Despite Federal Reserve concerns, equities still look attractive, BlackRock’s Russ Koesterich says

Expect more volatility but keep investing in stocks,Russ Koesterich, BlackRock’s Chief Investment Strategist, tells investors.

Investor Sentiment Sours
It does seem clear that market sentiment has shifted in recent weeks, primarily due to the fact that investors are uncertain about the future path of monetary policy. For years now, policy has moved in only one direction (toward easing) and investors are highly unnerved by the prospect of even a well telegraphed and gradual change by the Federal Reserve. In our view, the economy can probably withstand a reduction in the pace of Fed asset purchases (or “tapering” as it is being called), but investors are certainly rattled. The most visible evidence of this can be seen in the recent outflow from bond funds, which lost $7.5 billion last week.

It is important to note that the selloff in Treasuries and the exodus from bond funds is occurring at a time of lower inflation expectations. In other words, the climb in yields is not being driven by inflation expectations, but rather by investors demanding more compensation to hold bonds. This backup in rates has been particularly harmful to asset classes such as gold and US dividend-paying stocks, which have been hit hard in recent weeks.

In addition to concerns over Fed policy, markets have been responding to additional evidence that the global economy is slowing. Last week brought new evidence on that front in the form of weaker Chinese manufacturing data. Although investors have become accustomed to slower growth, they are less used to seeing a slowdown in emerging markets and Asia, which until recently have been holding up relatively well despite weaker data from the United States and Europe.

Expect More Volatility, but Stick with Stocks
So what does all of this mean for the financial markets? First and foremost, we would point out that higher levels of market volatility should persist for the coming months, but the case for stocks remains intact. Investors are likely to continue to struggle with the possibility of a less dovish Fed and with weaker growth, which will translate into higher levels of uncertainty. That said, however, the basic ingredients of the equity bull market remain intact. Stocks are reasonably priced, interest rates are low, inflation is not a threat and corporate balance sheets remain healthy-all reasons why we believe stock prices should move higher over the intermediate term. There are areas of the market that warrant caution, however. The utilities sector (which is often viewed as a bond market proxy) looks particularly vulnerable in an environment of rising rates.

Additionally, while we have a favourable long-term view on emerging markets, we would suggest increased caution toward areas of the market that may be especially vulnerable to a tighter liquidity environment and a stronger US dollar, such as Russia. For the same reason, we are growing more wary of Hong Kong.

Within fixed income markets, the recent spike in Treasury yields may be extreme and it is certainly possible that we will see some sort of pullback as volatility persists, but we do believe that upward pressure on yields will persist for the coming year. As such, we continue to believe Treasuries (and agency mortgages) look unattractive and we would advocate underweight positions to these sectors. At the same time, while prices for TIPS (Treasury Inflation-Protected Securities) and gold have dropped noticeably, we still view these inflation hedges as expensive and vulnerable to rising rates.

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