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There are more reasons than ever to understand how to protect your personal information. Major website hackings seem ever more frequent. A set of top-secret National Security Agency hacking tools were dumped online over the past year. In May, hackers used some of those tools to hijack computers around the world. More recently, the credit reporting agency, Equifax, announced it was hacked.
The reality is that your personal information is being stored electronically whether you are an avid Internet-user or not. As such, you should be vigilant about protecting your personal information. Just how to do so is beyond the scope of this blog, but there are many excellent sources for this information on the Internet. One such source is this NY Times article from November 16, 2016 entitled, Protecting Your Digital Life in 9 Easy Steps. Ask your Harbor Capital Advisor for more information or click this link: https://www.nytimes.com/2016/11/17/technology/personaltech/encryption-privacy.html.
Protecting your information is very important to us as your advisor, but this is undoubtedly a collaborative effort between you, Harbor Capital and your account custodian. In addition to the steps that you should take, such as the ones mentioned in the above article, we would like you to know that we and your account custodian, such as TD Ameritrade, provide further oversight on the accounts that we advise.
As an account intermediary, we maintain a personal, interactive relationship with your account custodians and are alerted to changes or other activities in your account. One common alert is an address change that a client may not have notified us about directly.
In addition, each day, we download data from account custodians to our secured server then reconcile the activity that is downloaded with the transactions that we expect to see. Though they are infrequent, we investigate any anomalies to determine whether further action is required. These interactions provide an opportunity to quickly address and correct issues for our clients.
Additionally, your account custodian maintains its own level of protections. These are discussed in detail at the custodian’s website. In the case of TD Ameritrade’s website: www.AdvisorClient.com, you may find a discussion of this information under the Client Services tab, then clicking on Security Center for more information.
At Harbor Capital Management, we take this matter very seriously. We encourage you to take the necessary steps to protect your information. We stay abreast of major breaches such as the Equifax matter, but if you suspect that your information has been compromised in some other way, please notify us immediately so that we may take steps to secure your account.
The following is a re-post from Russell Investments Blog on June 14, 2017. See http://blog.russellinvestments.com/the-fed-hikes-rates-into-mediocrity/ for the full text of the posting.
The U.S. Federal Reserve (The Fed) raised interest rates for the fourth time of the expansion at today’s June 14 meeting, taking the U.S. policy rate slightly above 1%. While this decision was widely anticipated by markets, there are several important observations for global investors to bear in mind going forward.
The macro backdrop for today’s decision: Domestic mediocrity offset by global strength
The Fed normally hikes interest rates into economic strength. But following a lackluster showing in the first quarter (1.2% real U.S. GDP growth), the U.S. economy in our view is continuing to underperform expectations. For example, the Citi U.S. Economic Surprise Index—a measure that tracks incoming economic data against consensus estimates—collapsed from +58 in mid-March to -40 in early June. This is a dynamic that we correctly anticipated in our Global Market Outlook. But it has yet to push the Fed off course.
Inflationary pressures have also failed to materialize. Core consumer price inflation slowed markedly in March, April, and May. Again, this is normally a dynamic that would slow the Fed down.
The rate hike justification
So, what gives? Regarding the outlook for both growth and inflation, it appears that the Fed is essentially forecasting that much of the recent slowdown is transitory in nature. There are some elements to this argument that we are receptive to. The inventory drawdown in the first quarter was a large headwind to growth in the first quarter (and is likely to reverse) and a price war in the telecom industry has had a significant impact on the recent inflation statistics (and is likely to fade away over time). But we also see more fundamental reasons for caution. Bank lending to consumers AND businesses has cooled notably in recent months. Automobile sales – one of the timeliest indicators on consumption activity – is tracking three percent below its first quarter average through May. And rental price inflation is starting to moderate after a significant build-out in multifamily homes in recent years.
While domestic economic fundamentals, in our view, have been lackluster, three other forces have aligned to warrant today’s hike.
- First, the global cycle has strengthened. The slowdown in China, in particular, was a major source of worry for the Fed in 2016. But more recently we have seen a broad-based reacceleration in economic and earnings trends across the emerging market economies. Stronger global growth removed a source of downside risk to the Fed’s domestic U.S. outlook.
- Second, the unemployment rate at 4.3% is very low by historical standards. Monetary policy acts with a lag in terms of its impact on the real economy. And with the economy by most measures at or near full employment, this was a key catalyst for a hike.
