Keep Calm and Add More Carry

Rake

Twenty years ago investing was much easier. Between 1995 and 1999 the S&P 500 staged a remarkable streak of five straight years in which total return exceeded 20 percent. But that period was followed by a prolonged period of subpar returns.

Is history repeating itself? Few would confuse the last seven years with the late 1990s, but equities, particularly U.S. stocks, have once again been producing outsized returns. Even including 2015’s flat performance, between 2009 and 2015 the average price return on the S&P 500 was nearly 13 percent. This is unlikely to hold over the next seven years.

But if price appreciation becomes harder to come by, investors need to consider the role of positive cash flow, whether through dividends, or yields. This is referred to as “carry” by financial professionals. Three trends support the case for a greater focus on carry in a portfolio:

Lower equity returns

The BlackRock Investment Institute forecasts just 4.3 percent annual returns for domestic large-cap stocks over the next five years, mostly due to elevated valuations. Today the S&P 500 trades at roughly 19 times trailing earnings. Small cap valuations are even more elevated, with the Russell 2000 trading at over 35 times trailing earnings. In our opinion, this bodes poorly for future long-term returns. Other markets, notably emerging markets (EMs), are likely to perform better thanks to much lower valuations. However, EMs come with considerably more risk, a problem for more conservative investors.

Higher risk

While volatility has been on the rise since last August, much of the past five years has been characterized by unusually low volatility. Today the VIX Index is around 15, roughly 25 percent below the long-term average. Looking at the futures curve for the index, investors expect volatility to rise back to around 20 by the fall. Even this may understate the potential rise in volatility. Volatility normally moves in tandem with credit markets. While financial market conditions have become easier, evidenced by tighter spreads, they are still considerably tighter than was the case two years ago. This suggests that volatility should rise back into the low to mid-20s.

Wider spreads

Yields on U.S. Treasuries continue to defy expectations, remaining near multi-decade lows. However, the spread on corporate bonds, i.e. the incremental return over Treasuries, has widened in recent years. For example, while high yield spreads are considerably lower than they were at the January market bottom, they are approximately 200 basis points (2 percent) wider than they were two years ago, as Bloomberg data shows. Although corporate defaults are also on the rise, investors are being compensated for taking incremental risk in credit markets.

Where does this leave investors?

To the extent investors are trying to maximize risk-adjusted returns, in our view, parts of the credit market look attractive, at least relative to U.S. stocks. Based on BlackRock’s long-term assumptions, some of the better return-to-risk ratios are in high yield bonds, EM dollar-denominated debt and bank loans. International stocks also look attractive relative to domestic ones thanks to lower valuations and generally higher dividend yields. Another potential asset class that scores well on expected yield relative to expected risk: preferred stocks. According to Bloomberg data, a broad basket of preferred stock currently yields around 5 percent with modest single digit volatility.

Based on our research, none of these asset classes are likely to produce the same type of double-digit returns that investors have enjoyed in recent years. But adding carry can help boost returns—or cushion a portfolio—at a time when returns will be harder to come by. This is probably not the right point in the cycle to try to replicate the halcyon days of the late 1990s.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

 

Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Investing involves risks, including possible loss of principal. International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets. 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.

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 May 2016 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.

©2016 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.

The Recent Struggles of India’s Stock Market

India Performance

Optimistic investors had hoped that Narendra Modi, who became India’s Prime Minister with his party’s election victory in May 2014, would jump-start India’s stock market. From early 2014, when Modi’s Bharatiya Janata Party became the overwhelming favorite to win the election, India’s stock market gained almost 40% during the subsequent year. Over the past 12 months, however, Indian stocks have drifted back down, losing almost 15% of their value. Does Modi still have a shot at reviving India’s stock market?

