With stocks on shaky ground, a promising ballast in bonds

Russ Koesterich, BlackRock’s Global Chief Investment Strategist

Stocks advance, but on wobbly trends

Stocks advanced last week, with the biggest gains in Asia. In the US, the Dow Jones Industrial Average rose 0.77% to 17,215, the S&P 500 Index grew 0.94% to 2,033 and the tech-heavy Nasdaq Composite Index climbed 1.16% to close the week at 4,886. Equities continue to benefit from an active cycle of mergers and acquisitions. Last week’s list included Dell’s plans to buy hardware maker EMC and AB InBev raising its bid for SAB Miller.

Stocks are also benefiting from the recent drop in interest rates, a trend that continued last week: The yield on the 10-year Treasury fell from 2.09% to 2.03%, and at one point dipped below 2%. German, Italian and Australian yields also dropped last week, as bond prices rose.

Recent weeks have seen stocks, credit and even emerging markets start to recover. Unfortunately, the gains have not been driven by signs of economic improvement, firming inflation or rising earnings. Instead, investors are once again taking solace in low rates and benign monetary conditions, which can and probably will persist for the remainder of the year.

But that can only take the market so far. Meanwhile, another important trend is emerging: For investors looking for some longer-term ballast in their portfolios, particularly equity-centric portfolios, longer-duration bonds are reasserting their role as an effective hedge to equity risk.

Sugar high

In most countries, interest rates are being held down by persistently low inflation. For example, the latest readings on Chinese inflation came in below expectations while UK readings turned negative for only the second time since 1960. Even in the US, producer prices are falling at the fastest pace since 2009.

As realized inflation has remained stubbornly low, inflation expectations have also been stuck. For example, US five-year inflation expectations fell to around 1.15%, down from 1.25% the previous week. With inflation expectations still falling, a 2015 rate hike by the Federal Reserve (Fed) looks increasingly unlikely; even the odds of an early 2016 hike appear to be fading.

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