- Third, financial conditions remain very accommodative. Despite having now raised short-term interest rates four times this cycle, the ten-year Treasury yield is actually lower than it was before the Fed started hiking. Longer-term interest rates on mortgages and business loans are what matter for economic activity, and the Fed has not injected much restraint into the economy through its rate hikes thus far.
The balance sheet unwind: Making monetary policy boring again
In addition to hiking interest rates, the Fed is also talking about starting the process of winding down its balance sheet—its portfolio of asset holdings—later this year. In many ways, this is the opposite of the Fed’s Quantitative Easing (QE) program, where they bought assets to suppress long-term interest rates and stimulate the economy. Now that the Fed is closer to achieving their goals, they want to gradually unwind the balance sheet. The key for investors is that they plan to do this in a passive, predictable, and plodding way:
- Passive—Rather than selling their Treasuries and Mortgage-Backed Securities (MBS), the Fed will simply stop reinvesting the principal when these assets mature.
- Predictable— The cessation of reinvestments is expected to be introduced gradually every three months on a pre-specified timeline (rather than turning off the spigot all at once).
- Plodding – Recent simulations from the Fed staff suggest they are planning to draw down the balance sheet at a much slower pace than that at which they grew it following the crisis.
San Francisco Fed President, John Williams, has even said2 that they have designed the process to be “boring.” Markets can handle boring, and as such we do not expect a major impact from this proposal on fixed income assets.
Market implications: Not a favorable mix for U.S. equity investors
The biggest issue for investors, in our view, is that the Fed is hiking into a mediocre U.S. economy. We don’t see the fundamentals as being strong enough to warrant another hike this year. But the risks to this view are skewed towards the Fed staying on course for another rate increase in September or December. Under this scenario, our analysis of Fed hiking cycles over the last 30 years shows that rate hikes can be quite damaging to valuation multiples. In a normal cycle, this headwind is more than offset by a strong economy and strong corporate earnings. But in a mediocre growth world, there is unlikely to be enough fundamental support from U.S. earnings to warrant chasing the U.S. equity rally. Instead, we continue to look for opportunities in non-U.S. equity markets, where valuations are more attractive, and economic and earnings trends are stronger. Emerging market local currency debt is another area where we see good value.
The Fed raised rates again. Still, there may be some opportunities in bonds.
After just two rate hikes in nearly a decade, the Fed raised rates again at the March meeting. Citing moderate growth in economic activity, solid job gains, and increased inflation, the Fed pushed its key borrowing rate up 25 basis points higher. The federal funds rate target range is now 0.75%-1.00%.
The economy by all appearances has made really good progress: Job gains have been quite solid, and the unemployment rate is now in line with the Fed’s estimate of normal long-term levels. Meanwhile, inflation continues to rise toward the Fed’s target of 2% a year.
What was less certain entering the meeting was how much the Fed’s expectations for the path of future rate hikes had changed. When we look at the survey of Fed officials rate forecasts, known as the “dot plot,” there was little change. The median expectation was still for two additional quarter-point hikes in 2017, and three in 2018, though there was a slightly higher expectation for 2019.
The Fed also indicated a willingness to let inflation rise slightly above the bank’s 2% target. Overall, it appears to be pretty consistent with market expectations going into the meeting.
This year’s rate hikes are already built into bond yields. And while retail investors may worry that a rising rate environment is bad for bonds, they should keep in mind that the Federal Reserve doesn’t control the entire yield curve: Changes in the federal funds rate most directly affect the short end of the curve, or shorter maturity bonds. When the Fed raises rates, it pushes up yields on short-term bonds. But yields on 10-year bonds, for example, can be affected by a whole host of other factors, including risk sentiment, expectations for inflation and economic growth, and investors’ demand for longer-maturity securities.
Put simply, the long end of the yield curve doesn’t always move in sync with the short end, so the Fed’s rate increase may not cause prices to fall on longer-term bonds. What’s more, longer bonds can provide yield as well as protection in the event of a flight to quality that causes stocks and other, riskier assets to underperform.
We think the key is to owning bonds is having a flexible mandate whereby you can obtain attractive yields from various segments of the bond universe. This may include government bonds, corporates, preferred securities, floating rate securities and inflation protected bonds, to name a few. This reduces the pure interest rate sensitivity of your overall portfolio.
