In the past week, we've witnessed a violent shift in market sentiment amid fears of less monetary accommodation and more evidence of a slowing global economy. Stocks had rallied this year through May, mostly on expectations of continued easy money from the Federal Reserve. But after the Fed indicated last week that tapering could begin as early as this fall, stocks sharply reversed course and Treasury yields spiked. Concerns about Chinese growth only added fuel to the sell-off fire.
Market declines continued on Monday and I expect market volatility to last through the summer as investors remain uncertain about the future of monetary policy and the strength of the global recovery. That said, I wouldn't advocate abandoning stocks, as I write in my latest weekly commentary.
Here are three reasons why:
1.) The basic ingredients of the 2013 equity bull market remain in place. Nominal interest rates remain relatively low, inflation is not a threat and corporate balance sheets remain healthy. In addition, stocks are reasonably priced and still look cheap relative to bonds.
2.) The recent rise in yields is extreme. While I expect that bond prices will continue to come under pressure over the next year, a number of factors keeping a lid on rates still remain in place. In other words, while rates will likely continue to rise, I predict that ultimately the rise will be modest and include some near-term pullback. I expect that the 10-year Treasury will finish the year around 2.5%.
3.) The U.S. economy can probably withstand a reduction in the pace of Fed asset purchases, assuming a gradual taper that is not so aggressive as to derail the recovery. This could help support stocks.
For these reasons, I expect that equities will ultimately finish the year higher and I still like equities over the long term. However, there are areas of the equity market that warrant caution.
Bond market proxies (such as the utilities sector and REITs) look particularly vulnerable in an environment of rising real rates (It's important to note that higher real yields, not rising inflation, are driving today's higher nominal yields as investors are demanding more compensation for holding bonds). Instead, I prefer select cyclical sectors such as energy and technology.
In addition, I'm now advocating trimming exposure to certain emerging markets, such as Russia, and parts of developed Asia, such as Hong Kong, that will likely be hurt by less liquidity and a stronger dollar. But while I no longer have a preference for Russia, I still like emerging market equities over the long term.