What Low Market Volatility Does Not Signal

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Wall Street’s fear gauge spiked last week amid Washington turmoil. Yet the VIX remains comfortably below its long-term average of around 20, after a stretch of near-record lows. Low volatility isn’t a signal to sell or of imminent sustained higher volatility, in our view.

The VIX represents current near-term stock market volatility levels. Very high VIX levels have been reliable buy signals. The opposite isn’t the case. Low volatility tells us little about the direction of future equity returns, our analysis suggests. There has been a wide range of returns in the three- and 12-month periods following daily closes of the VIX below 14.

S&P Following VIX

Focus on fundamentals

Periods of low volatility also do not imply that higher volatility is imminent. Low-volatility periods historically have lasted a long time. They have generally occurred amid economic expansion and predictable monetary policy, both of which we see today. Low volatility today likely in part also reflects investors seeking income by selling volatility in options markets.

We believe a steady economic environment should help keep equity market volatility relatively low, with a sustained and synchronized global expansion in full swing. We see few signs of late-cycle equity market complacency, with a broad swathe of stocks behind gains in major markets. Yet investors should be wary in asset classes where low volatility has encouraged many to herd into similar trades, we believe.

A move to a new regime of extended higher volatility would be negative for risk assets. It’s impossible to predict what could trigger this but candidates include a credit crunch in China and a much more aggressive pace of Federal Reserve tightening. Neither is our base case. We also do not rule out short-lived volatility spikes on risks such as further U.S. political turmoil. For now, we believe equity investors are being compensated to take risk, particularly outside the U.S. Bottom line: Look beyond short-term volatility and stay focused on fundamentals. 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.

 

Investing involves risks, including possible loss of principal.

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 2017 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.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States or elsewhere. All other marks are the property of their respective owners.

The Yield “Melt-Up” That Wasn’t

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The second half of 2016 witnessed the rise of the “reflation trade”, a trend that accelerated after the U.S. election. The thesis: The global economy was finally breaking out, inflation was firming and bond yields would be rising as bonds are sold. While parts of this trade remain in place, other manifestations have reversed, including bond yields. After today’s turmoil, U.S. 10-Year Treasury yields are currently around 2.21%, below where they started the year.

What happened to the bond market meltdown and the thesis of rising rates?

Growth has yet to break out

By now everyone is aware of another disappointing first quarter for the U.S. economy. In part, a weak Q1 can be attributed to lingering seasonal quirks in the data. Still, the simple truth is that there is not much evidence that the economy is surging. Yes, job growth remains strong and consumers and small businesses optimistic. However, outside of the labor market actual economic activity remains modest. Adjusted retail sales are growing at roughly 4.5% year-over-year, in-line with the post-crisis average. While investment activity improved in Q1 and manufacturing is crawling back from its recession, industrial production remains muted. Finally, economic data are not keeping up with lofty expectations. The U.S. Citigroup Economic Surprise Index, which measures how actual economic data releases compare to expectations, is back into negative territory and at its worst level since October.

Economic Surprise Index

Inflation and inflation expectations remain modest

The funny thing about the reflation trade is we’ve yet to experience the inflation. In fact, realized inflation is decelerating: Core consumer prices, excluding food and energy, are down to 1.9% year-over-year, the slowest rate since late 2015. The Federal Reserve’s (Fed’s) preferred measure of inflation, core personal consumption expenditure (PCE), is at a one-year low of 1.60%. Crude oil prices, a big driver of short-term inflation, are below year ago levels as U.S. shale producers make up the supply OPEC has removed. The net result: 10-year TIPS inflation expectations have slipped to 1.90%, close to where they were in the immediate aftermath of the election.

Yields remain lower just about everywhere else

While U.S. investors, particularly those dependent on income, bemoan the lack of yield, pity the investor in Europe or Japan. German 10-year yields are still below 0.50%, while similar maturities in Japan and Switzerland yield 0.03% and -0.09% respectively. With the exception of Australia and New Zealand, the U.S. has just about the highest long-term rates in the developed world. For many foreign investors, the U.S. remains an attractive place to invest, keeping bond prices high and yields suppressed.

I still believe yields will creep higher this year. The Fed is likely to continue to lift short-term rates while increasing tightness in labor markets should nudge wages higher. That said, it is not obvious that the secular factors that have been suppressing bond yields—slow nominal gross domestic product, demographics, regulatory pressure and even lower yields outside the United States—allow for a melt-up in rates. When we look back on 2017, we may very well see another year in which rates defied expectations.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

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 2017 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. Past performance is no guarantee of future results.

