7th May 2014
Investors may be reaching too far in their search for yield, Russ Koesterich, BlackRock’s Global Chief Investment Strategist has warned.
He says the US is presented a mixed picture economically with solid company results, a rise in new jobs but flat wages. The extreme winter weather has also played a role, he says. The rest of the note is below.
U.S. Economy Appears to Be Accelerating
A dismal first-quarter gross domestic product (GDP) growth report revealed the economy expanded at only a 0.1% rate last quarter, well below expectations and significantly lagged the 2.6% pace of growth recorded in fourth quarter 2013. It appeared that much of the weakness could be attributed to the bad winter weather, as more recent data show the economy has strengthened since February. In addition, a measure of Chicago-area manufacturing activity reached a six-month high in April and the national Institute of Supply Management manufacturing survey was also ahead of expectations.
The bigger economic focus last week was on April’s employment report. There were some elements in the data that raise concern, such as the large drop in the participation rate and flat wage growth, but the headline number was impressive: 288,000 new jobs were created in April, the largest increase since January 2012.
Companies Are Slow to Hire, but are posting solid results
Jobs growth does appear to be improving, but remains soft compared to other periods of economic recovery. One reason is because companies remain focused on cost containment and managing business risks—a state that has existed since the financial crisis. In general, companies appear to be more focused on stock buybacks, cost management and process efficiencies than they are on expanding their workforce.
The upside of this behaviour is that the emphasis on cost control is once again helping companies beat earnings expectations. Compared to the first quarter of last year, earnings are up 0.6% in the current reporting season. While not necessarily an impressive number on its own, it is well ahead of the 1.2% decline analysts were predicting, and is one reason that stock prices have been moving higher.
Rates Remain Low, and Investors May Be Stretching Too Far for Yield
Many observers (us included) have been expecting interest rates to begin drifting higher as the economy improves. So far, however, this has yet to happen. Part of the reason is that while economic growth is accelerating, there is still little evidence of inflation. Price levels have been relatively stable in recent inflation readings and, as mentioned above, wages aren’t really growing. This means the Federal Reserve is under no real pressure to raise interest rates any time soon. As expected, the Fed announced another $10 billion reduction in its asset-purchase programs last week, but there was nothing in its policy statement that suggested it was set to increase interest rates any time soon.
Echoing a point we’ve made before, with interest rates still quite low, investors are grabbing for yield anywhere they can, and may be taking on too much risk in the process. As an example, investors have been pouring money into a number of peripheral European sovereign bond markets, such as Spain and Portugal. We’ve also seen corporate bond deals that have been massively oversubscribed.
This suggests to us that investors may be stretching too far for income while ignoring the risks. There are few genuine bargains in fixed income today, but we would suggest that investors continue to focus on areas of the market that offer better relative value. Municipal bonds remain a chief example; we also believe there is value to be found in mortgage-backed securities. For those hungry for additional yield, we believe having some exposure to high yield bonds continues to make sense.