Russ Koesterich, CFA

Mutual fund manager, bonds, commodities
Russ Koesterich, CFA
Mutual fund manager, bonds, commodities
Contributor since: 2011
Company: BlackRock
Yes, but at a significantly reduced weight. The reason I would not eliminate them entirely is that they do provide some diversification benefit, even compared to other fixed income assets.
Generally when I refer to mega caps, I’m thinking of the S&P 100.
Thank you all for the comments. My list of the 15 riskiest countries was not meant to be an exhaustive list of all countries in the world. Instead, it was meant to be a look at the riskiness of a tradable subset of countries, meaning that there are liquid instruments to get exposure to those countries. Thus, some countries like Venezuela weren’t included. Other countries like Greece, Portugal, Ireland and Argentina weren’t included in the analysis as I question their efficacy as reliable vehicles to trade risk due to their dependency on idiosyncratic political issues.
To analyze our subset, we relied primarily on realized one-year USD return volatilities of the countries’ MSCI country indices as measures of risk. Countries that have a relatively stable currency relative to the dollar would show up as less risky.
Meanwhile, the United States didn’t make the list as it has relatively low volatility compared to other countries, particularly emerging markets, and even though China is an emerging market, it’s somewhat less sensitive to “risk on/risk off” than other emerging markets thanks to its stable currency.
Because it slows economic growth and volatility moves inversely with economic activity.
Thanks for reading. Certainly a full blown European crisis would negatively impact US credit creation. However, to the extent this can be avoided and we're instead dealing with continuing deleveraging by the European banks, then I believe the US will be relatively unaffected, particularly in comparison to other countries such as emerging markets in or around Europe that are likely to bear the brunt of the asset disposition.
I actually agree as far as physical real estate is concerned. If you own the bricks and mortar variety, as you suggest, real estate has been a good way to hedge against inflation. The record on REITs is more mixed. While rents go up, multiples have often contracted during periods of unexpected inflation. This, at least historically, has made REITs a less effective inflation hedge.
Very long term return estimates look different. Looking at returns going back to 1896 – more reliable as you have more data points – the seasonal bias is not nearly so clear cut. May and June tend to be weak and September is clearly negative. That said, historically, average returns in July in August are 1.33% and 1.24% respectively.
While I would agree that today’s large spreads are mostly driven by Treasuries being artificially expensive, rather than investment grade being particularly cheap, negative real yields in the Treasury market still argue for underweighting Treasuries and raising allocations to other sectors, like investment grade. In terms of the relative attractiveness of investment grade to high yield, spreads are well below their long-term average. Currently, high yield is only yielding about 200 bps over BBB, well below the 25-year average of 310 bps.
Thanks for reading and for the comments. While I agree that bonds look very expensive relative to equities, bonds are inherently less volatile than stocks. And while stocks are arguably the better value, few investors are likely to accept the volatility that would accompany an all equity portfolio. This is why I expect that most investors will maintain some significant allocation to fixed income. My view is that investors should raise their equity allocation and lower their fixed-income allocation relative to whichever benchmark they follow.
The rally off of the fall lows has been largely driven by liquidity and accompanying multiple expansion. While I believe the market can move higher in 2012, further gains are likely to be driven by earnings growth - which will be positive, but modest - and be accompanied by more volatility.
I agree, though I would phrase it differently: Equities can withstand inflation. However, unexpected inflation - which generally tends to be more abrupt - is what typically leads to multiple contraction.
Typically the correlation with equities has been considerably higher for high yield than for investment grade. This basically reflects the fact that high yield has had a stronger correlation with economic growth than any other segment of the bond market.
On the valuation side, I do think that the lower end of the investment grade space, i.e. BBB, has room for modest spread compression. In terms of sensitivity to rates, I would agree that this is a major risk and it’s why I generally prefer equities to bonds. That said, I do think that within the fixed income space, investment grade credit appears to be relatively cheaper than Treasuries or even high yield.
On municipals. I would agree that a number of smaller, municipalities are at risk. My view is that the state GO obligations are offering a significant premium over Treasuries with only a modest increase in risk. For that reason, I would stick with the higher quality issues.
The Fed is purchasing a significant amount of long-dated Treasuries (the exact percentage depends on which timeframe you’re referencing). Effectively, this is the equivalent of printing money. The Fed buys the Treasuries and credits the Federal Reserve account of the bank it bought the Treasuries from. This has the impact of increasing the monetary base, which is currency + bank reserves. Basically, the Fed is creating money out of thin air. Now, while Fed lending impacts the monetary base, it doesn’t impact the money supply until banks use their new reserves to extend credit to customers. While the Fed can technically keep this up indefinitely, as bank lending rises, this policy runs the risk of stoking inflation. Given the dearth of private borrowers for Treasuries, cessation of the Fed program is likely to push interest rates higher. My estimate is that without Fed buying, the 10-year Treasury would probably be trading at a yield of around 3% to 3.5%, as opposed to 2%. I answered your question on
You’re right that money supply alone only explains a portion of the inflation picture. Wage growth, capacity constraints and overall demand also play a large part in driving inflation. In Japan, most of these factors have been deflationary, starting with weak aggregate demand. However, even in Japan, it’s useful to consider the monetarist argument. While Japan has anchored short-term rates at zero and increased its monetary base, the supply of money (M2) has been growing slowly due to weak bank lending. In Japan, M2 growth has averaged less than 3% year over year during the past decade. In contrast, in the United States, the money supply grew at nearly 10% over the past year. In short, Japan is a cautionary tale of what happens when the mechanism for credit creation – bank lending – breaks. I answered your question on
While a higher dividend tax rate wouldn’t hurt the underlying utilities business, it would lessen the value of a utility’s dividend stream. This is an important consideration for investors in utility stocks who often view this sector primarily as a dividend play. Utility stocks’ relative price-to-earnings ratio rose significantly following the Bush Tax Cuts as the after-tax value of the dividends went up. As a result, it’s reasonable to assume that the relative multiple for the sector would contract after a tax increase as a utility’s dividend stream would be worth less after taxes. Practically, this means that while the overall stock market multiple may not be impacted by a dividend tax increase, utility stocks are likely to revert to a lower multiple relative to other types of stocks.
