Asian opportunities rise with US volatility

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Stocks succumb to steepest slide in months, says Russ Koesterich, BlackRock’s global chief investment strategist in his weekly commentary.

Last week, stocks suffered their worst one-day slide in six months while volatility reached the highest level since last spring. The Dow Jones Industrial Average fell 2.75% to 16,493, the S&P 500 Index declined 2.69% to 1,925 and the tech-heavy Nasdaq Composite Index dropped 2.18% to end the week at 4,353. Meanwhile, the yield on the 10-year Treasury rose from 2.46% to 2.50%, as its price correspondingly fell.

Although the US economic recovery appears to be gaining steam, lofty stock prices and rising geopolitical risks are finally taking a toll. However, some interesting opportunities reside outside the United States. In particular, Asian stocks — both developed and emerging — are intriguing, and have outperformed thanks in part to less challenged valuations.

Good News Not Enough to Prevent Sell-Off

Ironically, last week brought the release of a string of positive economic news, not the least of which was a strong gross domestic product (GDP) report for the second quarter. The July employment data also showed more than 200,000 net new jobs were added for the sixth straight month, further confirming that the United States has fully recovered from the first quarter’s economic contraction.

However, the good news was not enough to keep stocks moving higher. Instead, a host of issues caused stocks to sink: Argentina defaulted on its debt for the second time since 2001, a key Portuguese bank was ordered to raise capital, the US and Europe imposed new sanctions on Russia and investors were disappointed over soft earnings from Samsung, Adidas AG and Lufthansa.

A pronounced sell-off on the final day of the month pushed stocks into negative territory for July, with some of the worst damage in European equities and U.S. small caps. The latter fell over 6% last month, their largest monthly loss in more than two years.

We are also beginning to witness the long-anticipated spike in volatility. The Chicago Board of Options Exchange Volatility Index, known as the VIX, surged 27% on Thursday to 17, its highest level since April. Based on this measure, equity market volatility is up roughly 70% from its summer lows.

Beware Shorter-Term Bonds

Meanwhile, US bonds sold off sharply following the release of the strong second quarter GDP report, which showed growth of 4%, well above expectations. The numbers also confirmed the first quarter was not as weak as originally thought. Following the release of the GDP report on Wednesday, yields spiked for all bonds, but the damage was particularly acute for shorter-term bonds. For example, the yield on two-year note rose as high as 0.59%, its highest yield since May 2011.

Treasury bonds recouped much of their losses on Friday after the July employment numbers were a bit below expectations. Even so, our view is that the U.S. labor market is making significant strides. On average, roughly 245,000 jobs have been added  in each of the past six months, meaningfully higher than the just over 200,000 level often seen in recovery periods. In addition, hiring typically tends to slow down in the summer, making the recent figures particularly notable.

Overall, last week’s data suggest the Federal Reserve may raise interest rates sooner than the markets expect, despite the generally dovish tone to statements made by Fed officials last week. This should put renewed pressure on short-dated bonds (those with two- to five-year maturities), which we believe will be most affected by an earlier-than-expected rate hike.

We find valuations, some lift in China’s economy and improving sentiment are all good reasons to consider larger allocations to Asian equities, including those in both China and Japan.

Asian Equities Buck the Trend

Many of last week’s headlines were suggestive of problems in emerging markets (EMs), yet EM funds saw their largest inflows since early 2013. Much of the turn in sentiment and performance can be attributed to visible improvement in the Chinese economy.

Last week, a key measure of Chinese manufacturing activity improved for a fifth consecutive month. Stronger economic numbers such as this helped Chinese equities to rise more than 8% last month. And the gains were not limited to China. Korean and Japanese stocks — indirect beneficiaries of the upturn in China’s economy — are also outperforming the broader market.

It is difficult to predict if the spike in US volatility we saw this week will be short-lived. Even if it is, we find valuations, some lift in China’s economy and improving sentiment are all good reasons to consider larger allocations to Asian equities, including those in both China and Japan.

 

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