Part of Modi’s problem may simply have been overly optimistic expectations. Political power in India is split between the federal government and the states, and even at the federal level Modi’s coalition doesn’t have a majority of the upper house of India’s Parliament. A prime example of Modi’s struggles is the Goods and Services Tax Bill, an attempt to streamline India’s complicated web of overlapping federal and state taxes. The bill may still be enacted, but the reform process has been far slower and more painful than Modi’s government had hoped.

Despite these setbacks, Modi has had some success in improving India’s economy. According to the Financial Times, India overtook China in 2015 to become the top destination for foreign direct investment. And according to the International Monetary Fund, India’s economy grew by a robust 7.3% last year, its fastest growth rate since 2010. The stronger economy is part of the reason why Indian stocks, though down over the past year, have substantially outperformed emerging markets as a whole.

Yet the issue that may have the biggest effect on India’s stock market may not be related to Modi or even India’s economy. In recent years, emerging markets have been battered as the US Federal Reserve has begun reversing course after seven years of keeping interest rates at near-zero levels to try to boost the American economy. The possibility of higher US interest rates has caused investors to pull money out of emerging markets. After the Fed’s initial move to raise rates last December, futures prices suggest that traders are currently expecting the Fed to additionally raise rates once or twice this year. If a strengthening US economy causes the Fed to act more aggressively than that, the effects of those moves on India’s stock market could swamp any success that Modi has with his economic reforms.

A Chart Showing Why Deflation Is Dead

Soccer ball

U.S. deflation is no longer an imminent risk. This week’s chart helps illustrate why.

U.S. inflation has been picking up, following a prolonged period of subdued price rises, as evident in the chart above. The U.S. Consumer Price Index (CPI) in April posted its largest increase since February 2013. The inflation upturn is even more pronounced in forward-looking prices-paid surveys, such as the Institute for Supply Management’s Price Index, our analysis suggests. A greater number of purchasing manager survey respondents reported paying more for products and services in March and April, as the chart above shows.

Inflation

We see the inflation upturn continuing over the near term. Energy supply-demand fundamentals are turning from a headwind into a tailwind for inflation. Oil supply has tightened, and demand is picking up, primarily out of China and India. This suggests current prices look increasingly sustainable, unless we get a significant reopening of idled shale-oil production. It points to energy’s downward pressures on inflation beginning to subside, in line with the view expressed in hawkish Federal Reserve (Fed) meeting minutes released last week.

Our analysis suggests rising U.S. inflation pressures will persist, as factory-gate price increases are passed on to consumers. It is not just the rebound in energy prices pushing inflation higher. An appreciating U.S. dollar is abating as a headwind. Prices of more stable service-based components of the CPI are also rising. Wages, too, are moderately increasing, as are survey-based consumer inflation expectations.

Bottom line: The odds of the Fed increasing rates this summer have increased, although we see only one to two rate increases this year amid slow U.S. growth. We are cautious on duration, but rising inflation means owning Treasury Inflation Protected Securities (TIPS) in lieu of nominal Treasuries can be an important hedge for fixed income portfolios. Read more market insights in my weekly commentary.

Richard Turnill is BlackRock’s global chief investment strategist. 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 May 2016 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.

©2016 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 the Eurozone Recovery for Real?

Spool

The eurozone has been caught in crosscurrents over the past few months. The European Central Bank (ECB) in March doubled-down on its efforts to stimulate inflation by taking its deposit rate deeper in negative territory and expanding its asset purchases program. Since then, a slew of positive economic activity data from across the region appeared to signal the stimulus was working.

Among the positives: Many leading economic indicators point to stronger household consumption, according to data accessible via Bloomberg. Also, private credit is expanding after years of contraction, albeit at a modest pace. Small business borrowing costs have come down even further this year, as the chart shows.

Yet credit is not always easy to come by for those businesses that need it. Plus, data on inflation and corporate earnings have disappointed. Market concerns have been growing about the stability of Italy’s fragile banking system. And investor sentiment toward Europe has soured, as reflected in hefty flows out of equity exchange traded products focused on the region, according to Bloomberg data.