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.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Preventive Medicine: Playing Defense With Health Care

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With markets currently at or flirting with new highs, some investors are already thinking about the eventual reckoning. U.S. stocks have rallied, along with those of the rest of the planet, following the outcome of the first round of the French election. However, although more political stability in Europe is an unambiguous positive, as everyone knows, other risks abound. And that leads to the vexing question: How do you potentially manage those risks?

For equity investors looking to manage their risk there are two broad choices: raise cash or lower volatility. Historically, lower volatility has correlated with less exposure to the vagaries of the economy. This is generally found in companies in one of four sectors: health care, utilities, consumer staples, and telecommunications, often referred to as “defensives.”

Today the challenge is that many of these sectors have become expensive as bond market refugees have piled in searching for yield. I would exercise caution on U.S. utilities and consumer staples companies and instead focus on health care. Here’s why:

  1. Health care is relatively cheap. Since 1995, S&P 500 large-cap health care stocks have typically traded at a 10% premium to the market. Today they trade at nearly a 10% discount, close to a six-year low (see chart below). To some extent this drop in relative valuation is justified. Profitability is down from the glory years of the late 1990s when pharmaceutical companies were churning out a record number of blockbuster drugs. Currently the return on equity is roughly 18%, below the 22-year average of 20%. Still, profitability has been improving in recent years and is currently at the highest level since 2013.
  2. Historically, it’s been the best defensive play when rates rise. Consistent with other defensive sectors, health care stocks are often viewed as a bond market proxy. As such, their relative valuations tend to be influenced by interest rates. In other words, earnings multiples relative to the market typically fall when rates rise. However, given lower financial leverage compared to other defensive industries, health care is less sensitive to rising rates. For example, since 2010 the level of the 10-year Treasury has explained roughly 20% of the relative value of the health care sector. However, during the same period the level of long-term rates has explained nearly 70% of the variation in the relative value of the consumer staples sector. Put another way, trading consumer staples has been overwhelmingly a play on interest rates.

Health Care Relative Value

Investors worried about a correction need to consider not just the when but the why. With the exception of 2013’s taper tantrum, recent spikes in volatility have been driven by growth concerns. However, with the Federal Reserve firmly in tightening mode the next correction may be about rates, not growth. Under this scenario, some of the classic defensive plays, notably consumer staples and utilities, may not work as advertised. Health care is likely to be a better way to play defense.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Investments that concentrate in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and may be more volatile than the general securities market.

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 2017 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. Past performance is no guarantee of future results.

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.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Two Reasons to Skip the Market’s Joy Ride

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There are two primary reasons to be cautious about investing fresh capital in today’s richly valued US equity markets, in my view. The first reason is shaky pricing power — or top line growth — for companies in the S&P 500 Index. The second is the low level of investment that large companies are making in their collective futures.

Typically, when you get beyond the midpoint in a business cycle, pricing power improves as inflation kicks in. Revenues grow quickly, outpacing cost increases. In previous cycles, once inflation took hold, publicly traded company revenues grew faster than the US economy. However, fully eight years into this cycle, S&P 500 Index revenues have struggled to keep pace with the economy as a whole, with many industries struggling to raise prices. Recent price cuts in the telecom and auto industries have underscored this point.

There’s a notion that inflation is indeed on its way back and that energy prices, rents and wages will begin to rise. Top line inflation has been rising in the United States and abroad, but it hasn’t occurred as quickly or as dramatically as forecasters thought. One reason inflation is being held back is the departure of much of the leading edge of the baby boom generation from the workforce. Workers in this demographic are often among the highest paid workers in the labor force, and they are being replaced by younger, lower-paid workers, suppressing wage inflation.

Another factor suppressing inflation is new oil drilling technologies. Oil prices are a big determinant of inflation in the developed world. And while there is growing demand for energy, ever-lower production costs, combined with ample US reserves, are creating a virtual ceiling on prices.

Rent (or its equivalent) is a big part of the government’s inflation calculations, accounting for upwards of 30% of the consumer price index. Earlier in this cycle, there was underbuilding of housing units in the United States in response to the excesses of the last cycle. But years have passed, the population has grown and there has finally been a supply response. Large amounts of new square footage have been built — and continue to be built — in many US cities, resulting in slowing rent hikes.

Back to the future?