Source: Fidelity Viewpoints
Why the delay? In a nutshell, the recent economic news has been OK, but not quite good enough. The August jobs report, for instance, saw an addition of 151,000 new jobs. Decent, but not anything like the 200,000-plus jobs that the economy has been generating over the past few years. Inflation remains stubbornly low. And global concerns such as China’s wobbling economy and the continued uncertainty from Brexit no doubt played a role in the Fed’s thinking. As Brainard put it earlier this month, we may be in an economy of a “new normal,” where growth continues but never really accelerates.
Given these circumstances, it appears that the Fed believes the benefits of a rate hike are outweighed by the risks for now. Pushing rates up to around 1% or so would give the Fed a little more leeway if it needs to respond to an economic downturn by lowering rates. But doing so in an economy that is only growing at a mediocre pace could have the clearly undesirable outcome of causing such a downturn.
Besides, relative to the European Central Bank and the Bank of Japan, the Fed does have at least a few more tools in the toolbox. It could cut rates back to near-zero – the others already are below zero. It could offer guidance that rates will stay in place for some time. Or it could embark on a new round of quantitative easing, here again something the European and Japanese central banks already have in place (although an expected boost in the ECB’s quantitative easing did not materialize when it met September 8).
We still believe that U.S. interest rates are likely to go up in December. The August 2016 small business survey from the National Federation of Independent Business (NFIB) showed that finding qualified workers to fill open positions was one of their biggest problems, a potential indication that wage inflation is about to begin stirring. This could move the Fed to raise rates before 2016 comes to a close. Looking ahead, we do believe two more hikes in 2017 are possible, which could put rates to around 1.25% by the end of next year.
As a part of our investment strategy team, I know we will be taking a close look at the potential implications of rising rates in our upcoming Global Market Outlook quarterly update, which I hope you’ll read. Generally speaking, any U.S. rate increases will likely exert upward pressure on the dollar and draw capital to dollar assets. That could act as a headwind on the emerging markets whose cyclical positions have actually improved thus far in 2016. Oil too could feel the impact, given its inverse correlation with the dollar.
Overall, we continue to believe that current conditions lend support to the potential power of a multi-asset strategy. With the expensiveness of U.S. equities, it may be particularly useful to consider a globally diversified approach in today’s markets.
This information is reprinted from Russell Investments Blog. You may visit here for original content and appropriate disclosures. (http://blog.russell.com/fed-rate-remains-steady/)
[The following update was provided by Russell Investments.]
Back in August of 2015, Russell Investments’ team of global investment strategists said the mid-year global market volatility sparked by economic news in China reflected
“volatility consistent with the long grinding global recovery.” We wrote at the time: As far
as China is concerned, we belong to the “growing pains” camp rather than ascribing to
the “sky is falling” view.
As the first week of January 2016 wrapped up, China’s Shanghai Composite Index had
lost 10% for the week, marking its steepest decline since the week of August 21. This
sparked volatility globally, such as in the U.S. market, where the Russell 1000® Index
declined 6.7% for the week. Similarly, the Stoxx Europe 600 dropped 6.7% and Japan’s
Nikkei 225 Index fell 7%.
Looking through all this market noise, our strategists believe the volatility in Chinese
markets over the past week was due to market idiosyncrasies and does not reflect a shift
in the fundamentals of the Chinese economy.
As stated in the team’s recently released 2016 Annual Global Market Outlook, and
despite the recent sell-off, “we are witnessing a convincing program of market reform —
recently acknowledged by the International Monetary Fund with its inclusion of China’s
official currency in the international Special Drawing Rights (SDRs) currency basket.
Further, the transition from an economy driven by fixed investment to one driven by
consumption and services also appears to be on track.”
Specifically, our strategists do not see the economic and related events that unfolded in
China during the first week of 2016—including the disappointing Caixin China
manufacturing Purchasing Managers’ Index (PMI) for December—as negative enough to
sway their ‘soft landing’ assessment for China in 2016. However, given the magnitude of
growth in China’s market over 2015, the team expects to continue seeing air pockets on
Three primary factors trigger “air pockets on the downside”
Russell Investments’ strategists noted the following three factors regarding China as converging during the first week of 2016 to trigger the week’s market sell-off:
1. Yuan devaluation: On Monday, China devalued its currency by placing the official reference rate at a four-year low. Accordingly, both onshore and offshore yuan markets weakened and raised concerns of weaker than previously thought domestic growth. Yuan devaluation continued over the week.
