One Man’s Opinion: Will Correlation Between Stocks And Bonds Rise In 2014?

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92835431The US economic recovery is gaining speed, but there are a few underpinnings that are still fragile, said Russ Koesterich, chief investment strategist at BlackRock Inc. The good news is there is much less fiscal drag this year and household balance-sheets are in a better shape, which in turn will help the economy accelerate modestly in 2014.

The missing piece, which triggered words of caution from the IMF, is the slow recovery in the labor market. The missing ingredient for this recovery has been income growth, which means consumption may not grow as fast some people think, he said.

Asked if the Fed tapering is priced in, Russ answered in affirmative. The market understands this would be a gradual taper, and they expect about $10 billion a month going forward. The real question for stock and bond markets in 2014 is how effective the Fed is going to be in holding down the short-end of the yield curve; i.e. how successful will be the Fed’s forward guidance as a substitute for quantitative easing, he noted.

Asked if the risk of deflation still looms over the US and Europe, Russ said deflation risk is much higher in Europe than in the US because the pace of recovery in Europe is much slower than in the US. Europe is likely to clock about one percent growth this year while it’s most likely to be 2.5-3 percent for the US.

Also, despite inflation remaining below the Fed’s target of 2 percent in the US, the reassuring news is that inflation expectations have remained fairly well anchored there. The inflation-expectation embedded in the TIPS market shows they have been rising in recent weeks. So the risk of outright deflation is much lower in the US than probably it is in Europe, he argued.

Asked to comment on his investment strategy, Russ said investment strategy for 2014 will be fairly similar to that of 2013 with a couple of nuances. BlackRock is still overweight in equities and thinks it can get good growth in places like Japan that had a stale year in 2013.

Within fixed-income, BlackRock remains overweight in credit. However, when it comes to exposure in the bond market, BlackRock changes its position on the yield-curve as it perceives greater danger in the middle of the curve. 2-5 years maturity securities have perhaps a greater risk than longer dated bonds where yields have backed up quite a bit already, he observed.

Asked if US stocks could give the same returns this year as in 2013 at current valuation levels, Russ said he will be very surprised if he sees another 30 percent-year for the markets. If that happens, it will probably be very dangerous because it will be predicated on a lot of multiple expansions.

Nevertheless, though US stocks are unlikely to give returns of 30 percent in 2014, they are most likely to outperform bonds and cash. Investors should have muted expectations as valuations are higher. But on a relative basis, stocks still look more reasonable than many of the available alternatives.

However, diversification is going to be a little difficult this year as there has been a rising correlation between bonds and stocks. So investors may have to look further afield and consider some of the alternative asset classes as a way to get some diversification into their portfolios, he concluded.

You can watch the video here.

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