Investor concerns increase, but an early Fed shift remains unlikely says BlackRock’s Russ Koesterich
One of the primary causes of higher levels of volatility and increased selling is the fact that investors are attempting to position their portfolios for a coming shift in US monetary policy, says Russ Koesterich, BlackRock’s chief investment strategist
As we have been saying for several weeks, one of the primary causes of higher levels of volatility and increased selling is the fact that investors are attempting to position their portfolios for a coming shift in US monetary policy. That is one of the reasons money is flowing out of emerging markets: there is a perception that emerging market countries will be negatively impacted by a tighter monetary policy given that a less liquid environment in the United States could translate into diminished demand.
While we believe it makes sense to focus on Fed policy, recent reactions appear to us to be extreme. We agree that it is likely that the Fed will begin to taper its current policy at some point late this year or by early next year, but any movement by the Fed will be gradual (and communicated well in advance) given that large segments of the US economy are still quite lethargic. We saw more evidence of this in last week’s economic data. While May’s retail sales figures were better than expected, the manufacturing sector remains weak. May’s industrial production report confirmed that manufacturing levels continue to slow. Industrial production grew at a scant 0.1% in May, a number that was below expectations and one that followed two straight monthly declines.
Even when the Federal Reserve does begin to move toward a less accomodative monetary policy, the effect of the tapering may be more muted than many investors anticipate. To be sure, the Fed will be buying fewer Treasuries when this happens, but with the US budget improving (at least temporarily) the available supply of Treasuries will be lower. Additionally, other central banks (not to mention pension funds) around the world remain large buyers of Treasuries, which should help maintain demand levels. All of this suggests that when the Fed does begin to taper, the backup in yields should be tempered.
Risks Receding in Europe?
Turning from the United States to Europe, we are starting to see some indications of improvements. To be sure, Europe still has a host of problems. Unemployment remains at a record high and bond yields in Italy and Spain are still creeping higher. We are also seeing a potential roadblock on the horizon in the form of a pending ruling from the German constitutional court on the legality of the European Central Bank’s proposed asset purchase program. All of that said, however, Europe has one distinct advantage: low expectations. In the current environment, even modest signs of good news can have a positive impact on the region.
As such, while we would remain cautious on European equities, our view has turned less bearish, even on some of the peripheral countries such as Spain. The country still faces some severe headwinds, and the Spanish economy is likely to struggle in the coming year, but following some improvements in the real estate and banking sectors, Spanish corporate profits should start to recover. Additionally, after massively underperforming Europe and other developed markets, it appears to us that bad news is already priced into current valuations on Spanish equities. This is hardly to say that we have become bullish on Spain, but the outlook is modestly improving.