Over the past three months, the macroeconomic backdrop has improved slightly with economic data moving from bad to less bad but not yet good, according to BlackRock’s Bob Doll, chief equity strategist for fundamental equities, and Peter Fisher, global head of fixed income.
However, both equity and fixed income markets are “pricing in a gloomier outlook that we expect. While we would continue to advise investors to proceed with caution, we believe this disconnect presents investment opportunities,” Doll and Fisher write in the latest edition of BlackRock Investment Directions.
According to the report, stocks are likely to continue to make modest gains in the months ahead. Nevertheless, it will take more than an absence of bad news for the rally to proceed further.
“In our view, equity valuations are attractive and, looking ahead, stocks appear likely to outperform Treasuries and cash over a two- to three-year time horizon.”
On the fixed income front, the duo continue to forecast a slow-growth environment, with low (and range-bound) interest rates and only moderate inflation levels, for the time being.
Since an anaemic recovery does not make for a sustainable long-term recovery, they think additional government action will be required to break out onto a more favourable trajectory. Should a significant expansion of the Federal Reserve’s balance sheet take place with quantitative easing, this would likely produce support for ownership of higher-quality spread sector assets.
In the equity markets, positive forces recently have been winning out, Doll notes, but investors have questioned whether the trend represents a move toward the upper end of the trading range or a longer-term, more positive shift in tone.
“While we acknowledge that a number of risks remain, we are leaning more toward the positive outlook,” he says.
Equities are underpriced at current levels, Doll believes: “The tricky economic backdrop suggests a continued focus on high-quality equities, but also some allocation to cyclical areas of the market,” he says.
From a sector perspective, Doll continues to favour telecommunications, and has grown more positive about healthcare, consumer staples and materials.
“We have adopted a more cautious view toward information technology and still believe that financials are facing a difficult environment,” he says.
In the fixed income markets, positive technical factors include considerable capital flows toward fixed income and limited supply in certain high-quality spread sectors.
“We continue to find value selectively in high yield bonds and securitized assets,” Fisher says. “With yield in short supply, we think these parts of the market should outperform higher-quality regions, such as Treasuries and agency MBS, although investors expecting to see a collapse in the prices of these high-quality assets (due to a purported ‘bubble’ in fixed income assets) are likely to be disappointed.”
Within the tax-exempt sector, Fisher says, the negative headlines that have persisted for some time should continue in the near term, as the slowly improving economic environment has not translated into meaningfully increased revenues for states and municipalities.
“Nevertheless, with tax-exempt yields at all-time lows, we see income as the greatest opportunity in new investments, as price appreciation potential from current levels will be difficult to achieve,” he says.
State tax-backed and essential service bonds, particularly the Southwest, Plains and Southeast regions, are favoured, Fisher says.
“We also like dedicated-tax bonds and housing issues. We have a less favourable view toward land-secured bonds, senior living bonds, bond insurers, student loans, pre-refunded bonds and local tax-backed issues.”