Investors should be keeping a close eye on asset allocation and risk levels as the US Federal Reserve brings its second round of quantitative easing to a close, says
BlackRock, warning that in an environment of moderate economic growth and less liquidity, volatility will be elevated.

The Fed’s QE2 program has been effective in boosting confidence and growth; lending constraints have eased since mid-2010 and the business and consumer loan markets have been growing. Risk asset prices have been supported, and the stock markets have marched upwards quite dramatically. With higher financial asset prices and an increase in inflation expectations, the Fed successfully achieved a wealth effect, according to BlackRock.

However, the US asset management giant believes that unless there are increases in wages and unit labor costs, core inflation won’t rise significantly, and it believes there is still some time before that will occur.

At the same time, statements by certain regional Fed presidents indicate that “nothing is off the table” with respect to efforts to improve the US employment environment, increasing uncertainty about the Fed’s next policy move.

As investors are faced with increased market uncertainties in the near future, it is essential to protect their portfolios from increased volatility in both fixed income and equity markets, says BlackRock.

Although there are risks associated with yield spikes from loss of demand, “the transparency with which the Fed has communicated the timing, amount and intentions of its treasury bond purchases has meant that markets have had months to price in the Fed’s exit from the program,” said Rick Rieder, BlackRock’s chief investment officer of fundamental fixed income.

Also, as the US’s population continues to age, the rapid increase, of around 25 per cent, in retirees in the next five years will continue to fuel strong demand for “safe” fixed income securities. Although, considering that the Fed’s purchases on a monthly basis amounted to $75 billion, compared to the more than $600 billion insurance companies alone will need to purchase over the next year, it becomes apparent that the demand for fixed income securities will likely outpace supply,  Rieder said. 

BlackRock believes that investors can find opportunities in the short area of the yield curve (5 years or less).

“We are identifying attractive opportunities in high-yield corporates, commercial mortgage-backed securities and parts of the asset-backed market. As long as the yield curve remains steep, holding shorter duration higher-yielding assets is the best way to generate long-term returns in an environment of only modest inflation and high levels of rate volatility,” Rieder says.

The asset manager advocates a mix of both high-quality and cyclical companies with strong cash flows. In particular, there is a favorable outlook for US stocks compared to other developed markets, the asset manager says. 

In light of increased expectations of market volatility, BlackRock says investors should stay on the defensive, closely managing portfolio asset allocation and risk levels: “In this sort of environment, carefully choosing sectors and individual securities will be critical; as such, actively managed portfolios capable of capturing diverse opportunities could be an attractive strategy.”