A Time to Take Stock – and Advantage of Pockets of Value

Weekly Commentary Overview

  • Equities around the world struggled last week, driven by a couple of catalysts: China slowing, and expectations (and some confusion) around a Federal Reserve (Fed) hike.
  • Investors find themselves in a bind of sorts, caught between two contradictory risks: an emerging market-induced slowdown in the global economy and the prospect of an upcoming interest rate hike by the Fed.
  • As such, it is understandable that many investors are tempted to head for the doors and abandon stocks and other risky assets.
  • But rather than exit the markets, we believe investors should view this as an opportunity to take advantage of pockets of value that have emerged, while also recognizing that more volatility could be ahead.

Another Rough Week

Another week, another selloff. Stocks tumbled again last week with the S&P 500 Index falling 3.37% to 1,921 and the Dow Jones Industrial Average declining 3.25% to 16,102. The tech-heavy Nasdaq Composite Index struggled as well, down 3.00% to 4,683. Meanwhile, bond yields were relatively unchanged, with the yield on the 10-year Treasury slipping from 2.18% to 2.13%, as its price correspondingly rose.

Investors find themselves in a bind of sorts, caught between two somewhat contradictory risks: an emerging market-induced slowdown in the global economy and the prospect of an upcoming interest rate hike by the Federal Reserve (Fed). As such, it is understandable that many investors are tempted to head for the doors and abandon stocks and other risky assets. But rather than exit the markets, we believe investors should view this as an opportunity to take advantage of pockets of value that have emerged, while also recognizing that more volatility could be ahead.

China Slumps, as the Fed Argues in Front of the Children

Equities around the world struggled last week, driven by a couple of catalysts. One was further evidence of weakness in China; a manufacturing gauge hit a three-year low, while a key measure of services also disappointed, falling sharply from July's level. The softness in China is also having a noticeable impact beyond its borders, particularly in places that depend on commodities exports. Both the Russian ruble and Brazilian real have come under significant pressure lately. But even developed countries are feeling the effects: Canada slipped into a recession during the first half of the year, and Australia’s second quarter gross domestic product has revealed an economy struggling with the precipitous drop in commodities prices.

The other specter spooking markets is closer to home: the Fed. Last week, investors were faced with numerous and somewhat contradictory statements from various Fed officials. This cacophony of views only added to the confusion over what path and pace the Fed is likely to adopt.

The uncertainty was particularly acute on Friday, following a "good enough" August payroll report. While job creation was below expectations, the unemployment rate fell to 5.1%, the lowest since 2008, and hourly earnings accelerated.

The U.S. economic outlook is less than ideal, but the data in recent weeks have been strong enough to allow the Fed to still hike later this fall. To the extent it would be hiking into an environment of falling inflation expectations—which means even higher real, or after-inflation, interest rates—this is also troubling investors.

Investors may be feeling unnerved from the recent roller-coaster ride in the markets, but it is important to maintain perspective.

A Moment to Exit – Or Seek Opportunities?

As we have been discussing since early August, volatility was bound to rise given slowing economic growth and the likelihood of an impending Fed hike. Indeed, the recent correction has returned some value to markets. Still, we expect volatility to remain elevated until either global growth stabilizes and/or investors get some clarity from the Fed.

But we do not believe investors should be abandoning risky assets. Our basic portfolio positioning is unchanged: We would still favor a portfolio tilted toward equities, select credit, tax-exempt bonds and inflation protection through Treasury Inflation Protected Securities (TIPS) rather than physical commodities. And we would look to take advantage of some pockets of value, as well as assets that are best positioned in the current "Fed hike, but low-growth environment."

Starting with stocks, we would suggest adding to positions in international developed markets, particularly Europe, which remains attractively priced and is seeing an improving economy. New economic data revealed that euro-area unemployment fell to the lowest level in three years. In addition, given stubbornly low inflation and concerns over global growth, there is also the prospect for an extension of the current quantitative easing program. In the U.S., we see large-cap, cyclical companies as best positioned to withstand the start of the Fed's tightening cycle.

We also maintain a preference for credit within fixed income. Despite the equity market volatility, high yield has stabilized over the past week and yields remain attractive. Investment-grade credit is also looking cheap, although investors may want to hold off until later this fall given pending supply. Finally, as we have been noting, tax-exempt bonds are offering compelling yields relative to taxable instruments of the same maturity. Despite the recent rise in volatility, municipals have held up relatively well.

Areas where we would remain cautious include U.S. Treasuries and commodities. On the former, with inflation expectations still near recent lows, we’d prefer to get our duration from TIPS rather than traditional Treasuries. On commodities, we would remain cautious. This asset class has struggled all year and will continue to be pressured by sluggish growth, oversupply and the potential for a Fed-induced strengthening of the dollar.

Overall, however, this is an environment in which it is best to prepare for more bumps in the road, but stay the course and make sure you are taking advantage of opportunities along the way as we enter the fall season.

Russ Koesterich, CFA
Global Chief Investment Strategist and Head of the Model Portfolio & Solutions Business

© BlackRock

© BlackRock

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