Lightbulbs

Since my colleagues and I put out our 2014 outlook late last year, much has changed and the economic backdrop has shifted.

Severe weather had a significant impact on first quarter economic data, and a major new geopolitical risk popped up in Ukraine. Indeed, if I could use one phrase to describe what’s happened over the last three months, it would probably be “reversal of fortune,” since the best-performing assets of 2013 underperformed, while the 2013 losers flourished. In the biggest surprise, bond yields fell as prices rose.

Nonetheless, we’re sticking with the broad game plan we laid out in December for how to navigate this environment. As we enter the second quarter of 2014, investing opportunities appear more elusive than at the beginning of the year (and the challenges more evident).

However, as Jeffrey Rosenberg, Peter Hayes and I write in the spring update to our 2014 Outlook – The List: What to Know, What to Do, even though it’s a tough environment, it’s not one without opportunity. Here are five opportunities we think are worth considering this spring:

1. Stick with stocks. We still believe that stocks offer better value than bonds, even after a five-year bull market. At the same time, we expect to see continued low inflation and low interest rates, as well as a gradually improving economy— all factors that are supportive of stocks. As such, we expect that the market will push ahead in the months to come, although it will likely be a slow and uneven grind given ongoing geopolitical turmoil and Federal Reserve (Fed) tapering. As such, investors should have modest expectations, at least compared to 2013′s outsized gains.

2. More international exposure. Within equities, we believe that, in general, many investors should consider paring back some U.S. exposure in favor of non-U.S. stocks. Despite the reality of geopolitical uncertainty, we see plenty of growth opportunities abroad and would encourage investors to expand their reach globally.

In particular, we have a favorable view toward eurozone and Japanese stocks. Events in Ukraine present some risks for Europe, but we believe both European and Japanese equities look attractively valued compared to U.S. stocks. Finally, for investors with a strong stomach and long time horizon, we suggest having some exposure to emerging markets, which offer a combination of attractive value and compelling long-term growth prospects.

3. Consider a flexible bond approach. It has been a tough time for bond investors, and conditions aren’t getting any easier. What to do? Being flexible and diversified globally remains key. With yields likely to be volatile, and some areas of the fixed income market feeling the effects more so than others, a flexible, go-anywhere bond portfolio that can make adjustments on the fly is something to consider having in your fixed income toolkit.

4. Think high yield and municipal bonds. We continue to believe that investments such as high yield bonds and municipal bonds remain attractive sources of income. In regards to the latter, municipal bonds continue to look attractive versus both Treasuries and corporate bonds. We’re seeing competitive yields on a before-tax basis—which only further illuminates the after-tax value. However given the likelihood of rising rates and improving data, a diversified and unconstrained approach is a necessary strategy in the tax-exempt space as well.

5. Go beyond traditional stocks and bonds. Investors could incorporate alternative strategies that can help broaden their diversification, protect against rising rates, and contribute to growth. (Remember, however, that diversification does not ensure profits or protect against loss.)

Diversifying with alternatives means adding new asset classes such as physical real estate and infrastructure investments. You also may want to consider new strategies such as long/short approaches that can be employed with both stocks and bonds to mitigate volatility, seek out returns and contribute to diversification. While the risks of long/short strategies include the possibility of losses larger than invested capital, we believe they can offer a powerful differentiated source of return and the potential for more consistent results over time.
To learn more about what might occur in the months ahead and how to capitalize on some potential opportunities, check out the spring update to our 2014 Outlook – The List: What to Know, What to Do.

 

Sources: BlackRock research

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.

 

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.

 

iS-12235