Rally Could Continue
January 31, 2012
Equity Market Outlook
Three months ago, stocks were pricing in about a 50% chance of a US recession and it looked increasingly likely that the European debt crisis would escalate into an Armageddon scenario. Today, while we would hardly say that the United States is poised to enter boom conditions or that the eurozone crisis has been solved, these risks have clearly receded, which has helped stocks to regain some footing. Our base case outlook is that these improving trends will continue along an uneven path, suggesting that stocks are poised for additional outperformance in the months ahead.
As was the case for the latter half of 2011, the key wildcard for global stocks remains the extent to which progress can be made in terms of resolving the European debt crisis. Over the closing months of last year, there did appear to be a change in tone among Europe’s policymakers and elected officials as they moved from a sort of complacency into taking more forceful action. The difficult decisions that need to be made combined with a contentious political backdrop in Europe do mean that progress will be slow and uneven, but we do expect it will continue.
Over the near term, we expect volatility levels will remain high given that we will likely see a “two steps forward, one step back” theme in both the eurozone debt crisis and in US economic growth. Nevertheless, we also expect that conditions should improve enough that investors will be willing to move back into risk assets. That trend, combined with attractive valuations and still-decent earnings growth, should set the stage for equity market outperformance.
Our main investing theme as we enter 2012 is a focus on free cash flow generation, particularly those companies that have the cash flow needed to increase their dividends. These types of companies can be found across capitalizations, styles and sectors.
From a geographic perspective, we continue to believe that the United States is better positioned than other developed markets. Regarding emerging markets, we may see a turnaround at some point in 2012, but we believe it is too early to make that call.
Taxable Fixed Income Market Outlook
Fears regarding European debt crisis contagion and, ultimately, the viability of the financial system and the euro have driven fixed income market volatility and flight-to-quality sentiment. However, we believe positive winds of change are afoot stemming from policymakers’ extension of banking system funding and support. These moves should mitigate near-term risks of a banking system failure that is a root cause of risk aversion. That said, considerable risks remain, particularly the speed of European bank deleveraging and its impact on the depth of the eurozone recession in 2012. If the deleveraging is measured or even postponed, the recession should be short and mild. However, accelerating deleveraging would create a negative feedback loop of credit contraction and credit losses, contributing to a more severe recession.
The United States, in contrast, continues to demonstrate surprising growth despite the negative impacts from the eurozone crisis and slowing growth in emerging markets. While we anticipate slowing from the current pace, easing of macro concerns in this context should induce higher interest rates in the intermediate to long duration part of the yield curve. However, expanded Fed QE potential in the face of any slowing in growth should limit the scope of potential increases.
With minimal US fiscal policy improvements available to ameliorate moribund housing and employment, we expect additional monetary stimulus in 2012 if the current pace of growth slows. This would dull volatility and take out some shock risk, leading to an upward move in abnormally-low interest rates, a negative for US Treasuries and long duration. As such, credit sectors such as high yield, securitized assets and agency mortgage backed securities will provide income while policymakers seek structural change.
Taxable Fixed Income Views
We continue to believe additional policy stimulus could come to mute volatility and support moribund employment and housing markets, taking out shock risk and encouraging risk-on trades.
Investors should anticipate a shift back to risk by reducing exposure to Treasuries and increasing exposure to risk assets, particularly credit sectors.
Municipal Market Outlook
Tax-exempt supply picked up in in the final quarter of the year, but continued to be met with strong demand, particularly from individual investors. Issuers’ return to the market seems to suggest greater fiscal optimism among political leaders and reduced anxiety around the idea of incurring debt. Notably, a year since the doomsday prediction of mass municipal bond defaults, Standard & Poor’s data reveals that muni bond defaults in 2011 were well below 2010 levels. In fact, munis were the best-performing fixed income asset class for all of 2011. With munis attractive on both an absolute and relative value basis (as well as being less volatile than comparable US Treasuries) we believe the asset class remains compelling. Given low absolute rates currently, we believe performance will be driven by yield curve positioning, accrual of principal and capital preservation.
Municipal Market Views
We continue to favor a barbell approach to yield curve positioning, with exposure to both long and short maturities. We recommend overweighting state tax-backed and essential service bonds, as well as revenue sectors such as hospitals, transportation, housing and education.
We are less inclined toward land-secured bonds, senior living bonds, bond insurers, student loans and local tax-backed issues.
The stated investment preferences are the opinions of the authors and do not reflect individual investor’s risk and return goals. Individual investors should consult with their financial professional about how to implement these opinions into a portfolio that is suitable for their goals and risk tolerance. A “Neutral” preference indicates a recommendation that investors should maintain their long-term allocation regarding that investment decision. These views do not necessarily reflect the investment decisions made within specific BlackRock portfolios.
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 January 9, 2012, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that, in certain respects, may not be consistent with the information contained in this report. 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. Stock and bond values fluctuate in price so that the value of an investment can go down depending on market conditions. 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. These risks are typically heightened for investments in emerging markets. Investments in the natural resources industries can be significantly affected by events relating to those industries, such as variations in the commodities markets, weather, disease, embargoes, international, political and economic developments, the success of exploration projects, tax and other government regulations, as well as other factors. 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. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income from municipal securities may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions on municipal securities, if any, are taxable.
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