Stocks stabilise but risks rise, says BlackRock’s Koesterich

Russ Koesterich, BlackRock’s Chief Investment Strategist, says global risks have increased for investors.

Odds Rise That Fed Tapering Begins This Autumn

The recent better-than-expected economic data has come from modest firming in the manufacturing sector, as seen in the uptick in the ISM Manufacturing Survey, and a solid jobs report. While June’s non-farm payrolls report of 195,000 new jobs was by no means the long hoped for breakout in the labor market, it was consistent with the 190,000 average for the past year and strong enough to indicate the recovery is making progress. Although we see little evidence of the economy taking off, we continue to believe we should see slow improvement into year’s end.

However, there is a flip side to continuing progress in the recovery. Eventually, the Fed will have to pull back on its extremely accommodative monetary policy. At this time in the economic cycle, it means a tapering and eventual cessation of the Fed’s quantitative easing bond-buying programme. With a solid if uninspiring June payroll report, the odds rise that the Fed will begin to taper the rate of asset purchases sometime this autumn. As a result, investors are still looking to lower their exposure to the bonds the Fed has been buying, and Friday witnessed yet another bond market selloff (although we believe the magnitude of Friday’s selling was exacerbated by thin volume due to the holiday).

Risks Increase With Higher Rates
While markets can withstand a small rise in interest rates without derailing the rally, the risks going forward have risen. We saw on Friday that markets can weather a modest rate increase, as stocks rallied despite the selloff in bonds. And there is further evidence that investors are growing accustomed to somewhat higher rates: Despite the yield on the 10-year Treasury note remaining at or above 2.5%, $6bn flowed into equity funds last week. At some point, however, higher rates will create a more significant headwind for stocks. While there is no magic level, a prolonged and substantial move over 3% in the 10-year US Treasury yield would represent a risk to equities for several reasons. Higher rates would hurt corporate margins, slow the housing recovery and create more of an alternative for yield-hungry investors.

Global Risks Escalate
While the first six months of the year were mostly free of market-rattling headlines, the number of global risks that investors should watch closely has risen. With the exception of a brief scare over Cyprus banks, the political issues in both Europe and the United States have at least temporarily faded. Going into the second half of the year, we see a number of potential issues. Two in particular surfaced last week: fatigue with austerity measures in Europe and rising tensions throughout the Middle East.

The Portuguese government is the latest to show cracks. While Prime Minister Coelho’s government avoided collapse, the country is clearly struggling with divisions regarding its austerity approach. Elsewhere, the recent departure of the Democratic Left, one of the smaller political parties in Greece, puts the Grecian political coalition at risk. With Europe still mired in a recession and its banking system fragmented, we continue to view the region as a major risk factor.

Our other major concern continues to be the Middle East. With the recent collapse of the Egyptian government, and Syria still embroiled in a civil war, there is the potential for more unrest. In addition, political and terrorism risks have already impacted oil production in several countries, including Nigeria, Iran and Iraq. Fortunately, rising US production has offset these losses, but oil prices are creeping higher and any further disruption in production would likely send them higher still. While a stronger jobs market is helping the US consumer, higher gasoline prices would represent a painful headwind at a time when many consumers are still getting back on their feet.

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