24th February 2015
Russ Koesterich, BlackRock’s global chief investment strategist explains the trends behind the fund group’s preferences for international over US equities, and within bonds, credit over long-term Treasuries and other rate-sensitive assets…
Prior to Friday afternoon, U.S. stock and bond indexes were generally flat for the week, with little in the way of corporate earnings and on the heels of mixed economic data releases. For example, producer prices fell at a much quicker pace than expected in January, even after stripping out energy prices.
Investors spent much of last week pondering what the Federal Reserve (Fed) will do with respect to raising rates in the coming months. Minutes released from the Jan. 27-28 meeting suggest the Fed is somewhat divided over when to raise rates, given that inflation is low and global risks elevated.
Ambiguity over the pace of monetary tightening reversed some of the recent uptick in short-term yields. However, 10-year U.S. rates remain roughly 45 basis points above their January lows. The shift in the rate environment has had a more noticeable impact on rate-sensitive assets as investors grow more cautious. U.S. utility exchange traded funds experienced significant outflows last week. Finally, gold prices, which are historically sensitive to real interest rates (the interest rate after inflation), have slid as rates have risen, with gold now down 8% from its January peak.
While investors have become more cautious on investments most likely to be affected by higher interest rates, there is a growing comfort with other areas of the bond market. Flows into high yield bonds have surged and as investors have favoured the asset class, spreads––the difference between the yield of high yield bond funds and Treasuries––have narrowed by more than 50 basis points over the last few weeks. We still see relative value in this asset class, despite outperforming both nominal Treasuries and Treasury Inflation Protected Securities this year.
International Markets Continue to Rally
Meanwhile, international markets continue to set the pace for stocks. Japanese equities have hit their highest levels since May 2000. The Topix Index is now up 6.5% year-to-date, outpacing U.S. equity markets by roughly 4%.
What has distinguished this year’s rally is that Japanese equities no longer appear dependent on a weak yen. With the Bank of Japan declining to add further monetary stimulus, the yen has been relatively stable year-to-date. We continue to see good opportunity in Japanese equities.
European assets have also performed well, as investors are taking comfort from a steadier economy and the tailwind of quantitative easing by the European Central Bank (ECB). But the rally suggests investors had been discounting an eventual agreement between Greece and its creditors. This view appeared to be validated on Friday when EU finance ministers agreed to extend aid to Greece for four months. Whether this will be sufficient time to address the longer-term differences between Greece and its creditors remains an open question.
Prior to the announcement, it was revealed that factions within the German government were prepared to let Greece leave the eurozone. This hardline stance is partly a function of shifting domestic considerations. As the new anti-euro Alternative party continues to gain momentum in Germany, Chancellor Merkel’s latitude to compromise with the Greek government is increasingly constrained.
While Friday’s news should provide some short-term relief, the issue of Greece’s place in the eurozone is unlikely to go away. As the negotiations continue, investors should focus on a couple of metrics: bank deposits and government finances. Greece has been bleeding deposits since late last year and is now dependent on the ECB’s emergency liquidity assistance facility. A second problem is a plunge in tax collections as individuals withhold tax payments on hopes for future relief.
In short, Greece will remain a chronic issue for investors for some time to come. Still, we maintain our preference for international equities over U.S. stocks, which are fully valued at the moment.