Volatility Should Persist, But Stick With Stocks

Markets Recover From Early-Week Losses

Markets traded in a volatile fashion last week before ending slightly higher. Investor attention was heavily focused on continuing turmoil in emerging markets and some weaker-than-expected economic reports in the U.S. Although stocks started the week on a down note, they managed to stage a late recovery that helped the major averages notch modest gains. By the numbers, the Dow Jones Industrial Average gained 0.6% on the week to end at 15,794, the S&P 500 Index climbed 0.8% to 1,797 and the Nasdaq Composite advanced 0.5% to 4,125. Fixed income markets also saw their share of movement, but ended the week little changed, with the yield on the 10-year Treasury rising slightly from 2.64% to 2.68%

Economic Growth Looks Dicier, But Don't Expect a Change in Fed Policy

For the second straight month, the jobs market report was disappointing. In January, only 113,000 new jobs were created, a number that was significantly below the expected 180,000. Some of the weakness might be attributed to winter storms and extremely cold temperatures across the country, but sizeable drops in retail, education, health care and public sector jobs suggest the soft data cannot be attributed entirely to bad weather. The fact that construction jobs (arguably the most weather-sensitive segment of the labor market) showed improvements further emphasizes this point. If there was a silver lining to the report, it was that the unemployment rate fell another notch to 6.6%.

In addition to the weak employment report, we also saw a drop in the Institute for Supply Management's manufacturing survey. The headline data that showed a dip in manufacturing activity was bad enough, but even more troubling was the plunge in new orders, a data point that tends to be a strong leading indicator for overall economic growth. Specifically, new orders fell from an index level of 64.4 to 51.2. To put that in perspective, the size of this drop is close to what we saw in the aftermath of the September 11, 2001 terrorist attacks. February's ISM survey will bear close watching.Unless we see a quick rebound (which would suggest January's collapse was weather related), first quarter growth may be disappointing.

Despite some arguments to the contrary, we do not believe the recent spate of negative economic news will be enough for the Fed to change course. We'll get additional perspective this week when new Fed Chair Janet Yellen provides her testimony to Congress, butwe expect the central bank will stick with its policy of tapering the pace of asset purchases by $10 billion per meeting. We also expect the Fed will continue to focus on keeping short-term interest rates near zero for some time. With inflation still well below the Fed's target of 2%, and with persistent weakness in the labor market, the Fed is under no real pressure to increase rates.

Downturns Provide an Opportunity to Add to Stocks

Periods of weakness like we have seen over the past couple of weeks provide opportunities to selectively add to equity exposures while trimming bond holdings.

Although stocks did stage a late-week recovery,volatility has been rising. The VIX Index (a measure of market volatility often called the "fear index") jumped to a 13-month high of 21.44 last Monday when stocks endured their worst single-day losses since last June. In addition to rising volatility, fund flows are also pointing to a growing sense of investor risk aversion. So far this year, we have seen aggressive selling out of equity funds and into bond funds, a clear sign of investor unease.

Sentiment is more uneven than it was at the end of 2013, but it is important to put all of this in perspective. Even at the market lows on Monday, the peak-to-trough downturn was still well below the 10% threshold that is usually associated with a "market correction." Also, while volatility is higher now than it was last year, it has merely reverted to its long-term average.

Looking ahead, given lackluster U.S. economic data and ongoing issues in emerging markets, we expect that markets will remain more volatile than they were in 2013. Even so, we continue to believe stocks offer better value than bonds (a view reinforced by the market recovery we saw on Thursday and Friday). We do expect equity gains will be more muted this year than last year and the ride will be rockier, but we would also suggest that periods of weakness like we have seen over the past couple of weeks provide opportunities to selectively add to equity exposures while trimming bond holdings.

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 February 10, 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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