2. Regulatory uncertainty: In 2015, Chinese authorities put a ban on investors who owned stakes of over 5% from selling their shares on the secondary market. This ban was due to expire on Jan. 8, 2016, causing some investor concern. Following Monday’s sell off, Chinese authorities announced that this was no longer the case and the selling restriction was to be kept in place. Later in the week, regulators announced new rules: major shareholders of listed companies are restricted to selling a maximum of 1% of their holdings in a single entity via the competitive-bidding process every three months and are required to give 15 days’ notice in advance of a sale.
3. Disappointing Purchasing Managers’ Index (PMI) report: The Caixin China manufacturing PMI came in at 48.2, which was below the expectation of 49.0. Meanwhile, the non-manufacturing (services) PMI came in at 50.2, also below the expectation of 52.3.
With global markets very jittery, Russell Investments’ strategists are keeping a close eye
on daily currency fixings. We are also focused on Chinese trade data as well as the
fourth-quarter 2015 gross domestic product report on 19 January.
Despite global market volatility and the large sell-off in the Chinese market during the
first week of 2016, our team continues to hold a neutral view on Chinese equities for both A-shares and H-shares. We are inclined to look through market volatility at this
stage and focus on China’s underlying economic fundamentals, which in our view, remain intact.
However, investment professionals across Russell Investments are closely monitoring
the situation in China and the knock-on effect to all asset classes. The consensus
agrees that underlying fundamentals of the Chinese economy are relatively sound and
the week’s market moves globally weren’t sufficient to shift our overarching views.
Bottom line – what does this mean for investors?
Russell Investments’ strategists do not expect China’s ongoing economic growing pains
to cause a global recession. However, the week’s global market volatility is a reminder to
investors that with stretched valuations and questionable growth, market risks remain
Especially in periods of market volatility, it is important to remember that markets rise and fall, particularly over the short term. If you’re a long-term investor, it’s best to avoid knee-jerk reactions at the risk of ‘locking in your losses’—because you don’t truly feel the pain of market declines until you sell investments at a low. Sometimes, short-term volatility provides good buying opportunities.
As always, Russell Investments is continually monitoring its funds and seeks to help
clients manage risks through diversification and dynamic portfolio management by
looking to take advantage of any opportunities arising from market volatility.
OK, so we’ll wait a little longer for the U.S. Federal Reserve (the Fed) to finally raise interest rates. As you know, Janet Yellen and the Federal Open Market Committee held interest rates at near-zero at their last meeting. In hindsight, the delay wasn’t all that surprising: The U.S. equity market decline in August and ongoing volatility—prompted in large part by worries about China and the emerging markets, plus continued concerns about stubbornly low domestic inflation rates—made caution a good choice for the time being.
One thing that’s clear as a result of today’s announcement: We certainly know what the Fed is thinking. Yellen and others at the Fed have been exceptionally transparent about what will drive them to hike rates. Even though September was widely seen as a potential time for rate “lift-off,” minutes from the Fed’s July meeting made it obvious that it was not a done deal. Rather, the choice about a rate increase would depend on economic data. That’s a good thing. We still remember what happened in 1994 when the Fed surprised markets with a rate hike that didn’t seem to be based on available data: it sent bonds and equities tumbling.
In any event, despite the Fed’s caution we remain optimistic about the outlook for the U.S. economy. The U.S. is a large, relatively closed economy, which means it is impacted less by the China slowdown than, say, commodities-intensive Australia. Cheap oil is certainly helping to drive down inflation (and hammering energy producers) but we see that as largely transitory, and lower energy prices act as a tailwind for the consumer. Recent U.S. economic data reports have remained solid; vehicle sales in August were the strongest since 2005 and, as the U.S. Bureau of Labor Statistics notes, the unemployment rate has fallen all the way from 10% during the Great Recession crisis to 5.1% today.
As such, the Fed is still likely to move on raising interest rates this year. They just need a bit more time to assess the recent market volatility in financial markets and feel absolutely confident that the economy is still chugging along. The initial hike will be modest – probably 25 basis points in December. But this is likely to be an extremely gradual rate-hiking cycle which is a positive for both the U.S. economy and financial markets. After seven years of essentially zero interest rates, we’re entering a new world.
We suggest that this may be a good time to re-assess your goals and objectives and have a conversation with your adviser.
