The debt crisis in Europe and ensuing sell-off in risk assets in the second quarter have raised fears that the global economy could slip back into recession. We view these events as a speed bump for the recovery, and maintain a bias toward higher quality assets in light of their attractive valuations and tendency to perform well during periods of weak economic growth.
INVESTMENT THEMES
- Stay with risk assets: We have not changed our broad view that risk assets (including stocks, credit-related fixed income and commodities) should outperform in an environment of slow, but positive, economic growth.
- In equities, continue with quality: Our focus on higher-quality equities remains unchanged, and we believe good quality companies can be found across styles, capitalizations and sectors.
- Spread sectors remain compelling: We think investor demand for higher-yielding assets and favorable technical factors should support spread assets.
(Click here to view Mr. Doll and Mr. Arledge's asset allocation views.)
EQUITY MARKET OUTLOOK
At the beginning of this year, we described the macroeconomic backdrop as being a sort of tug of war between a cyclical recovery and ongoing structural concerns. For the first part of this year, the former dominated, but over the past couple of months, structural problems have won out, which has resulted in a significant downturn in global equity prices.
Investors have grown increasingly nervous about the potential contagion from the European sovereign debt crisis, and less positive economic data has called into question the strength of the ongoing recovery. It is a cliché (but nonetheless true) that markets loath uncertainty, and it is precisely the current high levels of uncertainty that have been dominating market action.
The bearish view is that renewed credit concerns will overwhelm a still-fragile global financial system, that the long-term threats of high inflation, large deficits and rising tax levels will become stronger headwinds and that equity markets are entering a bear market. From our perspective, these issues are real concerns, but are unlikely to come to fruition. When it becomes clearer that the economic recovery remains intact and when the ultimate resolution of European credit issues is better crystallized, we expect investors will return to a focus on market fundamentals, which should allow risk assets to embark on a renewed rally. As long as a renewed economic contraction is avoided, we believe equity prices should grind higher over the course of the year, albeit with continued high levels of volatility.
EQUITY VIEWS
- We have had a long-held view that investors should focus on high-quality equities in the current environment. The wrinkle we would add at present is as we expect markets to recover later this year, we would also expect those areas of the market that have been hit the hardest in recent months (i.e., cyclical stocks) to outperform, so a slight rotation to those areas would make sense.
- From a sector perspective, we have a particularly favorable view of telecommunication services and have upgraded our outlook on the consumer discretionary and utilities sectors. We still recommend a broad underweight to financials, but that sector is slowly improving. Energy stocks are looking less appealing in the short-term.
(Click here to view Mr. Doll and Mr. Arledge's outlook on equity markets.)
FIXED INCOME MARKET OUTLOOK
Investor fears over rising rates quickly dissipated as a combination of moderating economic performance and concerns over credit quality deterioration in European sovereign debt markets left many investors scrambling to adjust interest rate positioning. We continue to believe that a variety of structural headwinds will place limits on economic growth prospects, although we view a “double dip” recession scenario as a lower probability outcome. We also believe it will be important to see how regulatory regimes, such as the forthcoming Basel capital rules, are structured in the coming months; and we are closely watching political developments surrounding the November US elections.
Continuing investor demand for yield and favorable technical dynamics, such as moderate supplies of higher-yielding assets, provide a favorable context for strong performance by spread assets. As such, we continue to like the non-Agency mortgage-backed securities sector, despite modestly rotating capital from this sector to select high-yield names we find attractive. Moreover, various other spread sectors, such as higher-quality corporate debt issues that saw spreads widen over the quarter, look more compelling than the Treasury/Agency sectors or Agency MBS, where we have lightened exposures on solid gains amid risk averse market dynamics.
Turning to municipals, the negative headlines that have persisted for the last several quarters are expected to continue as the slowly improving economic environment has not translated into increased revenues for states and municipalities. While spending cuts are beginning to play a larger role in balancing budgets, stimulus monies from the federal government are running out, increasing the likelihood of further budget deficits.
FIXED INCOME VIEWS
- Investor thirst for yield amid a moderate supply of high-quality higher-yielding assets should support spread assets going forward.
- Although the supply of municipal debt continues to be manageable, a neutral stance is warranted as absolute yields are low while headline risk remains.
(Click here to view Mr. Doll and Mr. Arledge's outlook on fixed income markets.).
Bob Doll is vice chairman and chief equity strategist for fundamental equities at BlackRock Inc. Curtis Arledge is a managing director and CIO of fixed income, fundamental portfolios at the firm.