In addition to weak pricing power and some disappointment that Washington has been slow to roll out promised reforms, there is yet another problem investors must contend with: a lack of investment in the future. This cycle has been noted for historically weak spending on property, plant and equipment. And capital expenditures in the private sector have traditionally been closely related to future growth, specifically in jobs, profits and return on assets. No one is sure why spending on long-lived assets has been so weak, but given the rise in profits in recent years, we should have expected better spending. If this cycle is going to be prolonged, it cannot be done on consumption alone. In my view, there needs to be a commitment to factories, machines, computers and software to prolong the cycle. However, at present, there is no apparent catalyst to higher spending on long term assets, assets that in turn would lift declining US productivity.

I’d accept the current narrative of further gains ahead if I could see the route to better profits through strong pricing increases and committed spending on future growth, but I don’t see that route. So far, first quarter 2017 profits look good in both the United States and in Europe, but will this run of good numbers be sustained without improved pricing power or additional capex as the year wears on? Lots of earnings growth will be required in the remaining three quarters of 2017 to make the current market price/earnings ratio seem reasonable. Consequently, I remain cautious with new monies.

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

 

Past performance is no guarantee of future results.

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 to purchase any security or as a solicitation or investment advice from the Advisor.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

Impact Investing Can Drive Growth and Lower Risk

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For most investors, a strong annual return to help grow the family assets is almost always the top priority. But a growing number of investors also want their investments to reflect their social and environmental values.

The two goals aren’t mutually exclusive. In fact, more people are finding they can do both. It’s called “impact investing” – investing in companies, nonprofit organizations and funds with the goal of generating social and environmental impact, as well as a strong financial return.

“Our clients view investment as the economic expression of their thoughts and values,” says Thomas Van Dyck, a financial advisor for RBC Wealth Management-U.S. in San Francisco who consults on $1.8 billion of socially responsible assets. “What you buy at the store, how you vote and what you invest in should align with the values you support.”

A growth area

Although the label “impact investing” only emerged in 2007, it’s part of a broader realm of responsible investing that dates back to the 1970s. Other strategies include socially responsible investing (SRI), which prioritizes investing in companies that are openly committed to having a positive impact, and incorporates environmental, social and governance factors (ESG) into the investment screening process. Impact investing can include characteristics of SRI and ESG.

Today, impact investing is on the rise, but many investors are confused about its value, according to a recent survey by RBC Global Asset Management, the asset management arm of RBC that provides investment products to investors around the world. The inaugural survey, which was released in November 2016 and is entitled Near-Term Uncertainty, Long-Term Opportunity, indicates that investors want more information showing how they can use their capital to achieve positive change while growing their assets.

“So many people are confused by the space,” says Kent McClanahan, a senior research analyst for RBC Wealth Management-U.S. in Minneapolis, explaining that many of the terms used to describe impact investing are vague and therefore difficult to understand. “We really try to define it for our clients.”

It appears to be working. RBC financial advisors and portfolio managers say they’re seeing a significant increase in interest and capital going toward impact investing. The proof is in the data.

Impact investing assets under management in the U.S. nearly tripled – from about $3 trillion in 2010 to $8.72 trillion in 2016, according to the 2016 Report on US Sustainable, Responsible and Impact Investing Trends by the US Forum for Sustainable and Responsible Investment, also known as US SIF. Today, such assets account for more than $1 of every $5 professionally managed.

As well, a 2015 report by RBC Wealth Management and Capgemini found that 92 percent of high net worth individuals say driving social impact is important to them. While high net worth individuals are certainly part of the trend, more often it’s family offices, endowments and nonprofit organizations that lead the way.

One family foundation Van Dyck works with, for example, was already donating 5 percent of its assets to good causes. Eventually the foundation decided to add ESG advisors and criteria to all of its assets. “Investors can start making a significant change with their money,” he says. “They’re also creating a legacy to pass on to the children.”

Risk and reward

Two common misperceptions about impact investing involve risk and returns. Only 30 percent of respondents to RBC’s responsible investing survey believe that environmental, social and governance factors drive greater financial performance, or “alpha.” And only a third think these factors reduce investment risk.

However, investors should not assume that they are sacrificing returns by making investments that reflect their particular values. In fact, impact investing and ESG criteria can both lower risk and drive alpha.

“Many investors may be happy with a lower return for the satisfaction they get in outcomes,” says Jeremy Richardson, a London-based senior portfolio manager for RBC Global Asset Management’s global equity team. “But investors should not expect a lower return.”

To drive alpha using ESG factors, McClanahan suggests looking for opportunities to invest in emerging technologies or new industries looking beyond social and environmental changes. When California required all residents to cut their water usage by 25 percent, for example, this may have been an opportunity to invest in companies developing water innovations.

