In Treasuries, the Risks Outweigh the Rewards
By Russ Koesterich
May 2, 2013
- The 1Q GDP report was mixed, but the lack of income growth remains troubling.
- Oil prices are likely to remain range-bound, but that should be good enough to help energy stocks.
- While yields could decline further in the near-term, Treasuries look quite unappealing.
Stocks Bounce Back, but Dip on GDP Report
Following a notable downturn two weeks ago, stock prices managed to stage a recovery last week, but did falter on Friday in the face of a first-quarter gross domestic product report that was a bit worse than expected. For the week, the Dow Jones Industrial Average rose 1.1% to 14,712, the S&P 500 Index advanced 1.7% to 1,582 and the Nasdaq Composite climbed 2.3% to 3,279. In fixed income markets, Treasury yields continued to fall, as prices correspondingly rose. The yield on the 10-year Treasury declined from 1.70% to 1.66%
The first-quarter GDP report showed that the economy grew by 2.5%, less than expected but a significant improvement over the fourth quarter of last year. The data showed that the economy was dragged down by lower government spending (which should not have been a surprise given the sequester-related spending cuts), but, encouragingly, we also saw a healthy rise in household spending.
One problem with the economy is that higher spending has not been matched by higher income levels. We have been saying for some time that for the economy to continue to grow, consumers will need to make more if they are going to continue to spend more. On early Monday morning (April 29), the Commerce Department released March's personal income data, which showed only a 0.2% increase, less than the anticipated 0.4% advance. For the economy to continue to grow at the pace seen in the first quarter, we'll need to see improvements in this statistic; otherwise consumption is likely to slow, and with it, the overall economy.
Energy Stocks Continue to Look Attractive
In the aftermath of the recent selloff in gold, investors have been taking a closer look at commodities to see if there are any bargains available. Oil prices, in particular, have been a focus and while oil has declined in recent months, prices have been inching higher more recently and are above the $85-per-barrel level they reached earlier this month. Looking ahead, we expect energy prices to be range-bound. While global demand is growing, so too is production. We would expect oil prices to remain in a stable range between the high $80s and the mid $90s, absent a supply shock in the Middle East, which would arguably drive prices higher.
Though range-bound oil may not be that exciting, it may be enough to support an energy sector that has dramatically underperformed the rest of the market so far this month. US energy companies are now trading at a 20% discount to the broader market and just 12.5x trailing earnings, the lowest valuation of any sector. Additionally, large integrated oil companies are offering dividend yields of around 3%, likely welcome news for income-starved investors.
Lower Rates Suggest a Move away from Treasuries
It has been a surprise to many investors that while we are one-third of the way through the year, we have yet to see the increase in interest rates that many have been expecting. On the contrary, rates are lower than they were at the beginning of the year (the 10-year started the year with a 1.76% yield). The recent drop in interest rates can be attributed to a number of factors, including some weaker US economic data, renewed risk aversion due to Europe's ongoing debt issues and some highly aggressive asset purchases from the Bank of Japan.
While these factors could mean that rates might fall further in the short term, in our view Treasuries look extremely unattractive. Treasury yields are now below the rate of inflation, meaning that they offer little value beyond acting as a hedge against higher-risk assets. We would suggest that the recent drop in rates presents another opportunity for investors to lighten up on their Treasury holdings. As we have said in the past, we would encourage investors to look at the non-government sectors of the fixed income market, including high yield, which has managed to outperform other areas of the fixed income market on a year-to-date basis.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 29, 2013, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
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