Why it’s time for caution

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We have downgraded our near-term view of global stocks to neutral. Global Chief Investment Strategist Richard Turnill's chart of the week helps explain why.

This week’s chart helps illustrate why we’re taking a more cautious view of global equities over the near term.

Falling real (or inflation-adjusted) yields have often been a tailwind for equities in recent history, encouraging investors to move into riskier and higher-yielding assets, as the chart below shows.

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As evident above, U.S. stocks have been in a sweet spot since mid-February, supported by solid economic growth and falling real yields on the back of expectations of a Federal Reserve (Fed) on hold.

Yet yields have started rising again. Higher U.S. inflation and hawkish Fed comments have now put a mid-year rate increase back on the table, increasing investor anxiety and the likelihood of near-term volatility.

Another reason for our more cautious stance: the extent of the recent stock market rally. The MSCI World Index is up 14 percent from its mid-February lows, as stocks have shaken off fears of a global recession, an oil-price collapse and a Chinese currency devaluation.

U.S. equity valuations now sit around the 70th percentile of their long-term historical range, according to our calculations. And stocks overall appear more vulnerable to short-term risks. These include a Fed that increases rates too aggressively, a Brexit, a worsening European immigration crisis and a slowdown in global growth. We also see less upside to China’s growth expectations after a recent uptick in activity, and oil prices have rebounded a long way and now reflect improved fundamentals.

Some actions to consider

We have downgraded global, U.S. and European stocks to neutral from overweight. We do prefer stocks to government bonds, and within equities, we like global dividend-growth and quality stocks. We expect the Fed to raise rates once or twice this year. We also see the potential for a corporate earnings recovery later in 2016.

What would make us more bullish? Evidence of reflation, and an emphasis on expansionary fiscal policy and structural reform over monetary policy globally.

The bottom line: The growing likelihood of an imminent Fed rate increase and more elevated U.S. valuations warrant short-term caution. Read more market insights in my Weekly Commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

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