The head of US markets and investment strategy at $2.1 trillion iShares lays out 5 reasons why stocks and bonds could thrive regardless of rising rates – and shares 3 areas of the market that have already started running higher

  • Last weeks’ sharp move in the 10-year yield unsettled the stock market. 
  • However, Gargi Chaudhuri doesn’t expect nominal interest rates to return to pre-pandemic levels.
  • She explains why, and shares three areas of the market that have already gained traction. 
  • Visit the Business section of Insider for more stories.

Last week, the stock market came under pressure as rising bond yields sparked a volatile end to February. 

However, US stocks came out strong on Monday, with all three major indexes bouncing back from last week’s losses. On Monday morning, the Dow kicked off with a 2% spike, while the S&P 500 climbed around 1.9%. The Nasdaq enjoyed a 3% gain in response to the fall in bond yields and the passing of Biden’s $1.9 trillion spending package. 

The 10-year yield briefly traded last week above 1.6%, its highest level since Feb. 2020. Still, “rates are moving for the right reason,” and the economic reopening in the second half of the year can continue to fuel the reflation theme. This can be positive for equities and bonds, Gargi Chaudhuri, the head of US iShares markets and investments strategy at BlackRock, wrote in a March 1 note. The ETF provider oversees $2.1 trillion in assets under management.

Stocks can continue to do well as flows to equity ETFs have far outpaced the new money picked up in fixed income ETFs by a four-to-one ratio in 2021, despite the 0.4% rise in real interest rates last month. In fact, value-based ETFs have accumulated over $8 billion in inflows, and equity ETFs with a value and cyclical tilt can continue to benefit from rising rates and a steepening yield curve, she wrote. 

And so far, investors responded in a surprising way to the Treasury yield curve steepening. 

Usually, higher yields mean investors can earn more income from owning bonds, which might result in them dumping their equities (that are riskier) for bonds. But it was different this time around. With the Fed pledging easy monetary policy and “extremely accommodative” inflation-adjusted interest rates, investors have responded instead with a high-risk appetite for equities as many continue to tap into names whose returns follow the economic cycle, she added. 

That being said, cyclical sectors like energy and financials are outperforming the S&P 500’s year-to-date returns. The S&P 500 Financials index has returned 9.22% year-to-date, while the S&P 500 Energy index’s 25.88% return has crushed the S&P 500’s 3.9% gain. 

Elevated consumer savings and the reopening of the economy in the second half of the year due to successful vaccines are likely to further fuel the rally in cyclicals and the reflation theme that began in August 2020, she wrote. Plus, nominal interest rates (which don’t account for inflation) probably won’t return to pre-pandemic levels, she added. 

And the demand for assets that protect against inflation will continue to rise, at least until the 10-year yield reaches a 1.5% to 1.75% level. If that’s the case, then investors might turn to fixed income, she wrote. 

3 market areas that are on the rise

Value shares, small-cap stocks, and emerging markets appear well-positioned to sustain further gains, she added. 

She points to BlackRock data which shows the value factor has attracted at least $8 billion in flows year-to-date, almost as much as the last six months combined. Her firm’s own iShares MSCI USA Value Factor ETF has outperformed the S&P 500 by nearly 9% this year. 

She also notes that in January, ETFs designed to invest in small-cap stocks saw almost $7 billion in inflows while large-cap ETFs diminished by $4 billion. 

And as investors look for ways to diversify their portfolios and be a part of the global growth story, she expects “the trend towards global- and EM-focused equities that began last year — with $36bn of inflows in H220 — continuing in 2021.” 

Investors looking for broad exposure in emerging markets might want to consider ETFs like the Vanguard Emerging Markets Stock Index Fund, and those seeking to pile into small-cap stocks might want to check out the Schwab U.S. Small-Cap ETF that aims to track the total return of the Dow Jones U.S. Small-Cap Total Stock Market Index. The Vanguard Value ETF seeks to replicate the performance of the US’ largest value stocks. 

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