One Man’s Opinion: Is The Fixed-Income Market Still Overvalued?

92835431Stocks are still the right long-term buy because of valuation, says Russ Koestrich, chief investment strategist at Blackrock Inc.  Blackrock preferred stocks over bonds at the beginning of the year and continues to do so. It had predicted more volatility this summer, partly because of a slowing economy, and partly because investors adjusting to the notion that monetary policy won’t be as accommodative going forward, Russ added.

If investors look at the long-term, they have to go back to relative valuation, he said. Bonds, even after the latest sell-off, are still extremely expensive because they have been bought by the central banks for most of the last four years. As a result their valuation doesn’t reflect all of the economic realities. Equities are not as cheap as they were at the beginning of the year, but they still look reasonably valued by most measures, particularly outside of the United States where most stock markets are fairly cheap, Russ noted.

Asked if investors should be scared of the impending tapering of QE by the Federal Reserve, Russ said the Fed will probably start tapering later this year or early 2014 and it’s going to take a very long time to unwind. So, investors should remember tapering doesn’t mean selling, it just means slowing down or stopping the rate of purchase. The Fed, like many other central banks of the world, is likely to have a very bloated and expanded balance sheet in the years to come; and hence it will be a very long unwind. This, in turn, changes where one wants to be in the market. The big beneficiaries over the last year, particularly the early part of this year, were bond market proxies like utility companies and REITs. Those parts of the market don’t look that attractive now in an environment of rising interest rates, he pointed out.

Asked if that means moving out of defensive stocks and moving into cyclicals, Russ answered in the affirmative. The reason for it is two-fold, he said. One, the Fed is only going to taper if the economy gets better, and if the economy gets better, investors should try to leverage it through cyclicals. Second, in an environment where real rates are rising the way they are, parts of the market that get hit the worst on that are the bond-market proxies. Defensive sectors, which are basically a dividend play, is the part where one should be underweight, he observed.

Asked which stocks investors should focus most on since all cyclical stocks are not equally sensitive to economic cycles, Russ said Blackrock is focused on energy. It’s been very instructive that when many commodities sold-off last month, energy prices held on there.

There has been a renaissance in US energy production that also benefits some of the manufacturing companies. Chemicals and plastics will benefit from cheap natural gas. But he will be much more cautious about the cyclicals that are tied to consumption. Though the consumer is getting better, the housing market is getting better, there’s still not much income growth. That can result in a pullback in consumption in the near-term which makes him want to leverage energy and manufacturing, and not consumer, Russ added.

Asked to comment about the lack of private sector investment that could potentially offset the sequestration, Russ said there have been some improvements, though they were not enough to offset the drag from the fiscal side. This is one of the reasons why he’s a little bit cautious about consumers because many things are going on in the realm of the economy.

There has been a housing rebound and improvement in energy production. But there’s still not enough strength in the labor market that can produce organic income growth. Until that happens, the economy will still be in a bit of a slow-growth mode, he added.

Asked which indicators give him the confidence that the economy is getting better, Russ said one is job creation, which the Fed is watching, and the other one is real income. The day there is an uptick in consumption and an uptick in the economy, it’s got to come from a stronger income-growth from the household sector, he noted.

Investors should not panic despite the recent slump in markets. There has been a lot of volatility and violent movements in the bond markets, but in the context of last five years, it’s still a relatively mild correction. They should prepare for more volatility this summer, but should look for parts of the market where there are energy companies, and some international parts of the market where they can increase their long term exposure where they can use the excess volatility to their advantage, Russ concluded.

You can watch the video here.

 

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