by Russ Koesterich, BlackRock
Overview
• Stocks rose again with the S&P 500 closing over 1,500 for the first time in five years.
• Treasury yields also rose, a trend that should continue in the year ahead.
• In this environment, investors should consider focusing on sectors such as high yield, bank loans and muni bonds.
Equity Rally Continues While Treasury Yields Begin to Rise
Stocks rose yet again last week, as strong early-year market conditions persisted. . For the week, the Dow Jones Industrial Average advanced 1.8% to 13,895, the S&P 500 Index rose 1.1% to 1,502 (marking the first time the index closed above 1,500 in five years) and the Nasdaq Composite climbed 0.5% to 3,149. For the year, stocks are already up over 5%. Bond markets also saw some movement with Treasury prices falling. The yield on the 10-year Treasury rose to 1.94% on Friday from less than 1.8% at the start of the week (bond prices move in the opposite directions of yields).
We expect yields to rise in a slow and erratic process over 2013,
climbing to perhaps 2.25%, which is where they were last March.
Treasury Yields Should Climb, Warranting Caution
Last week’s advance in the 10-year US Treasury yield has many investors wondering whether or not we are finally seeing the long-awaited back-up in rates. Our answer would be a qualified "yes." We expect yields to rise in a slow and erratic process over 2013, climbing to perhaps 2.25%, which is where they were last March.
One of the main reasons yields are unlikely to experience a more significant increase is that central banks remain major purchasers of Treasuries. The US Federal Reserve is still buying $45 billion worth of Treasuries each month and will likely continue to do so at least through the middle of this year. Other central banks, including those in China and Japan, are also still large buyers of Treasuries. Additionally, institutional investors such as pension funds and commercial banks are also continuing to purchase Treasuries, which they can use as a hedge against their liabilities. Finally, we would point out that while US Treasuries are still continuing to be issued, the net supply of bonds has been shrinking, meaning that the supply/demand dynamic has been propping up Treasury prices. The bottom line is that while a slowly improving economy is putting upward pressure on rates, there are enough competing sources of downward pressure that should prevent yields from rising too dramatically or too quickly.
Given this backdrop, we still believe Treasuries are unattractive and would encourage investors to approach this sector of the market cautiously. When adjusted for inflation, Treasury yields are flat or negative (as are Treasury inflation-protected securities (TIPS)), making them unattractive sources for income. Additionally, the potential for rising rates makes Treasuries even less attractive (rising yields reduces the attractiveness of currently held fixed income instruments). As such, we would encourage investors to migrate away from interest-rate-risk-based areas of the market (i.e., Treasuries) and toward credit instruments. In particular, we would focus on such areas as high yield, bank loans, emerging markets debt and municipal bonds as alternatives to Treasuries.
Fiscal Policy Risks Take a Breather (For Now)
As was hinted at the previous week, last week the House of Representatives passed a bill that would suspend the debt ceiling issue through the middle of May. This move does lessen the near-term risks of a government shutdown or default, but does not represent any sort of significant change since no one really expects the United States to default on its debt. We would view last week’s action as a minor positive for the economy and for risk assets.
The major fiscal policy issues remain unaddressed: Washington is getting no closer to a long-term budget deal and the national debt is growing faster than the overall economy. This is, and has been, a long-term issue and is unlikely to disrupt the markets in the short-term, especially since the debt ceiling threat has been postponed.
With fiscal issues moving to the sidelines, stocks and other risk assets have been able to advance. Our view is that this trend can continue for a bit longer, with the next significant threat coming in February or March if and when we begin to see evidence of an economic slowdown brought about by higher taxes and spending cuts.
