We are underweight U.S. stocks. After its June policy meeting, the Fed signaled that it was getting close to raising short-term interest rates on improving economic conditions and promised to move gradually. Yet turmoil surrounding Greece and China has brought more uncertainty to the global economic outlook, which could give the Fed some pause. To begin with, there is reason to proceed with caution. The latest U.S. readings on jobs and the housing market point to an economic reacceleration in the second half, but soft spots remain. Measures such as retail sales and durable goods continue to show weakness. And, the Chicago Fed National Activity Index (CFNAI), a good leading indicator for the country’s overall economic health, has inched higher but is still running below trend (see the chart below).
Given that valuations of U.S. stocks are relatively pricey, we tend to search abroad for better value and opportunities. But we think U.S. stocks have further upside potential, keeping in mind that mergers and acquisitions just hit a new high in the second quarter. It is still early in the second-quarter earnings season, but with estimates having already been lowered, the U.S. economy recovering and the dollar having stabilized, companies should have an easier time beating estimates this time around.
Turning Insight Into Action
Many measures of U.S. economic activity have improved since the slowdown early in the year. While weakness lingers in some areas, the U.S. economy looks set to regain speed. Selectivity is important in the U.S. market, where value will vary by sector and individual company.
Consider blending opportunities for core market exposure with high- conviction active solutions that focus on finding value in the market.
iShares Core S&P 500 ETF (IVV), iShares Core S&P Total U.S. Stock Market ETF (ITOT), Basic Value Fund (MABAX)
International Developed Markets
We hold an overweight to eurozone equities. Uncertainty surrounding Greece and its membership in the euro area will keep risk premiums and volatility elevated; however, we think fallout from the Greek drama will remain contained and short- lived (see Hot Topic on page 7). In fact, with economic data coming roughly in line with forecasts and profit expectations firming, any further volatility in eurozone equities could present an opportunity. This is especially true since the European Central Bank (ECB) is expanding its balance sheet and is poised to provide further monetary accommodation if needed. Any continued euro weakness associated with these events will likely give an additional kick to earnings as profits are repatriated. That said, investors should consider hedging their currency exposure to eurozone equities to avoid returns being eroded by euro weakness.
We are overweight Japanese stocks. Somewhat sheltered from this year’s financial market roller coaster ride, Japanese equities have not only been an island of relative calm and tranquility (see the chart below) but also an area of strong outperformance. Japan’s economy, while certainly not a locomotive, has managed to pull out of a shallow and brief recession and is beginning to show signs of benefiting from a weaker yen. Moreover, Japanese companies have come a long way in improving profitability, and they are also lifting dividends and share buybacks to boost return on equity. Despite outpacing the rest of the developed world so far this year, Japan remains inexpensive based on price-to-book and forward price-to-earnings ratios.
We have a neutral view on developed Asia ex-Japan equities. A setback in Chinese stocks, slower commodities demand growth and negative earnings revisions have weighed on the region’s equity markets this year. However, after the summer selloffs, we think Asia ex-Japan equities warrant a closer look. Take Hong Kong, the Hang Seng Index has very recently regained some lost ground, but not before it fell to the cheapest levels versus the MSCI World Index since September 2003. Also of note are the above-average dividend yields, with Australia yielding north of 4.5%.
Turning Insight Into Action
Earnings growth and valuations of European and Japanese companies are more compelling than for U.S. companies. But renewed strength in the greenback could erode returns in international markets for U.S. dollar- based investors, boosting the allure of currency hedged exposure.
Consider using an active manager with strong stock selection expertise or be selective with index-based exposures.
Global Long/Short Equity Fund (BDMIX), Global Dividend Fund (BIBDX), Global Allocation Fund (MALOX), iShares MSCI Japan ETF (EWJ), iShares Currency Hedged MSCI Japan ETF (HEWJ), iShares MSCI Eurozone ETF (EZU), iShares Currency Hedged MSCI Eurozone ETF (HEZU), iShares International Select Dividend ETF (IDV)
We hold a benchmark weight to emerging markets. Since topping out at the end of April, emerging markets have entered another correction phase, and the selloff has been quite indiscriminate. While markets have stabilized somewhat very recently, emerging Asia has clearly dominated price action since the end of June. In addition to China’s equity market woes, Latin America has underperformed again so far this year and Eastern Europe sharply declined since mid-May. However, we still prefer emerging Asia. Countries in emerging Asia have greater scope for monetary accommodation and market reforms, will likely experience better growth (though not great), should benefit most from lower oil prices and have increasingly competitive currencies.
We have a neutral weight in China with a preference for H-shares. Chinese stocks tumbled the most in nearly six years in early July after a series of measures (and some quick backtracking) paradoxically aimed at stabilizing financial market conditions backfired. While the slide has paused for now, we expect more volatility, particularly in the onshore exchanges. After downgrading China to neutral in June, we will hold off from chasing newly attractive valuations until the situation stabilizes. That said, it may be possible to find bargains in the Hong Kong-listed H-shares market, which is both cheaper and less volatile than the A-shares market. Select banks, property developers and new energy companies could present value.
It is worth noting, however, this stock turmoil has not affected the Chinese economy. The PBOC has plenty of spare power to support economic growth and financial markets, unlike some developed market central banks, and will likely continue to implement countermeasures. And when it comes down to it, we have not seen a material impact from the equity selloff on the global economy and markets to date.
