inflation were around 2.25 percent. However, since the summer, inflation expectations have collapsed. As of December 1, 10-year TIPS breakevens, a measure of investor expectations for future inflation, were below 1.6 percent. While this is nominally above the multi-year low reached in late September, it’s well below the long-term 10-year breakeven average of around 2 percent.

The collapse in investor inflation expectations coincides with a similar recalibration among consumers. In addition to measuring consumer confidence, the University of Michigan publishes several surveys measuring consumer expectations for inflation. The most recent survey suggests that 1-year inflation expectations are at 2.7 percent, down from 3 percent in March. The longer-term 5-year survey has inflation expectations at 2.6 percent, just above a multi-year low.

Why have both investors and consumers lowered their expectations for inflation so dramatically? While the sluggish recovery has certainly contributed, there’s some evidence that the precipitous drop in oil has played an outsized factor. Since peaking last summer, U.S. crude benchmark WTI has fallen by approximately 55 percent, according to Bloomberg.

As consumers and investors are constantly exposed to the price of a gallon of gasoline, itself a function of crude prices, the drop in oil may have disproportionately impacted perceptions of inflation. There’s some empirical evidence to support this. Since the third quarter of 2015, the drop in oil prices explains roughly 80 percent of the variation in 10-year inflation expectations, according to a BlackRock analysis using Bloomberg data.

Should oil prices continue to collapse, inflation may remain at today’s low levels or sink even further. However, there are a number of signs that that the recent drop in inflation expectations may be overdone.

Inflation Expectations Underrated?

First, U.S. inflation stripped of food and energy prices, which are inherently volatile, has been much more stable than the headline number. The core consumer price index (CPI), which excludes both food and energy prices, is currently running at 1.9 percent year over year, the highest level since June of 2014, according to data via Bloomberg.

Looking at this from an economic perspective also seems to indicate that today’s inflation expectations may be unrealistically low. My preferred leading economic indicator—the Chicago Fed National Activity Index (CFNAI)—suggests that current estimates for U.S. inflation appear roughly 40 basis points too low.

While I don’t envision a significant surge in inflation anytime soon, I do expect to see some stabilization in inflation and inflation expectations given factors including declining slack in the labor market. In addition, U.S. inflation should firm as the one-off impact of a stronger dollar and lower energy prices start to fade from CPI calculations.

In the meantime, today’s TIPS prices tell me that investors’ inflation expectations may be too sanguine. As such, in bond portfolios, I prefer TIPS to plain-vanilla Treasuries. An allocation to TIPS could help hedge the risk that inflation may be on the rise.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

iS-17266

Can Small Caps Rebound?

Basketball

If there was one strong consensus view coming into 2015, it was that the dollar would rise. In this instance, the collective wisdom was correct. The U.S. Dollar Index (DXY) is up roughly 10 percent year-to-date, according to Bloomberg data.

However, while the consensus was right on the direction of the dollar, it was wrong on at least one implication of a stronger greenback: small-cap outperformance.

The Large-Cap/Small Cap Dynamic

Many investors assumed that a strong dollar would provide more of headwind for large-cap companies, allowing small caps to outperform this year. But while large-cap earnings have been dented by the dollar’s strength, Bloomberg data show that the large-cap S&P 500 Index was outperforming the small-cap Russell 2000 by more than 300 basis points (bps) through late November.

What went wrong, and how should investors think about the small-cap tilt in 2016?

In terms of what went wrong, it was the value side of the equation. Since the start of the year, the trailing earnings multiple on the S&P 500 has nudged higher, advancing approximately 2.5 percent. In contrast, the price-to-earnings (P/E) on the Russell 2000 has contracted by around 2 percent.

The relative performance of small and large caps against financial market conditions helps to explain these shifting valuations.

While a stronger dollar provides less of a headwind for small-cap companies, the dollar has been strengthening in the context of pending Federal Reserve (Fed) tightening and less benign credit markets. The latter point is particularly important for small caps, which perform best when credit conditions are easing.

There are several interpretations for this phenomenon. Small-cap firms are more of a credit risk, so the availability and ease of financing is more critical for these companies. Another mechanism is market sentiment. Small caps are generally considered more speculative. In an environment in which credit conditions are easing, volatility is typically lower and investors are more willing to embrace risk.

History supports this thesis, according to an analysis using data accessible via Bloomberg. Looking back over the past fifteen years, in months when high yield credit spreads were widening, indicating tighter financial conditions and more risk aversion, the S&P 500 outperformed the Russell 2000 by an average of roughly 0.45 percent.

However, when financial conditions were easing, indicated by tighter credit spreads, the Russell 2000 outperformed by roughly 1 percent a month. This dynamic was supportive of small-cap performance for most of the period from the spring of 2012 through early 2014. Then, as credit conditions started to turn last spring, the environment became less favorable for small caps. Since last July, small caps have underperformed large caps by around 50 bps a month, Bloomberg data show.

The key lesson is to watch not only earnings, but also what investors are willing to pay for those earnings. While I don’t expect a significant deterioration in credit markets next year, conditions are turning less favorable: corporate leverage is higher, default rates are rising and with oil hovering near $40, energy issuers are at risk. If spreads do continue to widen in 2016, there’s a case for again tilting toward the safety of larger firms.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

iS-17234