A lull in volatility, but not for long?

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Russ Koesterich, BlackRock’s Global Chief Investment Strategist comments

A Quiet Week for Stocks …

US stocks continued to grind higher, although gains were limited in a week marked by a return to low volatility.  The Dow Jones Industrial Average added a modest 0.35% to close the week at 17,634, the S&P 500 Index rose 0.39% to 2,039, and the Nasdaq Composite Index performed better, climbing 1.25% to 4,688. Meanwhile, the yield on the 10-year Treasury was essentially flat, moving from 2.31% to 2.32%.

Last week’s decline in volatility for both stocks and bonds is likely to be a temporary phenomenon. We would expect a pick-up next year as the Federal Reserve prepares to raise interest rates.  We would also point out that as other markets inched along, Asian equities were able to extend their rally.

All told, recent market and economic action leads us to a few key conclusions: a more favorable view toward US small-cap stocks, a confirmation of our preference for equities in Japan and China, and a wary outlook for gold..

… But Don’t Get Used to It

The return of low volatility saw the S&P 500 Index rise or fall less than 0.1% for four consecutive days, the longest such stretch in 25 years. The story was similar for bonds, as interest rates remained contained in an exceptionally narrow range.

Stocks’ tight trading range last week could be attributed to countervailing forces of good economic data — namely, strong US retail sales data and a decent gross domestic product report in Europe — balanced against lingering concerns over the conflict in Russia and Ukraine.

At this juncture, equity market volatility has drifted back toward the low teens (around 13 on the VIX Index), but we do not expect the relative calm to last. Although seasonal strength may keep volatility below normal for the remainder of the year, the situation is likely to change in 2015. A shift in US monetary policy next year (i.e., Fed action to raise short-term interest rates) is likely to lead to spikes in volatility of the type we witnessed in September and October.

New Liking for US Small Caps, Continued Affinity for Asia

Against this broad backdrop, one segment of the US market that is showing signs of improvement is small-cap stocks. After dramatically underperforming year-to-date, we are starting to see some shift in sentiment. We had been advocating an underweight to US small caps all year, but would now favor a more neutral stance.

While the US experienced an exceptionally quiet week, equity markets in Asia were livelier. We continue to see good opportunities in these markets, which have been outperforming of late.

Japanese stocks surged 3% last week to a six-year high (although it surrendered most of those gains on Monday), driven by good earnings, the weakening yen and hopes that an expected tax hike will be delayed. According to local reports, Prime Minister Abe is likely to call a snap election around mid-December and postpone the sales tax increase scheduled for next October.

In China, stocks continued to rally despite weaker economic growth there. The Shanghai Composite Index rose 2.8% to a three-year high after officials approved the launch of the Hong Kong-Shanghai trading link. Until now, overseas investors were largely limited to trading on the Hong Kong exchange. The new program will give overseas investors access to $2trn in Chinese equities, which could be supportive of stocks there.

Commodity Volatility Picks Up

While volatility in stocks and bonds is down, it is picking up for commodities. Before rebounding on Friday, both gold and oil traded to new lows for the year. Brent oil traded below $80 per barrel for the first time since 2010. At the same time, gold prices temporarily dipped below $1,150 per ounce. Gold was hit earlier in the week by news that Chinese demand contracted for a third consecutive quarter.

Gold managed to rebound on Friday, but several factors are still conspiring against the metal: a strong dollar, the prospect for rising real interest rates (in other words, the interest rate after inflation), and declining inflation expectations. Indeed, the University of Michigan Consumer Sentiment Survey showed US inflation expectations declining from 2.8% to 2.6% last month. As such, we would continue to be cautious on gold in this environment.


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