Studies show that ESG portfolios are less volatile and perform better over the long term than non-ESG companies. Analysis by the research firm MSCI found that ESG strategies outperformed the global benchmark by as much as 2.2 percentage points a year from 2007 to 2015.

Since 1994, gross returns for the MSCI KLD Domini 400 Social Index were slightly higher than the MSCI USA IMI, an equity index of large-, mid- and small-cap companies.

Screening methods

By investing with ESG standards in mind, investors can also lower their risk of being exposed to corporate scandals or environmental catastrophes. That, too, can drive alpha.

Perhaps that’s why more high net worth individuals and institutional investors are investing in mutual funds that incorporate ESG criteria, dedicating 5 percent to 20 percent of their portfolio toward a specific interest or integrating ESG screening across their entire portfolio. Some are filing or supporting shareholder resolutions on social and environmental issues.

Top ESG criteria include environmental issues, regions with conflict risk, weapons production and human rights. Climate change investing, which includes fossil fuel restrictions, is the top environmental factor affecting assets, according to the US SIF.

Risk avoidance is often used to exclude certain types of investments that don’t align with an investor’s values. The RBC survey, however, found that 52 percent of respondents think negative screening is only for mission-driven investors and don’t apply to them, which reflect some ongoing confusion.

“The greatest wealth creation opportunity of the upcoming generation is to identify companies that are embracing the transition to renewable energy across industries from transportation to technology,” notes Van Dyck.

Growing pains

A burgeoning market is bound to have some growing pains. One concern of impact investing identified by US SIF is the lack of information disclosed by companies about the specific ESG criteria used.

Our RBC responsible investing survey showed that 43 percent of respondents are dissatisfied with the amount of ESG-related information from companies. That means wealth managers and portfolio analysts will play an important role in developing and explaining research to investors.

RBC Global Asset Management has been integrating socially responsible investing criteria throughout its investment process since 2014. In 2016, RBC received an “A+” for overall strategy and governance from the United Nation’s Principles for Responsible Investing.

“Why wouldn’t you want to consider environmental resource risk mitigation, employee safety or corporate government practices?” asks McClanahan. “You can always make the world a better place.”

RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.

Reflation Moderation

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Back in late 2016 it seemed terribly simple. Growth and inflation would rise on the back of U.S. fiscal stimulus. Investors would buy cyclical companies, particularly U.S. small caps, and sell bonds. Four months later, the reflation trade, while not quite dead, seems less a sure thing.

Cyclical commodities that soared in late 2016 have struggled this year. Commodities, the U.S. dollar and Japanese stocks are some of the worst performers year-to-date (see the chart below). At the same time those assets that faded as investors embraced reflation have rallied, including gold, emerging markets and the Japanese yen. Even low yielding European bonds have found a bid. What happened?

Markets got ahead of themselves

YTD Asset Performance

Many asset classes rallied as if a fundamental shift in the growth/inflation paradigm was a foregone conclusion. Investors assumed Washington would effortlessly churn out an assortment of pro-growth measures: tax reform, fiscal spending and deregulation. When the reality proved much harder, disappointment set in. Trades that were predicated on faster U.S. growth, such as a stronger U.S. dollar, have fallen the most. After surging more than 10% to a multiyear high, the dollar has retraced nearly half of the move and is back to mid-November levels.

Real economic data have not kept up with “soft data”

By now most have noticed the divergence between the “hard” data, which measures actual economic activity, and the “soft data,” which mostly tracks surveys. While measures of positive economic surprises have risen sharply, most of the improvement is from soft data. Job creation, wage growth, hours worked, retail sales and core inflation have all decelerated. Although the economy appears solid, evidence of a pickup remains elusive.

Many asset classes were stretched even before the rally

The rally in risky assets was only the latest in a bull market now comfortably into its ninth year. Many asset classes, notably U.S. equities, have benefited from years of rising valuations. Large cap U.S. stocks were already trading at 20x trailing earnings in July of 2016. The subsequent rally pushed the multiple up towards nearly 22x, a seven-year high.   With the air coming out of the reflation trade, what should investors expect next? The good news is there is little evidence of a pending recession. The economy, both domestically and globally, is solid with less deflation risk than a year ago. That said, investors will want to consider a more balanced portfolio, one that includes assets that offer income, from both equity and credit, equities tied to secular growth themes and even a bit of U.S. duration and gold. Markets are a bit less frothy than they were in January, but valuations are still elevated and volatility unusually low. And as we’ve seen, it is not as if the risks in the world have gone away.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

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 2017 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. Past performance is no guarantee of future results.

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.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.