Keep your balance amid high real yields and stock valuations

Key takeaways

• High real yields create attractive fixed income investment opportunities.
• Stock prices are generally high but there is value in some parts of the market.
• Given higher-than-normal correlations in stock and bond performance, diversification is critical. We like the yield and relative safety of shorter duration treasuries in combination with select opportunities in higher yielding asset classes like EM debt and private credit.

The end of summer may bring lower temperatures, but interest rates and U.S. stock valuations remain high. In this environment, we prefer high quality within both stocks and bonds, and given the recently higher correlations in the performance of these markets, are seeking additional diversification via alternatives.

High yields create diverse opportunities

Inflation has been steadily coming down, and with the latest labor market data coming in softer-than-expected, it’s reasonable to believe that the Fed’s July rate hike might have been its last for this cycle. Still, anyone who took the summer off from watching markets might be surprised to see how much interest rates shifted up in just three months, particularly on longer-term bonds.

Key drivers of the increase in yields include Fitch downgrading its U.S. credit rating, the Bank of Japan relaxing its yield curve controls, and the U.S. Treasury announcing that it would need to raise more money (issue more debt) than previously expected.

Yields climbed higher this summer
Treasury yields as of 5/31/23 and 8/31/23

Higher yields can create more attractive buying opportunities within fixed income, and particularly so when real yields – or yields adjusted for inflation – are high.

Higher real yields have historically predicted stronger bond performance for the next year. On average, the Bloomberg U.S. Aggregate Bond Index has returned 6.4% for the 12-month-period following a month end where the real yield on the 10-year Treasury stood at 1.5% or higher, versus an average annual return of just 4.2% over the entire 1/1/97-8/31/23 period. The 10-year Treasury’s real yield hit a 15-year high of 1.98% in August and ended the month at 1.87%.

Bond returns have been higher following high real yields
Average returns for the 12-month period following month-end real yields above and below 1.5%

Indeed, we’re seeing more attractive yields across the bond market these days. We like the relative yield in shorter-term Treasuries, and we see opportunities to complement that position with core (high quality) bonds that may be able to capitalize on falling rates (when they eventually fall) and income-seeking assets like emerging market debt, high yield, and private credit.

Yields look attractive in both relatively safe and higher income assets
Yield to worst as of 8/31/23

Equity valuations reinforce the case for quality

Despite an August pullback, stocks still have strong year-to-date gains, with the S&P 500 Index up 18.7% through Aug 31. However, the rally has been driven mostly by investor sentiment, notably optimism that the Fed will achieve a soft landing for the U.S. economy, and excitement over the potential applications of generative artificial intelligence (AI) technology.

As a result, the total return on the S&P 500 Index year-to-date is derived mostly from multiple expansion – a rising price per dollar of expected earnings.

Investor sentiment has driven stock prices higher, especially in the U.S.
Composition of total return (%) on stocks year-to-date as of 8/31/23

While market performance has broadened out significantly since May, the “magnificent seven” technology names continue to drive the majority (66%) of U.S. stock returns year-to-date through 8/31/23.

Market breadth has widened, but big tech still dominates
Contribution to S&P 500 Index year-to-date performance

The AI opportunity may indeed justify higher prices in technology stocks, and we maintain conviction in companies that are able to capitalize on the nascent technology, but we also see opportunity to complement that exposure with more attractively priced parts of the equity market.

There’s still plenty of value out there
Current vs. long-term price-to-earnings (P/E) ratios

We prefer quality stocks, and quality dividend stocks in particular, as the full impact that high interest rates will have on the economy is not year clear. We expect companies with stronger balance sheets and economic moats to better weather high costs of capital and a potential economic slowdown.

Diversification continues to be critical

We have seen the correlation of stock and bond performance shift up and down this year as uncertainty around Fed policy affected investors’ expectations for equity valuations and earnings. Stocks and bonds are currently more correlated than normal (0.33 as of 8/31/23). While stocks and bonds are still moving in opposite directions more often than not, the positive correlations lead us to seek out additional sources of diversification to complement traditional bonds.

Stock/bond correlations relatively high
Rolling 90-day correlation of stock and bond performance

Do we still expect bonds to act as ballast if we were to see a shock to markets? Absolutely, and we saw that amid the regional banking concerns in March. But in an environment in which we could see more inflation surprises that influence Fed policy, stock and bond correlations could stay high relative to historic norms, creating the need to diversify your diversifiers.

Look for alternative investments that can capitalize on high cash rates and also have low correlations to stocks and bonds or, in other words, strategies that may be able to deliver bond-like diversification with returns that can beat cash. Consider diversifying across strategies designed to provide exposure to high interest rates, to benefit when interest rates fall, and to have no sensitivity to interest rates.

Keep your balance

Year-to-date market performance may be encouraging, but maintaining balance within your portfolio remains critical. Seek yield opportunities in both relatively safe and higher income areas of the bond market. Look for good values in quality stocks and balance your equity risk with diverse exposures in bonds and alternative strategies. And if you own AI-driven tech stocks, balance your position with more defensive, high quality dividend payers.

BlackRock can help you construct well-diversified portfolios for your clients. Contact your BlackRock representative for more information or explore our online investment tools and resources.

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