Small Business Borrowing Costs

Is the eurozone’s consumption-led growth uptick sustainable? The BlackRock Investment Institute took some of the firm’s most senior portfolio managers to Frankfurt, Berlin and Milan earlier this month to understand what’s taking place on the ground, and whether the recovery is for real. Here are the key takeaways.

– The recent pickup in economic activity likely has legs, but progress on structural reforms and a rebound in investment are needed to make the recovery sustainable beyond the next 12-18 months.

– Growth in Germany’s “golden decade” looks to be plateauing. The economy is doing fine, but signs of complacency are starting to seep in, with backtracking on some economic reforms. Banks are facing profitability challenges from increased regulation to negative interest rates.

– The periphery and the core in Europe are finally starting to converge. Italy is a bright spot. Reforms to jumpstart the economy, such as a more flexible labor market, are showing early results. An October referendum on the government’s reform agenda will be critical.

– Small business loan rates have come down, and private credit is growing again. This is a key development and makes the state of the banking sector critical to the outlook. Banks are facing profitability challenges from increased regulation and negative interest rates.

– Italy’s banks look vulnerable due to a mountain of crisis-era bad debts. A new bailout fund and rules that aim to strengthen creditors may help nurse the sector back to health, but we expect slow progress. This leaves the financial system and economy vulnerable.

– Key risks to the outlook include a possible Brexit vote and a renewed refugee influx that poses integration challenges with no discernible economic benefits in the short run.

Jean Boivin, PhD, is head of economic and markets research at the BlackRock Investment Institute. He is a regular contributor to The Blog.

Isabelle Mateos y Lago contributed to this insight. She is a global macro investment strategist for the BlackRock Investment Institute.

 

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 May 2016 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.

©2016 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.

Are These the Golden Days for Gold?

Gold Coins

As my colleague Jean Boivin recently wrote, central banks are pushing the outer limits of monetary policy. This has had many odd side effects, not the least of which is a significant portion of sovereign debt today is trading at a negative yield. If you buy government bonds from Japan today, you’d have to pay interest. Welcome to a world in which investors pay for the privilege of lending money.

Although central banks have been the primary architect of this surreal state of affairs, even if they decide to reverse course, real borrowing costs are likely to remain low relative to the historic norm. Factors such as demographics and tepid economic growth are contributing to the unusually low level of real interest rates (i.e. after inflation).

All told, this is a serious problem for yield starved investors. Ironically, one potential remedy is to take a second look at an asset class that provides no income: gold.

Even more than other asset classes, making predictions about gold is a dubious exercise. For starters, investors can barely agree on what gold is: commodity, currency or “barbaric relic.” Even investors like myself, who see a legitimate role for gold in a portfolio, need to admit that gold is extremely difficult to value. There is no cash flow to discount and, unlike oil or even other precious metals like silver or platinum, gold has few industrial uses.

Is now the perfect time and place for gold?

That said, some environments have been more kind to gold than others. As gold pays no interest or dividend, the opportunity cost of holding the precious metal is a critical driver of returns. During periods of low or negative real rates, when the opportunity cost is low, gold has generally performed better than in periods when real rates are higher. My colleague Heidi Richardson also mentioned this in a recent post. According to Bloomberg data, since 1971, the level of real U.S. 10-year yields has explained roughly 35 percent of the annual change in the price of gold. In those years in which real rates were above average (roughly 2.50 percent), gold rose by an average of 0.50 percent. However, in those years when rates were below the historical average, gold rose by an average of 21 percent.

While real rates have historically had the most significant impact on gold’s performance, inflation, more particularly the direction of inflation, has mattered as well. The best years for gold were those in which real rates were low and inflation was rising. Since 1971 there have been 12 years that fit that description, as Bloomberg data shows. Gold rose in 11 of those 12 years with an average return of over 35 percent.

