Dealing with Divergence

Central bank and economic divergence have been the underlying themes in my recent writings, and these are having, and will continue to have, significant influence on financial market direction. Going into 2015, how does that impact your investments, and where should you focus your attention? This is the focus of BlackRock’s 2015 Market Outlook, released today.

First, some background. These last few post-crisis years could be called the Age of Recovery: The Federal Reserve and other central banks have kept interest rates extraordinarily low to try to revive their economies. In doing so, they’ve helped stocks, but the low rates have made it much more difficult for investors in need of income. In addition, a period of unusually low rates has had the predictable effect of pushing up valuations in several asset classes as investors stretch for yield.

Now we are entering what we at BlackRock are calling the Age of Divergence: The U.S., U.K. and select emerging markets are getting stronger while other regions—including much of Europe—are still struggling. The result is that central banks are beginning to take different paths, with the Fed setting a course for higher interest rates and the European Central Bank and Bank of Japan doing the opposite.

What does this mean for you and your investment portfolio in the New Year?

One of the consequences of the diverging central bank actions is that it should lead to a stronger dollar. That has implications for the markets, such as downward pressure on both commodities and inflation.

With equities, it is hard to find bargains, but we believe stocks are still the best place to be. But you’ll have to be even pickier about the stocks you select and consider expanding your investment horizons beyond the U.S. We prefer U.S. cyclical stocks, Japanese equities, and emerging markets in Asia, but are keeping an eye out for opportunities in Europe, where the looser monetary policy could help stocks, particularly cyclical companies.

As for fixed income, we would still tread lightly in the bond market. Short-term bonds will bear the brunt of a Fed rate hike. Indeed, as a write in in my weekly commentary, this is already starting to happen; the yield on the two-year U.S. Treasury rose last week to over 0.65%, the highest level since the spring of 2011. Longer-term rates, on the other hand, should inch up at a gentler pace and are likely to remain low relative to their history. But all of this means finding a steady income stream will continue to be a challenge.

This is the world as my BlackRock colleagues and I see it. Of course, as is always the case in financial markets, uncertainty is one of the few certainties. In particular, we believe that most of the geopolitical trouble spots throughout the world are ‘frozen conflicts’; few are likely to be reconciled over the next year. Here at home, the big risk would be a quicker tightening campaign by the Fed that takes investors by surprise.

Overall, however, investors should avoid the temptation to cash out all their gains. Stocks may not march upward in a straight line, but we believe they should continue to do relatively well in 2015—and better than bonds and cash.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist.

This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

©2014 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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