Downward pressure on the markets is coming from a number of sources, including geopolitical risk in the form of heightened conflict between North and South Korea, the deepening of the European debt crisis, policy tightening in China, an FBI-led investigation of insider trading, confusion over the implementation of quantitative easing and weakening housing market data. Given this backdrop, US markets were mixed last week, with the Dow Jones Industrial Average declining 1.0% to 11,092, the S&P 500 Index falling 0.9% to 1,189 and the Nasdaq Composite rising 0.7% to 2,534. While we recognize that all of these issues represent downside risks for the market, we believe that stocks are in the midst of a normal corrective phase and that the longer-term trend remains positive.

 

Taking a closer look at a few of these issues, the specific details of the bailout package for Ireland are being worked out, and it appears that the bailout should quiet the credit storm for the short term. Longer-term issues for Ireland and the rest of the so-called “peripheral” European countries remain, however, and debt issues could continue to act as a headwind for the markets. Likewise, we do not believe that policy tightening in China will be severe enough to derail the Chinese economy, but we acknowledge that concerns over a Chinese crash add to the uncertainty of the markets. Regarding the confusion and concern over the implementation of quantitative easing by the Federal Reserve, there have been some conflicting statements by some Fed officials, but we do not believe that the Fed will meaningfully deviate from the program it announced earlier in the month. At least some of the backlash against QE2 has been politically motivated, but we think there is virtually no chance that any sort of legislation that would impact the Fed’s independence would be passed by Congress.

 

Turning to the economy, economic data continues to show signs of improvement. Last week saw an upward revision to third-quarter gross domestic product growth (to 2.5% from an originally reported 2.0%). It is clearly a positive to see that economic sectors such as equipment and software spending rose, and the fact that consumer spending grew by nearly 3% shows that the economy is getting back on track, but the numbers are not yet strong enough to suggest that we should be seeing a meaningful drop in the unemployment rate. On that front, initial jobless claims fell again last week, and the trailing four-week average of claims has fallen to its lowest level since August 2008, which was right before the intensification of the credit crisis. This suggests that labor market improvement is starting to accelerate, and we could see a decent employment report for November when the numbers are released this Friday.

 

Looking at the equity markets, in addition to some of the risks we highlighted earlier, it appears with 20/20 hindsight that investors may have become too complacent following the months-long rally that began in mid-summer. Following the US midterm elections and the launch of the QE2 program, there seemed to be a lack of any sort of catalyst that investors could look to that would drive the markets yet higher. Given this backdrop, it should perhaps not be surprising that stocks have taken a bit of a break in recent weeks.

 

Stocks and other risk assets have produced solid returns on a year-to-date basis and the high degree of uncertainty over some of the issues we discussed earlier may outweigh positive economic news for the time being, meaning that markets may continue to move sideways or drift lower over the coming weeks. We are not ruling out the possibility of a year-end rally (which often occurs) and our base case outlook remains that the bullish forces of an improving economy, rising earnings and decent valuations outweigh the bearish forces of potential downside risks over the longer term. Looking ahead, we believe that the global economy should be strong enough to withstand the likely rise of additional tightening measures that will be coming in 2011, and we would view any near-term weakness in stock prices as an opportunity to add to exposures given our stronger long-term outlook.

 

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Sources: BlackRock; Bank Credit Analyst. 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 November 22, 2010, 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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