Given slow growth, a cautious Federal Reserve and the proliferation of negative sovereign yields in Japan and Europe, U.S. real rates are likely to remain low for the foreseeable future. At the same time, both core inflation and wages have been firming while the inflation drag from last year’s strong dollar and collapse in oil is beginning to fade. This is exactly the type of environment that has historically been most favorable to gold.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Investments in natural resources can be significantly affected by events in the commodities markets.

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 May 2016 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.

©2016 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.

USR-9303

The Good (And Bad) News About One Fixed Income Sector

Fortune Cookie

The recent rebound in commodity prices has been good news for high yield bonds, helping the sector (and credit overall) rally since mid-February.

Now the bad news: A slower pace of appreciation is likely from here. Future high yield bond returns will likely be more muted—and depend more on improving fundamentals than commodity prices. This is evident in this week’s chart.

The chart shows how sharply rising commodity prices since February have translated into steeply falling high yield commodity sector spreads. The energy and materials sectors have disproportionately contributed to U.S. high yield performance overall. These sectors account for nearly half of high yield’s total return since the mid-February lows, though they represent less than 20 percent of the market, our analysis shows.

High Yield Spreads

There are some signs that this trend may not last. The People’s Bank of China (PBoC) helped spark the rally in commodity prices earlier this year. PBoC intervention halted fears of a destabilizing Chinese currency devaluation, and sparked hopes of a credit-fueled manufacturing and construction rebound. Recovering housing starts already point to a Chinese real estate recovery. A weaker U.S. dollar also helped commodity prices.

But price increases in some commodities have outpaced fundamental improvements in the supply-demand balance, according to our analysis. Sentiment has rebounded from extreme pessimism—and short positions look less crowded, our research shows. Speculation on Chinese commodity futures exchanges contributed to recent gains—but trading volumes have peaked since authorities raised collateral requirements.

We need to see improved supply-demand fundamentals for a sustained broad commodity rally, and the evidence of that so far is mixed. This means that high yield returns going forward will depend less on the commodities sector and more on evidence of broadening economic growth. A low growth outlook and the recent narrowing of spreads imply that we are likely to see more muted returns going forward. Read more market insights in my weekly commentary.

Richard Turnill is BlackRock’s global chief investment strategist. 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 May 2016 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.

©2016 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.

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Don’t Think About Your 401(k) in Isolation

Retirement Account

401(k) accounts can seem a bit strange. Unlike most other financial accounts where you can invest your money, your 401(k) account is tied to the company you work for. You can’t move your 401(k) account to a different financial institution (at least not while you’re still working for same employer) and (like many other types of retirement accounts) you generally can’t withdraw money from a 401(k) before the age of 59 ½ without incurring penalties. Yet just because your 401(k) account is different from other accounts doesn’t mean you should think about it in isolation.

If you have multiple accounts that you’re using to invest for retirement—whether they’re 401(k) accounts, IRA accounts, or regular brokerage accounts—thinking about each account as if the others don’t exist can be a mistake. Even if the allocation of your investments is reasonable in each account individually, it might not be ideal when your accounts are considered together. For example, a sizable exposure to a particular stock, fund, or sector of the market might not be a problem in one specific account. But if you have that same exposure across all of your accounts, it might put your ability to reach your retirement goal at risk.

Furthermore, only thinking about your accounts individually precludes some clever tactics that could help grow your wealth. If you’re investing for retirement with a mix of tax-advantaged accounts such as 401(k) accounts and regular taxable accounts, you might be able to use what’s called “asset location” to reduce your tax bill. Because income from different types of investments is taxed differently, the idea of asset location is to put more of the high-tax investments in the tax-advantaged accounts and the low-tax investments in the taxable accounts. Done properly, it can let you retain more of your wealth. But asset location requires that you think about your “retirement goal” as a single entity rather than as isolated accounts.

Time To Take A Step Back?

