Karen Schenone Positions For 2018: Not Enough Investors Are Thinking About Bonds As A Hedge To Equity Market Risk

Summary

Many investors are still sitting on too much cash.

Uncertainty in the political environment serves to prevent investors from taking risk.

Historically low interest rates and modest inflation is fueling earnings growth and some multiple expansion that could keep the market rally going.

Karen Schenone is a Fixed Income Product Strategist within BlackRock's Global Fixed Income Group focusing on iShares fixed income ETFs. She concentrates on supporting iShares clients, generating content on fixed income markets and ETFs, developing new fixed income iShares ETF strategies, and partnering with the iShares team on product delivery. She writes about fixed income ETFs and trends in that sector.

Rena Sherbill (RS): As we enter 2018, are you bullish or bearish on US stocks?

Karen Schenone (KS): Bullish, but adding high quality fixed income to serve as a hedge.

RS: Which domestic/global issue is most likely to adversely affect US markets in the coming year?

KS: NAFTA renegotiations could adversely affect trade with Mexico and Canada.

RS: How does the political climate affect the risks and opportunities for next year?

KS: Uncertainty in the political environment serves to prevent investors from taking risk. Any time there is concern about the debt ceiling and legislative gridlock, investors seek the safety of high quality bonds, such as US Treasuries, or sit in cash. The political climate adds some technical pressure to US rates as high demand for US Treasuries serves to keep rates low. This impacts investors as they get lower yields on fixed income assets.

RS: Do you expect the yield curve to continue flattening in 2018, and if so, what impacts will that have on the equity market and the economy in general?

KS: The market currently expects the Fed to hike 2-3 more times in 2018, which would bring short-term rates to ~2%. 10-year US Treasury yields are expected to be around 2.5% at the end of 2018. So, the 2-10s yield curve will have a slope of just 50 bps, but it's not expected to go negative. I could see more issuers continue to term out their debt and use the proceeds to fund share buybacks and fuel the equity market expansion.

RS: What do you expect to be the key driver of stock market performance in 2018?

KS: Historically low interest rates, coupled with modest inflation, is fueling earnings growth and some multiple expansion that could keep the rally going.

RS: Will the transition in Federal Reserve leadership from Yellen to Powell impact equity investing sentiment? Why or why not?

KS: The Fed has been very transparent with investors on the tapering of the Fed's balance sheet. Based on the track record of the incoming Fed Chair, Powell will most likely keep normalizing monetary policy. Too aggressive of a rate hike could cause an equity market pullback as the cost of capital increases. But I think the Fed will continue to be measured and data dependent in its decisions to hike rates.

RS: What issue is receiving too much investor attention and/or already priced in?

KS: Fed tapering is mostly priced in. But many investors remain wary of agency MBS.

RS: What do you see for emerging markets in 2017?

KS: Emerging market bonds benefited from relative easy global monetary policy and growing EM economies. Credit spreads continued to tighten in, and USD EM debt returned about 10% using the JPM EMB Global Core Index, which outperformed investment grade corporate bonds by almost 3.5% (using the Bloomberg Barclays Investment Grade Corporate Bond Index as of 12/14/2017).

RS: What 'surprise' do you see in the market that isn't currently getting sufficient investor attention?

KS: Investors are still chasing yield, and many have added risky asset classes like high yield. If there is an equity market selloff in 2018, these bonds will decline in value and therefore not provide diversification or downside protection. I think not enough investors are thinking about the role of bonds as a hedge to equity market risk. Government bonds, like US Treasuries and TIPS, serve a valuable role in bond portfolios and can help provide a buffer against a stock market selloff.

RS: What's your take on cryptocurrencies, and what does the price action in Bitcoin say about the financial markets in general?

KS: Bitcoin is gaining more acceptance from speculative investors, but it is in its infancy in being an acceptable method of payment. With the addition of CME futures, investors can more easily express views on this cryptocurrency. In 2018, expect Bitcoin's volatility to continue as a speculative asset.

RS: In terms of asset allocation, how are you positioned heading into the New Year?

KS: I am still overweight equities and am keeping my fixed income in high quality bonds like investment grade corporate, TIPS, and municipals.

RS: Any additional considerations you'd like to share with readers as they ponder their investing strategy in 2018 and beyond?

KS: Many investors are still sitting in too much cash. High equity valuations and rate hikes are keeping investors on the sidelines. However, even remaining in cash is an active decision. A high cash position risks not keeping up with inflation, and your purchasing power could be eroded over time. Rethink your approach to cash and consider moving into a short maturity or floating rate bond fund to keep pace with rising rates in the market.