The Global View

The “Great Re-Moderation” Defines Mid-Year 2014 Global Market

U.S. equities over fixed income; Market shocks cautioned

July 22, 2014 – SEATTLE–(BUSINESS WIRE)–Russell Investments released today its Strategists’ 2014 Global Outlook – Third Quarter Update, which provides the most recent guidance for the firm’s multi-asset portfolios and services from Russell’s global team of investment strategists.

In the report, the team maintains its overall viewpoint as stated in the 2014 annual outlook: A modest preference for equities over fixed income globally, though with a slightly diminished spread for the U.S. market. However, the combination of U.S. market volatility at near all-time lows as measured by the CBOE Volatility Index (VIX) and investor complacency as well as stretched equity market valuations are leading Russell’s strategists to caution that the markets are especially vulnerable to shocks.

“We’re calling current market conditions the ‘great re-moderation’ as they appear similar to the low volatility, high return markets we saw prior to the 2008 global financial crisis,” said Russell’s Global Head of Investment Strategy, Andrew Pease. “This time though, we think recession risks are low and a major market reversal seems unlikely. However, volatility could easily spike, creating a temporary shake-out, which we’d see as a ‘buy-the dips’ opportunity.”

In the report, the team highlights the impact on their outlook of three surprises that were seen in the first half of 2014: the -2.9% contraction in first-quarter U.S. Gross Domestic Product (GDP), the large rise in U.S. core inflation, and the decline in volatility across all asset classes to levels believed to be unsustainable in the long run. In addition, they cite a list of geopolitical risks, such as events escalating in Iraq and the ongoing China-Japan dispute in the East China Sea. Finally, the strategists highlight the possibility of an inflation scare, beyond the rise of the core U.S. Consumer Price Index (CPI) from 1.6% in January 2014 to 2.0% in May and the PCE deflator from 1.1% to 1.5% in the same time period.

Despite these changing considerations, the team’s investment strategy views remain largely unchanged, in part due to strong economic growth in the first half of 2014 and positive economic forecasts going forward. The team predicts monthly gains in U.S. non-farm jobs to average 230,000 over the next 12 months and the U.S. Federal Reserve’s (the Fed) interest rate hikes to be held off until mid-2015.

“Mid-year data points support our outlook that U.S. 10-year Treasury yields are likely to rise, U.S. credit default rates will stay low and support credit spreads, and equities can continue to outperform fixed income,” Pease summarized. “The CPI rise appears to be more noise than signal. Our models suggest core inflation will stay close to 2% through 2015.”

Russell’s strategists continuously update their market forecasts amid a changing market environment by implementing a three-pronged “value, cycle, sentiment” investment strategy process, which combines qualitative views and quantitative inputs. Based on this process, Russell’s current global market perspectives are as follows:

  • Value
    U.S. appears more expensive, Europe less so and Japan’s valuation shifts into neutral
    Russell’s strategists agree that little has changed on market valuations in the past three quarters. They believe the U.S. has become marginally more expensive as the market reaches record highs, with the cyclically adjusted price/earnings ratio for the U.S. large-cap Russell 1000® Index at more than 20 times and the price-to-book value at around 2.8 times.

    They also see European equities as modestly expensive and score Japan’s valuation as neutral. Emerging markets (EM) remain undervalued in their view by 30% to 40% relative to developed markets equities.

  • Cycle
    Eurozone growth expectations improving, U.S. regains its footing
    The team of strategists sees business cycle indicators as positive for the developed economies. They believe growth should strengthen across the United States and Europe over the remainder of the year, but feel that uncertainty remains in other markets.

    Supporting this view is the fact that Institutional Broker Estimate Service (IBES) consensus earnings-per-share growth forecasts for the Russell 1000 companies have stabilized near 8% as of early July 2014. For the U.S., the strategists are not placing much weight on the first-quarter 2014 GDP growth figure, believing the indicator should track between 2.5% to 3.0% for the next few quarters.

    The team has increased confidence on the growth outlook for Europe after the latest ECB stimulus package. While credit constraints have been a brake on European economic activity, they believe access to funds should start to improve now that banks have their balance sheets prepared for the asset quality review, and as the new €400 billion targeted LTRO program gets underway.

    In Japan, the growth figures seem to be recovering from the April consumption tax rise, but that said, the strategists think it’s still too early to make a firm conclusion on the outcome.

    Within EM, the team believes China is starting to stabilize as stimulus measures take effect, but uncertainty remains around the extent of the housing downturn.

  • Sentiment
    Positive momentum continues for developed equity markets
    This signal, which reflects price momentum, is based on a range of indicators on positioning, fund flows, investor confidence, risk appetite and technicals to judge market sentiment. The strategists still see momentum as a strong positive driver – particularly in Europe and the U.S. – with Europe just ahead of other regions due to the ECB stimulus package. Overall, the strategists agree that the low VIX level is concerning, but that most of the other indicators they track are not yet in dangerous territory.

Updated Market Forecasts and Exposure Recommendations

We’re calling current market conditions the ‘great re-moderation’ as they appear similar to the low volatility, high return markets we saw prior to the 2008 global financial crisis

Based on market shifts since the Second Quarter Update report was published in April, the strategists have updated their forecasts and exposure recommendations across global regions and asset classes.

  • Asia-Pacific region
    Russell’s strategists consider equity markets undemandingly priced, and expect regional equities to perform in line with their modest preference for equities over bonds globally. Despite a slow start in the first half of 2014, they expect solid economic growth in the Asia-Pacific region for the rest of the year. The team’s expectation is for Chinese GDP growth to stabilize, predicting figures in the 7.0% to 7.5% range through early 2015.

    “We look for firming Chinese manufacturing in general, and exports in particular, to fully take up the slack from a weakening property sector,” said Graham Harman, senior investment strategist, Asia-Pacific. “In Japan, GDP growth started 2014 with a rush, at 6.7% annualized, and following a period of adjustment mid-year we expect that recovery to persist, although at a steadier pace. Australia likely will slow from its current clip—just over 3.0%— but not dramatically.”

  • North America
    Russell’s strategists anticipate that the U.S. economic indicators for the remainder of the year will continue to validate 2013 equity market gains. While valuations aren’t cheap, U.S. equities remain relatively attractive to U.S. fixed income. The team believes that the anticipated increase in volatility could be a buying opportunity.
  • Eurozone
    As a result of decisive policy action by the ECB in June, the team believes that it is time to buy back into euro-zone risk assets and move back to a small overweight position. Going forward they will continue to monitor the recovery closely, paying particular attention to credit growth during the fragile recovery.
  • Emerging Markets
    The strategists’ models have become more positive on EM in recent months. They’ve assigned a more neutral ranking based on the improvement in relative attractiveness and an evenly balanced set of upside and downside risks. With continued strong valuation, they believe that EM could rebound on confidence in China’s outlook and stronger global export demand. However, they think that EM could drop if China disappoints or if concerns about Fed tightening cause another funding crisis for the current-account-deficit economies.
  • Credit
    While credit is expensive, the positive outlook for economic growth—and hence low default rates—keeps the strategists positive on the asset class. They have a slight preference for high yield over investment grade, mainly due to the lower interest rate (duration) risk in high yield exposure.
    In summary, Pease said, “High equity market valuations tell us that the longer term return outlook is subdued, but for now our value, cycle, sentiment process and models tell us to favor equities over fixed income and maintain some credit exposure.”

For more detailed information, please see the “Strategists’ 2014 Global Outlook – Third Quarter Update”.





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