Step Back

As a disappointing first quarter earnings season rolls on, I am beginning to feel more cautious about the markets in the months ahead. We’re in the midst of a third consecutive quarter of poor profits and cash flows, and what’s most troubling is the weakness that’s spreading beyond energy and exporters to a broader swath of companies in the index. To me, this is a signal to reduce risk in many portfolios.

Why the increasing level of concern? The three previous earnings recessions of the last 50 years that were caused by a combination of tumbling oil prices and a strong dollar tended to last two quarters. But this pronounced downturn in earnings has now stretched into a third quarter. By now, I would have expected sales and profits to have rebounded, with consumers responding to the “energy dividend” that has accompanied the tumble in oil prices. And the pass-through from lower input costs should have driven an increase in overall economic activity, fueled by higher real consumer incomes. That has not yet happened. I find it both discouraging and an ominous sign for risk assets.

Reevaluate your asset mix

With new money, investors may want to contemplate standing aside for now. An appropriate response for existing diversified portfolios could be to reevaluate their quality mix, and to consider favoring a tilt toward shares in companies with sustainable dividend yields and toward high-quality bonds, perhaps US corporate credits.

Although I don’t believe the present backdrop signals the beginning of a US recession, it does mean that we are now experiencing a protracted earnings recession. To resume favoring risk, I’d need to see the following:

– A recovery in capital expenditures

– An improved revenue line for US-based multinationals

– A sustained improvement in emerging markets

– Improved pricing power on the back of an increase in global inflation

Additional concerns

Aside from the concerns expressed above, there are a number of other issues that the market needs to confront. In particular, because of the growing weakness in earnings, the current price-earnings ratio for the S&P 500 is too high, at 16.3x.

Seasonal trends are not particularly favorable in the months ahead. The May–October period is historically characterized by sideways market movements, delivering indifferent returns to investors when viewed over many decades. As the popular saying goes, “Sell in May and go away.” This year, in particular, investors can afford to wait for more clarity from the data flow.

Generally, market participants tend to be cautious in the months leading up to major elections. And with this year’s US election likely to be contentious, that caution may be justified. Further risks that may warrant caution are the Brexit referendum on 23 June and a Spanish general election days after, as well as concerns about Greece’s ability to meet its financial obligations over the coming months.

The macroeconomic environment has proven less dynamic than expected in recent months. US government income tax receipts have slowed despite still-robust employment data. New single family home sales, though solid, have not met my expectations. Auto sales are losing momentum after a very strong 2015. And most importantly, the profit share of gross domestic product, one of the most important forward indicators I follow, has started to slide.

While the current US business cycle remains strong by many measures, like job and wage growth and corporate profit margins, the equity markets are laboring to produce the earnings and margins that we’ve come to expect in recent years.

Our job will be to follow the shifts in the markets and the economy, and it’s our hope that our current concerns will be temporary.

But for now, it might make sense to take a step back.

James T. Swanson is the chief investment strategist of MFS Investment Management.

 

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor. MFS makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. MFS has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

How I Learned to Stop Worrying and Love the Bond

Love

U.S. Treasuries are not cheap. At roughly 2%, nominal yields are less than a third of the 60-year average of 6%, according to Bloomberg data. Although they are not as egregiously expensive as 10-year Swiss government bonds—currently trading at a yield of negative 0.25%—U.S. bonds are offering a relatively paltry real return, even after adjusting for low inflation.

Moreover, government bonds are potentially more volatile. For now, that volatility is being suppressed by the lethargic pace of the Federal Reserve’s (Fed’s) tightening cycle. But there is plenty of risk embedded in traditionally safe government bonds.

Low coupon rates mean that investors get almost all of their cash flow at maturity. This pushes up a bond’s duration or rate sensitivity. In practice, a 10-year bond yielding 2% is more rate sensitive than a 10-year bond yielding 6%. If rates start to rise, bond volatility will be exacerbated by higher durations. Another way of looking at this: With a 2% coupon, a relatively small rate move will wipe out a year’s worth of interest.

