Investing in an era of divergence

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Russ Koesterich, BlackRock’s Global Chief Investment Strategist: Investing in an Era of Divergence

Stocks Move Higher, But Not Everywhere

Stocks were generally higher last week, with the Dow Jones Industrial Average rising 1.72% to close the week at 17,279, the S&P 500 Index climbing 1.26% to 2,010 and the Nasdaq Composite Index inching up 0.26% to 4,579. However, the Russell 2000 Index, which tracks small-cap US stocks, fell 2.17%. Meanwhile, the yield on the 10-year Treasury slipped from 2.61% to 2.58%, as its price correspondingly rose.

On balance, the economic and monetary environment remains supportive of stocks, but not every country or every sector is feeling the good vibrations. We continue to see significant differences among countries, as well as market segments. Going forward, that means investors should continue to focus on finding relative value, while avoiding segments of the market likely to be particularly sensitive to rising interest rates.

For Some, Record Highs

Developed market equities rallied last week, with some country averages hitting all-time or multi-year highs. Stocks continue to benefit from low inflation and accommodative monetary policy, both of which support higher multiples, as well as continued good fortune in avoiding “worst case” geopolitical scenarios. US equities hit a record high and European equities advanced to a 6 ½-year high last week, but the biggest rally occurred in Japan. The tailwind from a cheaper yen pushed Japanese equities to their best close since the fall of 2007.

Outside of Japan, stocks were helped by several factors, including the news that Scottish voters rejected independence and will remain part of the UK, and a record $21.8 billion IPO by Chinese e-commerce firm Alibaba.

Separating the Wheat From the Chaff

However, last week’s positive news was not universal, and it illustrates an important trend today: divergence. This is manifested in both markets and economies.

To begin, the global economy is increasingly marked by economic divergence: A strong US and UK are in contrast with softer growth in Europe. This was on display last week in the form of diverging central bank policies. The US Federal Reserve’s latest estimate of interest rates suggested a sooner-than-anticipated move away from ultra-low rates. At the same time, a “No” vote in last week’s Scottish referendum cleared the way for a rate hike by the Bank of England. In contrast, the European Central Bank is struggling with very different problems: how to grow its balance sheet and provide more monetary accommodation.

A potential Fed rate hike in 2015 is already having an impact on financial markets. The two-year Treasury yield hit its highest level since May 2011 and the dollar continues to strengthen. Last week, it hit a 14-month high against a basket of other currencies. Higher real yields (in other words, the yield after inflation) and a stronger dollar continue to exert pressure on commodity prices, with gold sliding to its lowest level since January. Finally, the potential rate hike is contributing to a pickup in bond volatility. Last week, the MOVE Index, which measures bond market volatility, hit its highest level since February. Meanwhile, equity market volatility has remained muted.

And just as economies are diverging, so are market segments. Emerging markets witnessed $1.4bn of outflows from exchange traded products last week. The category has been struggling of late on concerns over increasingly erratic Russian policy, slower Chinese growth and higher US rates. Even in the United States, the gains have not been universal. Small caps largely sat out last week’s rally and defensive sectors, particularly utilities, are off roughly 4% from their summer peak.

Seek Relative Value, But Beware Bonds in Equity Clothing

How should investors navigate the divergence we’re seeing? We would suggest a couple of themes as we head toward the year’s end.

For stocks, a marginal tightening in monetary conditions suggests being cautious on those segments of the equity market with hidden rate exposure. This includes both small caps and certain defensive income plays, like utilities – both of which have historically proved more vulnerable to contracting valuations as real rates rise. At the same time, we continue to prefer areas that offer relative value, in particular U.S. large- and mega-cap stocks as well as Japanese equities, which we believe can move higher, despite having hit their best level since November 2007.


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