We elect to downgrade Poland from an overweight to neutral. Poland’s economy is in relatively good shape and profitability is quite strong among Polish companies. However, the financials sector, which represents more than 40% of Poland’s market capitalization, faces the risk of a banking tax and other regulation if a more populist party (the Law and Justice party) comes to power this autumn, as is currently projected. Moreover, Poland no longer stands out as particularly cheap relative to other Eastern European countries, such as Turkey and Russia.
Turning Insight Into Action
It may be time to consider getting back to a benchmark exposure in emerging markets, but investors should remain selective.
Consider accessing specific countries or regions, or use an active manager with expertise to identify potential opportunities.
iShares MSCI Emerging Markets Asia ETF (EEMA), iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV), Emerging Market Allocation Fund (BEEIX)
We are overweight information technology and financials. As the economy firms, loan demand should rise, which could support financials stocks. Mergers and acquisitions as well as securities underwriting business will likely remain solid, which can also prove helpful. And, technology stocks should benefit from more and more companies deciding to replace antiquated technology infrastructure.
We hold a neutral weight to the health care sector. While health care has outperformed by a wide margin this year and is a consensus overweight among money managers, valuations appear reasonable against solid earnings growth and profitability, even for biotechnology stocks. In an environment of decent economic growth, favorable credit conditions and continued good earnings growth, we would anticipate biotech especially, but also life sciences, to outperform. Meanwhile, there are good reasons to consider pharmaceuticals stocks, which tend to have very high dividend payout ratios. This could prove particularly advantageous in a risk-off scenario (defined by a renewed drop in bond yields).
We are underweight U.S. utilities and consumer staples. These sectors outperformed during the past month as heightened global risk aversion prompted a decline in interest rates and a preference for defensive sectors. But while defensives may be somewhat less expensive after this year’s repricing, any stabilization from here could entail further downside.
We have a neutral exposure to the energy sector as oil prices have declined anew in recent weeks. We prefer integrated oil and gas companies given their more muted sensitivity to oil prices in the past. What is more, their refinery businesses benefit from lower oil prices.
We are neutral in industrials. The correction in transportation stocks has investors worried that the decline may be a harbinger of bad news for the broader market. We think the decline in transports has more to do with the subsector’s overvaluation after two years of strong outperformance. Plus, declining global trade volumes, weaker-than-forecast economic activity and reduced demand for coal shipments all play a role in the subsector’s recent outsized move lower.
Turning Insight Into Action
Consider cyclical sectors over defensive and dividend-oriented sectors. Consumer staples and U.S. utilities look particularly unattractive and are vulnerable to rising rates.
Look into possible opportunities in the technology and financials sectors and consider a long/short approach to potentially benefit from any continued market volatility.
iShares Global Financials ETF (IXG), iShares Global Tech ETF (IXN), iShares U.S. Technology ETF (IYW), Global Long/Short Equity Fund (BDMIX)
We are underweight Treasuries. Yields of long-term debt in the United States, Germany, United Kingdom and Japan hit their highest levels this year in June, but the upward movement was interrupted, at least temporarily, by jitters about Greece and China near month-end. Rate volatility is likely to remain elevated as markets wrestle with the timing of the Fed’s liftoff. We believe yields could climb higher over the course of the year, although much of the adjustment may have already taken place.
We hold a neutral position in Treasury Inflation-Protected Securities (TIPS). The backup in yields has returned some value to the asset class. We don’t think inflation will accelerate meaningfully anytime soon, but headline inflation and expectations have inched higher while the risk of disinflation has decreased.
We are overweight high yield. Outflows from the asset class continue and spreads are under pressure. Although volatility could persist, yields are attractive in both absolute and relative terms, and fundamentals remain encouraging.
We have an overweight in municipals. The municipal market had another negative month in June, though it performed better than the more volatile Treasuries. Puerto Rico’s debt woes grabbed headlines but had little price impact thus far on the overall muni market (see the chart below). Fundamentals of the majority of the muni market remain intact, as we anticipate minimal contagion risk. That said, if restructuring negotiations between the commonwealth and its bondholders turn contentious and drag on, this could stoke volatility for the broader market.
We are underweight in non-U.S. developed markets and neutral in emerging- market debt. Increased volatility in interest rates and risk assets, as well as the possibility of the dollar resuming its climb, could prove difficult for hard currency- denominated emerging-market debt.
We hold a benchmark weight in mortgage-backed securities (MBS). While MBS held up relatively well in the interest rate backup, mortgage spreads relative to Treasuries remain low and valuations do not suggest an attractive entry level yet.
Turning Insight Into Action
With interest rates likely to rise in the United States in 2015, fixed income investors will likely face challenges yet again this year.
Manage Interest Rate Duration
Consider a flexible strategy with the ability to actively manage duration.
Strategic Income Opportunities Fund (BSIIX), Strategic Municipal Opportunities Fund (MAMTX), Global Long/Short Credit Fund (BGCIX)
Manage Interest Rate Risk
Seek to reduce interest rate risk through time by using a diversified bond ladder and matching term maturity to specific investing needs.
Cast a wider net for income while carefully balancing the trade-offs between yield and risk.
Multi-Asset Income Fund (BIICX), High Yield Bond Fund (BHYIX), iShares iBoxx $ High Yield Corporate Bond ETF (HYG), iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
Build a Diversified Core
Consider using core bonds for potential diversification benefits and protection from unforeseen shocks to equity markets.
Total Return Fund (MAHQX), iShares Core U.S. Aggregate Bond ETF (AGG), iShares Core Total USD Bond Market ETF (IUSB)
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Written by Russ Koesterich of BlackRock