Economic or earnings growth has mostly remained insulated from the ongoing global unrest and as such, should have little significance for the global economy, according to Russ Koesterich, chief investment strategist at BlackRock Inc.
There are a number of reasons why investors chose to ignore geopolitical risks. First, central bank policies kept volatilities really low. Second, people have been conditioned to buy the dip. The third and the most important point, however, is that there has been no direct link between some of the events in Middle East and the economic/earnings environment. However, the catch is, that may change depending upon what happens in the Middle East because that could push up oil prices, he noted.
In a recent research note, Ross observed that this is the right time to buy volatility because nobody is paying attention to it and it is one of the last few cheap asset classes. Asked to explain, Russ said volatility is likely to pick up if there is a shock arising out of a spike in oil prices. But the biggest risk, however, remains the central bank policy.
The main reason why volatility is so low is that monetary conditions remain easy and credit cycles are benign. As the economy gets close to the end of the year and people start to think about the US and UK central bank tightening, that’s when risk will really go up along with volatility, he said.
Asked how investors should play volatility since the VIX (volatility index) is known to be imperfect and not the best gauge to measure risk, Russ said despite the shortcomings, VIX actually captures what people are trying to get at.
Investors could look at very sophisticated measures of volatility consisting of 30-40 indicators, but if they put them together, they’ll find it looks remarkably similar to the VIX. There are structural reasons why volatility is low and the VIX will reflect it when volatility picks up. Investors could buy cheap out-of-money put options on the market or some of the stocks to get some of that longer dated protection, he explained.
Fed Chair Janet Yellen has been signaling through forward guidance that she’ll continue with low interest rates for an extended period of time, leaving little to imagination. Asked how the central bank could potentially ‘shock’ the markets, Russ said there need not necessarily be a shock to the markets for the VIX to jump.
In an environment where VIX is in single digits, if risk starts to resemble the ‘normal’ readings of 2008 when VIX was in the twenties, it could still be a very significant jump with a near 100 percent increase from where the levels are today. That could happen when the interest rate environment normalizes and VIX gets near its long-term average, he argued.
Asked why he thinks Europe is attractive despite the threat of deflation looming over the currency region and fundamentals weakening in Europe’s powerhouse-economy Germany, Russ said despite being in the midst of a crisis, at the margins, things are looking better for Europe.
The Purchasing Managers’ Indexes in Europe this month hit an 18-month high. The earnings season has been decent so far with 65 percent companies beating forecasts. Though fundamentals don’t look great in Europe, some of the bad news has already been factored-in in asset prices.
Many investors think that US stocks can still go higher, but the reality is that a lot of good news about the US economy is reflected in the price. So investors who are underweight on international equities should increase their exposure in Europe, Asia and the emerging markets, he noted.
There has been a pick-up in deal activities in the US and North America in recent times across sectors like telecom, staples, energy and financials. Yet there has been little correlation between deal activity and sector performances. Asked to explain, Russ said to understand the apparent disconnect, investors need to recognize valuations and to what extent the sector-fundamentals have been discounted into the prices.
BlackRock recommends energy because part of it’s predicated on the fact that in a world where there are very few bargains left, energy looks relatively inexpensive. In a market where stocks have been going up for five years, where there has been a bid to high yield for a number of years, where sovereign debt is expensive, investors need to ask themselves where they can find relative value particularly when there are very few bargains, he concluded.
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