Investors buying international dividend stocks will be taking on currency, as well as equity, risk. However, over the long term, this may not be a bad thing. The United States still faces a number of structural issues – starting with the deficit – that will play out over the next decade. Because a weaker currency will help address some of those imbalances, dollar-based investors should consider increasing their allocation to assets denominated in other currencies. I also answered your question on
I agree that if Europe stabilizes, the dollar is vulnerable. That said I'd expect any correction of the dollar to occur against emerging market and "hard" currencies rather than the Euro, which looks expensive by most measures.
Europe continues to be the biggest source of risk in the global economy and the most likely source of another crisis. In particular, we continue to worry about a disorderly default - Greece's debt burden is not sustainable even after the recent haircut- or the impact of rising bond yields in Italy. Outside of Europe, other sources of risk include premature fiscal tightening in the US - which will happen in 2013 without a change in existing law - or an escalation of tensions in the Middle East, specifically around Iran.
Our preference is for large, multinational integrated oil companies.
If Italian bond yields remain above 6.5 percent, I don't disagree. We've been saying for months that Spanish and Italian bond markets are the key. If these bonds continue to sink, the risk of another global recession rises dramatically.
I completely agree that Treasury yields are artificially low due to buying by 'non-economic agents', specifically the Fed and Asian central banks. That said, this is unlikely to change in the near-term. To the extent that sovereigns, even artificially priced sovereigns, are still the benchmark for other fixed-income instruments, I think the comparison holds. Perhaps the real lesson is - to what may be your broader point - most fixed-income instruments look expensive and investors should try to get more of their income from equities.
To follow up on my post from yesterday, jobless claims came in slightly worse than expected, and the Conference Board's index of leading economic indicators was slightly better than expected. Both numbers confirm my belief that the next one to two quarters should be characterized by anemic, maybe flat, growth, but not a significant contraction. I'd still put the chances of a US recession at around 40%, with a European banking crisis the biggest risk. This has contributed to a continuation of yesterday's sell-off, which was arguably about disappointment over the Fed not doing more (to my mind, a strange response as the Fed pretty much did exactly what they had telegraphed).
Bottom line: is if you believe Europe muddles through, then this selling looks extreme.
On Thursday, the Institute for Supply Management’s report confirmed what I had expected: The US economy is experiencing slow but positive growth. The Purchasing Manager Index (PMI), the Institute’s main monthly gauge of US manufacturing activity, came in at 50.6 for August, down from 50.9 for July but higher than the 48.5 expected by economists. The index for new orders, meanwhile, which is a good predictor of future GDP growth, came in at 49.6, up from 49.2 in July. The figures show that the economy is slowing, but not contracting, and contradict the notion that the US is on the verge of a 2008-style recession. What does this mean for investors? The ISM report is somewhat supportive of stocks and is the latest evidence for my overweight view of equities:
Very much agree. Another issue with the ECRI - it appears to have a heavy reliance on stock prices. Historically, the ECRI has had a very tight correlation with equity markets. In effect, the ECRI is largely telling you much the same thing as the stock market.
I don't disagree that the Conference Board LEI is narrow, with just 10 factors. This is why I prefer watching the Chicago Fed National Activity Index, which is a much more robust method. Historically, this has had the highest correlation with GDP 1 quarter forward. The last reading ticked up indicating still sluggish, but positive growth
Goffriller - There are a couple of reasons. For one, widespread fears of resource nationalism have resulted in gold producer stocks such as Barrick Gold struggling over the last few months, as governments around the world have been looking to increase taxes and royalties on the sector to help their finances; in the meantime, gold price has continued its rise. Miners are also facing increasing labor and energy costs and generally higher full costs (which incorporate cash costs, capex and exploration), so shareholders only benefit partially from gold price increases.
Robin - VIX can certainly stay elevated for a prolonged period of time, as it did from fall of 2008 through the spring of 2009. However, barring a disruption of that magnitude the VIX typically mean reverts much faster, as it did during the bear markets in 2001-2002, 1998, and 1990. If you expect another 25% pullback in the market, it certainly makes sense that the VIX is going to remain well above not only its long-term average, but also our somewhat elevated ‘fair value’ level. However, it’s worth keeping in mind that another 25% correction would take you to 9x trailing earnings, a valuation level last seen in 1982 when both nominal and real-interest rates were much higher than they are today.
Old Trader – I wouldn’t disagree that the initial response to a downgrade may be modest. The wildcard is the extent to which asset owners will need to revisit their investment management agreements and see if the downgrade would in anyway prohibit them from holding US debt (think of an asset owner that can only hold AAA debt). That said, assuming there is not a lot of forced selling, any initial reaction in the Treasury market is likely to be muted. I see the danger as long-term. Given the significant deterioration in the US fiscal position, when private demand for capital eventually returns will investors be willing to lend long to the US for 3%.
Jan Tabek – You raise an excellent point. Not only does the US have a higher gross/debt to GDP than Spain, its debt/revenue ratio is worse than virtually every other developed market