Money Is Still Cheap Enough to Support Stocks

Wooden economy and currency unit on a craft background; Shutterstock ID 121452739

Recently, U.S. interest rates hit multi-year highs and the dollar came back from the dead. From the February low to Monday’s high the DXY Dollar Index gained approximately 6.5%. At the same time, long-term U.S. interest rates are back to their early 2014 peak; two-year Treasury rates are at their highest level in roughly a decade. Together, higher rates and a dearer currency both represent a tightening of financial market conditions.

Still, despite these developments stocks have bounced, with the S&P 500 up 5% from the May low. How is it that stocks are rallying despite tighter financial conditions? Strong earnings are part of the answer. But apart from a stellar earnings season, the simple truth: Financial conditions have actually become easier in recent weeks.

According to two measures of financial conditions maintained by the Chicago and St. Louis Federal Reserve Banks, financial conditions have eased in recent weeks. There are three reasons financial conditions have actually gotten easier.

1. The dollar is still down year-over-year

While the dollar rally has been abrupt, it has also been short-lived. The dollar has advanced roughly 5% between mid-April and mid-May, but that rally only puts it back to where it was in mid-December. On a year-over-year basis the dollar is still down approximately 4% (see Chart).

Trade-Weighted Dollar

2. Credit conditions remain benign

Equity market volatility in February and March never did spread to credit markets. As a result, high yield spreads remain extraordinarily low, approximately 180 basis points below the 20-year average. Unlike during the growth scare in early 2016, credit markets have remained remarkably calm throughout the recent bouts of volatility.

3. Equity volatility has fallen

Although the February and March spikes in volatility were an “equities-only” affair, even that has calmed down. While volatility remains elevated relative to last year’s comatose levels, the VIX has “mean reverted,” or dropped back closer to average. Since the start of the month the VIX has averaged approximately 14. In comparison, implied equity volatility averaged 20 in February and March.

The resilience of equities

The fact that financial conditions have actually eased goes a long way towards explaining the resilience of equities. As I’ve discussed in previous blogs, the price investors are willing to pay for a dollar of earnings is in large part driven by the cost and availability of money, i.e. financial conditions.

Historically, easy financial conditions, particularly low volatility, have been associated with higher valuations. Depending on the exact measure used, in the post-crisis environment the level of financial conditions has explained between 25% and 35% of the variation in the S&P 500’s price-to-earnings multiple.

In other words, while U.S. stocks are still not cheap, a premium valuation is easier to maintain in a world of still cheap money and low volatility.

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.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks may be heightened for investments in emerging 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 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary 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. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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.

©2018 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.

3 Reasons to Stick With Emerging Markets

The Great Wall of China.; Shutterstock ID 439146580

For the first time since late 2016, emerging markets (EM) are under-performing their developed market counterparts. While few asset classes—outside of oil—are having a stellar year, EM is having a particularly bad time. An index of developed equity markets is roughly flat year-to-date; EM stocks are down approximately 2%. Emerging market bonds are having an even worse year, down more than 5%.

What’s going on? Is it time to lighten up on the asset class? The answer to the latter question is no.

A number of catalysts are to blame. Emerging markets are struggling with a sharp and abrupt reversal in the dollar, concerns about global growth and idiosyncratic issues surrounding particular markets such as Turkey and Brazil. That said, there are three good reasons to stick with the asset class.

1. The return of relative value.

Like every other asset class, EM stocks and bonds have been cheaper. However, recent weakness has restored relative value, particularly for stocks. Based on price-to-book (P/B), the MSCI Emerging Index is trading at a 30% discount to MSCI World Index of developed markets (see accompanying chart). This represents the largest discount since December 2016 and compares favorably with the 10-year average of 14%.

MSCI Emerging Markets Relative Value

2. Despite the typical first quarter slowdown, the global economy is in solid shape.

As I discussed back in late January, global economic growth is key for EM and I referenced industrial metals as a good real-time proxy for global growth. While softer in recent days, the JOC-ERCRI Metals Index has risen 20% during the past year and is still up 4% year-to-date. Other indicators of global growth, such as the global purchasing managers index (PMI), also confirm the ongoing expansion.

3. A stronger dollar is a headwind, not a death sentence.

There is no doubt that the rapid and surprising appreciation of the dollar has hurt EM assets. That said, the dollar is not the sole, or even primary determinant of emerging market performance. For equities in particular, changes in the dollar have historically had a modest impact on relative returns.

Expecting a better second half

While the past several weeks have been extremely unpleasant for EMs, there is reason to expect a better second half. The dollar’s sharp rebound is arguably the result of a rapid and violent unwind of a very crowded short trade. Recent changes in positioning suggest much of this adjustment has already occurred.

Beyond the dollar, the global economy should rebound this summer as the lagged impact of U.S. tax cuts and fiscal stimulus are fully realized. In particular, a likely acceleration in capital spending should be supportive of global trade, and by extension emerging markets. For investors who have already lived through the volatility, this is probably the wrong time to sell.

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.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks may be heightened for investments in emerging 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 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary 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. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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.

©2018 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.