• Last week, equities benefited from a number of catalysts, including better-than-expected earnings in the U.S.
  • Going forward, we think stocks can make further gains.
  • We would continue to favor Japanese equities, which we think can continue to rally as major institutions increase stock purchases.
  • After the sell-off, the consumer discretionary sector is looking more attractive, helped by lower energy prices and the drop in interest rates.

Stocks Bounce Back

What a difference a week makes. Stocks staged a strong rebound last week, with the Dow Jones Industrial Average climbing 2.6% to close at 16,805, the S&P 500 Index rising 4.1% to 1,964 and the Nasdaq Composite Index up 5.3% to 4,483. Meanwhile, the yield on the 10-year Treasury rose from 2.20% to 2.27%, as its price correspondingly fell.

There was no single catalyst for the rally. Equities benefited from new stimulus from the European Central Bank (ECB), positive economic data out of China, the expectation for more equity purchases by Japanese pension funds and better-than-expected earnings in the United States. Going forward, we think stocks can make further gains, and would continue to favor Japanese equities while adopting a more constructive stance on U.S. consumer stocks.

A Shift in Sentiment

Sentiment continued to improve last week with investors taking solace in the potential for expanded bond buying by the ECB, a respectable Chinese gross domestic product (GDP) report and more buying of domestic stocks by Japanese pension funds.

Equities also benefited from generally positive earnings reports from U.S. companies. To be sure, there were some notable disappointments — namely, IBM, McDonald’s and Coca-Cola — but most companies are beating expectations. So far, with 30% of S&P 500 companies having reported, earnings have grown 11.3% and revenue by 5.1%, beating expectations of 5% and 1%, respectively. Notable winners included Apple and Caterpillar, which raised its full-year guidance on expectations for better global growth. All of this was welcome news for investors worried about how a stronger dollar and slower growth might impact U.S. earnings.

Stocks were not the only asset class to benefit from the change in sentiment. Fixed income flows were $7.8 billion last week, and aside from Treasury funds, the greatest inflows were into high yield funds. As we suggested a few weeks ago, high yield became attractive during the recent sell-off. Since then, high yield bonds have rallied and the spreads versus Treasury bond yields have contracted by over 60 basis points (0.60%).

One of the reasons for the rebound in high yield is the lack of yield in other segments of the fixed income markets. With inflation remaining low throughout the world — core U.S. inflation in September came in at just 1.7%, below the Fed’s target — the yield on more traditional bonds remains stuck at low levels. This has left investors, once again, stretching for sources of income in their portfolios.

"Going forward, we think stocks can make further gains, and would continue to favor Japanese equities while adopting a more constructive stance on U.S. consumer stocks."

Two Areas to Watch: Japanese and U.S. Consumer Discretionary Stocks

As we look ahead, where do we see value in the market? One is a country we have favored for some time, while the other is a sector that looks more attractive following the sell-off and lower energy prices and interest rates.

We have had a preference for Japan for some time. Japanese stocks surged last Monday (up nearly 4%) and continued to build on those gains throughout the week. The rally was sparked by news that Japan’s Government Pension Investment Fund (GPIF), the world's largest pension fund, would more than double its allocation to domestic stocks, from 12% of its portfolio to 25%, potentially as soon as this month. Other Japanese institutions are likely to follow suit. Stock purchases by major institutions should cause prices to rise and be a catalyst for further gains. As such, we remain positive on Japanese equities.

Meanwhile, investors also might want to take a new look at the U.S. consumer discretionary sector. We have been cautious on this sector all year. Indeed, a combination of sluggish income growth, below-trend spending and high valuations has resulted in significant underperformance: The sector is down year-to-date versus a 6% gain for the S&P 500. However, even though income growth is likely to remain lackluster, consumer spending could well be boosted going forward by lower energy prices and the recent drop in interest rates, which has pushed 30-year mortgage rates back down to 4%. These developments, coupled with stronger economic growth in the second half, suggest that consumer stocks are likely to come under less pressure, prompting us to move back toward a benchmark weight in this sector.

Market Perspectives

Our experts take a deep dive in analyzing the outlook for key sectors of the financial markets across an array of asset classes.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of October 27, 2014, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional 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. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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