But despite high prices and the potential for more volatility, there is still a very good reason to continue to own government bonds: diversification.

Use bonds as a hedge

While government bonds currently produce little in the way of income, U.S. Treasuries have been providing a hedge against equity risk. Since the financial crisis, but really since the bursting of the tech bubble, bonds have been more likely to move in the opposite direction to stocks. This trend has only intensified since the financial crisis.

Why should this be the case and is it likely to continue? Looking back over the past 25 years, a period of low and stable inflation, stock/bond correlation has generally moved in tandem with monetary policy, as measured by the effective federal funds rate. In the 1990s, when investors were more worried about inflation and an aggressive Fed, the correlation between stocks and bonds tended to be positive. However, as the Fed has increasingly pushed the boundary of monetary accommodation correlations have fallen.

What history tells us

Over the past quarter century the level of the fed funds rate has explained nearly 50% of the variation in stock/bond correlations, according to Bloomberg data. Take a look at the chart below. During this period, when the policy rate was above 2%, the average correlation was close to zero. In periods when the fed funds rate has been below 2%, as has been the case since late ’08, the average correlation has been roughly -0.25. (A correlation of 1 means two asset classes move in lockstep. A negative correlation means they move in opposite directions. A zero correlation means their movements are unrelated.) As long as the Fed remains reluctant to raise rates, history would suggest that the correlation between stocks and bonds is likely to remain negative.

Stock Bond Correlation

A negative stock/bond correlation is important for managing portfolio volatility. Portfolio risk is not simply the sum of the volatility of the individual assets; it is also influenced by the correlation between those assets. To the extent that longer-term government bonds provide diversification—a scenario more likely in an environment in which the policy rate is low—bonds have a role to play in a portfolio, even if they are expensive and more volatile.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. 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 maket principal and interest payments.

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 April 2016 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.

©2016 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. 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.

USR-9190

Can Japanese Stocks Rise Again?

Japan

This week’s chart shows how Japanese companies’ inflation expectations have been steadily declining in recent quarters, amid an appreciating yen. Bank of Japan (BoJ) stimulus efforts this year – including an expanded quantitative easing (QE) program and a shift into negative interest rate territory– have failed to stem the yen’s rise and boost inflation expectations.

Deflationary pressures have weakened market confidence in the central bank, and hurt Japanese stocks. Japanese equities experienced record outflows in April, according to BlackRock research based on exchange traded fund (ETF) flows, and Japan is now among the worst-performing equity markets this year in local currency terms, with the TOPIX index down more than 13% year to date, according to Bloomberg data.

Japan Inflation

Recent support for the market appears to be coming largely from BoJ purchases, which amount to more than 200 billion yen since April 11, our research shows.

This all begs the question: Can Japanese stocks rise again?

There are reasons to like Japan over the longer term, even as a strong yen contributes to Japanese corporate earnings downgrades. The “short Japan” trade looks increasingly crowded, Japanese stocks appear cheap (around 13x forward earnings) relative to their own history and to other markets, and Japanese corporate balance sheets in aggregate have low financing risk, BlackRock analysis suggests.

We still hold a neutral view of the market, however. We believe monetary policy, the first arrow of Prime Minister Shinzo Abe’s “three-arrow” economic plan, isn’t enough to boost the local economy and market. The BoJ still has ammunition left to raise inflation expectations, including increased equity purchases, despite last week’s inaction.

But we would need to see additional easing coupled with advances toward achieving Abe’s second and third arrows, for us to adopt a more bullish view of Japan. In the near term, we are awaiting credible fiscal stimulus aimed at paving the way for structural reforms. Over the longer term, we want to see tangible progress in labor reform and in cutting red tape for local businesses. Read more market insights in my weekly commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

 

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