In the wake of a flurry of US economic data that further underlines the uneven, troubled nature of the US recovery, Blackrock advises investors to beware of asset classes tied to rising real interest rates.
The economic reports, released last week, covered third-quarter gross domestic product (GDP) figures, the Institute for Supply Management Survey and October’s jobs figures - all pretty high profile readings for investors.
Investors took the data, in their stride, with stocks climbing modestly for the week. Dow Jones advanced 0.9% to 15,791, while the S&P 500 Index rose 0.5% to 1,770. The Nasdaq Composite was down fractionally to 3,919.
In fixed income markets, Treasury yields rose as prices correspondingly fell (with the 10-year Treasury moving from 2.62% to 2.75%), largely due to growing speculation that the Federal Reserve would soon announce its long-awaited plans to begin tapering its asset-purchase program.
Russ Koesterich, BlackRock’s global chief investment strategist says the common theme across all three sets of data was that the US economy is improving, but "remains troubled by the long-term structural problems of slow wage growth, weak consumption and a shrinking labour force".
Certainly the headline numbers were impressive, with the economy unexpectedly accelerating to a 2.8% growth rate in the third quarter and with a higher-than expected 204,000 new jobs created last month. But Koesterich cautions: “ A look behind the numbers showed some troubling signs. Much of the acceleration in growth last quarter can be attributed to a temporary build-up in inventories.
“Furthermore, both the GDP report and the jobs report painted a picture of an economy that is not creating jobs fast enough to put any real upward pressure on wages—a fact that is hurting consumer spending.”
He adds that while the dynamic of modest growth and stagnant wages is not benefiting many households, it is proving to be a boon for corporate earnings: “We’re well into the third-quarter earnings season, and so far we’ve seen almost 75% of companies beat earnings estimates, while just over half have experienced better-than forecasted sales. In other words, while only about half of the companies have been able to beat their top-line forecasts, many more have delivered impressive bottom-line results—thanks in large part to slow wage growth.
“This strong trend in corporate earnings has been a key factor in supporting this year’s rally in stocks. We believe this can continue into 2014, although higher rates suggest that any gains are likely to be accompanied by more volatility.”
Looking ahead, Koesterich reckons the current dynamics for the US —slow but improving growth, muted spending, low inflation, and a slow grind higher in real interest rates— will persist at least into early 2014.
“We would be most cognizant of that last factor [rising real interest rates] when thinking about portfolio construction. While we do not expect interest rates to rise quickly or dramatically, we do think they are headed higher, which would represent a significant obstacle for certain asset classes.”
As such, Koesterich suggests investors underweight those areas of the market that are most sensitive to increases in interest rates – US Treasuries and Treasury Inflation Protected Securities (TIPS) would be at the top of that list – but stocks that serve as proxies for the bond market and gold also warrant some caution. He says: For stocks, we’re thinking specifically of the consumer staples and utilities sectors. Both came under pressure [last] Friday when bonds sold off, a not-uncommon trend.
As for gold, he believes the precious metal has a place in investors’ portfolios, but notes that an environment of rising real rates tends to be a headwind for gold. Since late October, for example, real rates have climbed roughly 20 basis points, and at the same time, gold prices dropped approximately 4% to 5%.