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:
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(R) 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.
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.
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.
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.”
Russell Investments (Russell) is a global asset manager and one of only a few firms that offers actively managed multi-asset portfolios and services that include advice, investments and implementation. Russell stands with institutional investors, financial advisors and individuals working with their advisors-using the firm’s core capabilities that extend across capital market insights, manager research, portfolio construction, portfolio implementation and indexes to help each achieve their desired investment outcomes.
Russell has more than $259 billion in assets under management (as of 3/31/2014) and works with over 2,500 institutional clients, independent distribution partners and individual investors globally. As a consultant to some of the largest pools of capital in the world, Russell has $2.4 trillion in assets under advisement (as of 6/30/2013). It has four decades of experience researching and selecting investment managers and meets annually with more than 2,200 managers around the world. Russell traded more than $1.4 trillion in 2012 through its implementation services business. Russell also calculates approximately 700,000 benchmarks daily covering 98% of the investable market globally, including more than 80 countries and more than 10,000 securities. Approximately $5.2 trillion in assets are benchmarked to the Russell Indexes, which have provided investors with 30 years of smarter beta.
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
Investing involves risk and principal loss is possible.
Forecasting is inherently uncertain and may be incorrect. It is not representative of a projection of the stock market, or of any specific investment.
Investments in non-U.S. markets can involve risks of currency fluctuation, political and economic instability, different accounting standards and foreign taxation.
Russell Investment Group, a Washington, USA corporation, operates through subsidiaries worldwide including Russell Investments. Russell Investment Group is a subsidiary of The Northwestern Mutual Life Insurance Company.
CORP-9741 First Used: July 2014