Expect more volatility. Choose equities over bonds.
These are two of the conclusions of the BlackRock Investment Institute’s (BII) mid-year investment outlook.
The report suggests:
- Global monetary policy is diverging and the era of easy money is slowly ending. Distorted markets are resetting but could overshoot.
- The Fed is ready to wind down bond purchases if U.S. economic momentum holds. Economic data and jobs numbers take center stage.
- Risks are increasing, including a potential emerging market funding crunch and spike in real interest rates. Volatility is back.
Other highlights include:
- The Fed: The Fed has sketched out a plan for gradual QE withdrawal but made clear the pace depends on economic data. Other signposts include Europe making progress on cleaning up and recapitalizing its banks, and Japan not just talking about labor market reforms and deregulation but implementing them.
- Emerging Markets: Funding strains in some emerging economies are real and could get worse, but an exact repeat of the 1997-1998 Asia crisis looks unlikely. The most vulnerable countries are those dependent on external funding. This shows up in current account deficits and plummeting currencies. Disparities among emerging markets are growing fast—and so are disparities among returns. Picking the right exposure is more crucial than ever.
- China: Its economy is slowing—but those expecting a monster stimulus are probably daydreaming. If anything, China is reining in alarming credit growth. This is good in the long run, but can cause market disruptions in the short term.
BII’s investment recommendations for the rest of 2013:
- Big Picture: Favor equities over bonds but brace for a lot more volatility. Many bonds still look expensive and risky.
- Up and Down: Expect more market gyrations as policies, economies and currencies diverge.
- Hidden Risks: Correlations rise in periods of market stress, making portfolios riskier than they appear.
- Chemical Reaction: Beware of liquid assets suddenly turning into solid mass.
- On the Offensive: Slowly move to cyclical stocks from crowded income plays and defensives. Valuations between high- and low-quality stocks are near record levels.
- Structural Bond Bid: Rising rates will probably be capped by limited supply and steady institutional demand for yield. We favor the short end of the curve for now.
- Emerging Bargains: Emerging equities look good on most measures except free cash flow—which matters if financial conditions tighten. Wait for currencies to stabilize before sorting through the bargain bin.
- Awaiting Further Sales: Most emerging debt looks fully priced after an issuance boom brought to market risky bonds at high prices. Relative value is key.
- Red Flags: Watch currencies for funding strains in emerging markets and the drivers of real rates for signs of deflation in the developed world.
- Flow Flux: Bumper inflows into fixed income funds now look at risk of reversing. Investors who (mistakenly) saw bonds as money market substitutes may bail.
- Dawn in Japan: Our Japan trade (buy equities and sell the yen) is still on for now. structural reform is needed to propel Tokyo stocks much higher.