by Russ Koesterich, BlackRock’s Global Chief Investment Strategist
U.S. Stocks Lag the Rest of the World
It was a mixed week in the world’s stock markets. As equities in Europe continued to advance and emerging markets rallied, U.S. stocks struggled once again. While the S&P 500 Index inched up 0.24% to 2,066 and the Dow Jones Industrial Average managed to rise a modest 0.29% to 17,776, the Nasdaq Composite Index lost 0.71% to close the holiday-shortened week at 4,886. As for bonds, the yield on the 10-year Treasury fell from 1.96% to 1.84% as its price correspondingly rose.
U.S. stocks are facing a significant headwind in the form of falling earnings expectations, partly a function of a pronounced slowdown in the U.S. economy. We expect economic growth to re-accelerate in the second quarter, which should prompt the Federal Reserve (Fed) to raise short-term interest rates this fall. That said, long-term interest rates are likely to remain muted, leaving income investors still searching for yield, and perhaps turning again to high yield bonds.
Data Disappoint
U.S. stocks were helped last week by more merger news, notably the announcement that UnitedHealth would buy Catamaran for $12.8 billion. But merger announcements are not enough to lift stocks in the face of bigger uncertainties. The problem for U.S. equities is that with the Fed preparing to raise interest rates, removing the tailwind of quantitative easing, markets are now reliant on company earnings growth. Unfortunately, there is little to be found. Analyst estimates suggest first quarter earnings for the S&P 500 will be down 5% from this point last year. Companies are struggling with multiple factors, including softer-than-expected economic growth, the rapid appreciation of the dollar and a modest acceleration in wage growth. Indeed, McDonald’s became the latest company to announce an hourly raise for employees at company-owned locations.
Part of the recent soft growth is admittedly a function of two temporary factors: a brutally cold winter and the West Coast port strike. That said, it is worth reiterating how much economic numbers have disappointed of late. U.S. economic surprises continue to run at the most negative level since 2009. Last week brought several more examples: The Chicago Purchasing Managers Index plunged in March to 46.3, its lowest level since 2009. ISM New Orders fell to 51.8, the lowest since the spring of 2013. Finally, March’s payroll gains were 126,000, below even the most pessimistic expectations, although we continue to believe the underlying fundamentals of the labor market remain strong. All told, first quarter gross domestic product is likely to disappoint, as has been the pattern for most of this recovery.
The Quest for Yield Remains Challenging
Against this backdrop, it should not be surprising that bond yields remain low. This trend has been exacerbated by foreign central bank bond buying and a dearth of new supply. But low U.S. yields are also a function of even lower yields outside the United States. Currently, 25% of the European sovereign bond market is trading with a negative yield. In France, government bonds of up to three years carry a negative yield. In Germany it is eight years, and in Switzerland 10 years. In this context, a U.S. 10-year bond offering a roughly 2% yield and backed by a strong currency actually seems appealing.
We still believe a strengthening labor market will lead the Fed to hike later this year, probably in September. But this is most likely to manifest in what is referred to as a flattening of the yield curve. In other words, we are likely to see a greater lift in shorter-term interest rates, with a less substantial rise in long-term rates.
With rates stuck near historic lows, investors are left stretching for income wherever they can find it, which helps explain why last week’s fixed income inflows of $2.9 billion were led by U.S. investment grade and high yield funds. In this context, we would maintain our overweight to high yield bonds. In recent weeks, the spread (or difference) between the yield of the 10-year Treasury and a high yield bond of comparable maturity actually widened a bit, roughly 0.45%, restoring some value in the space. In an environment of generally decent (albeit recently disappointing) growth and gently rising yields, high yield offers attractive potential in a yield-starved world.