The selloff in markets around the world appears to have a variety of catalysts. The two factors that many investors have fixated on are a slowdown in China and the timing of the US Federal Reserve’s rate-hiking cycle.
Policymakers in China have implemented extraordinary measures to try to put a floor under equity markets, while cushioning a slowdown in economic growth. China’s slowdown, an oversupply in crude oil and a strong US dollar have driven commodity prices to multiyear lows, challenging nations that are dependent on oil revenues. Meanwhile, as the Federal Reserve approaches its first rate increase, the markets have become increasingly concerned about the potential ripple effects — particularly in currency markets — with memories of 2013’s “taper tantrum” still fresh. Emerging markets broadly have been under pressure of late with weakness in export markets, recessions in Russia and Brazil and political uncertainty in Turkey.
Middling growth in the US and continental Europe, combined with the latest market turmoil and deflationary forces from China’s devaluation, suggest the US Federal Reserve and the Bank of England may not be able to begin their policy normalization processes as soon as had been expected. This would be yet another sign that the global economy has not completely healed following the global financial crisis and still relies on continuing central bank stimulus.
China’s devaluation of the renminbi earlier this month was small in size, roughly 4.5 percent, but large in symbolism. Many market participants took the move as a sign that conventional methods of supporting China’s export-dependent domestic economy (and financial markets) had run their course and that more-drastic measures were needed. This concern is likely overblown, as currency devaluation is just another means of stimulating growth. Nonetheless, with recent interventions in equity markets and the currency devaluation failing to stem the tide, Chinese policymakers are implementing more traditional measures. On 25 August, the Chinese central bank lowered the reserve requirement ratio by 0.50 percentage point and cut the one-year lending rate by 0.25 percentage point.
Despite the tendency of countries to seek weaker currencies to boost their export sectors and to stave off deflationary pressures, China’s move caught the market unprepared. China’s attempts to stabilize its markets through intervention and trading halts have proved largely ineffective. The real economy continues to be weak, with manufacturing surveys showing a contraction in that all-important sector. While China is seeking to rebalance its economic drivers from fixed investment to consumption — a process that could take years, if not a decade — it needs to maintain its export sector so as to create the conditions where jobs and consumer confidence support that transition. That’s a tall order in the best of times and very difficult amid intense market volatility.
Commodities have performed poorly against this macro backdrop, heavily weighing on the energy, materials and industrial sectors as well as on commodity-exporting nations. Sluggish global growth and a strong US dollar are major contributing factors. We are now at an inflection point: Growth could get a boost from lower input costs or world growth could flatten out as profits begin to fall.
It’s worth noting that commodity prices have caused recessions in the past, but it has usually been a result of rising prices restraining growth. Low oil prices have historically led to higher global growth, so the recent drop could help cushion any slowdown. So could a delay in the Federal Reserve’s long-awaited first interest rate hike.
Several important cyclical factors that lent support to emerging market debt in the years leading up to and through the global financial crisis have shifted more recently to become headwinds. Slower global growth (and a reduction in global trade), weaker commodity prices and a gradual shift toward a less accommodative Fed policy have been weighing on several emerging market economies. This dynamic accentuates the already notable degree of fundamental differentiation between emerging market issuers.
These cyclical factors have contributed to credit deterioration in some countries, while others are making relatively good progress in adjusting to new economic realities. We expect a discriminating market to reward issuers making progress toward reforms aimed at restoring macro balances, while ultimately punishing those that fail to capitalize on opportunities to implement improved policy. As always, careful selectivity, with an emphasis on bottom-up country allocation will be critical over the long term.
Turning to the equity perspective, the recent jump in market volatility is not without precedent. Since 1980, the S&P 500 Index has fallen in excess of 5% in a week 28 times. The index has recovered those losses within four weeks more than 70% of the time. That said, we’ve not had a 10% correction in the S&P 500 for nearly four years, so the volatility we’re seeing now looks far worse compared to the unusually low levels of equity market volatility we’ve experienced in recent years. We feel it’s important not to overreact to what might be a return to a normal environment. This sell-off has created more reasonable equity valuations. With lower commodity prices, minimal wage pressure and low inflation, many companies should be able to generate mid-single digit earnings per share growth, which may provide compelling buying opportunities.
We feel the persistence of a global environment of slow growth, low inflation and easy monetary policy will continue to be reasonably supportive for risk assets, although bouts of volatility are to be expected. Overall, near-term volatility does not impact the way we invest. Thus we are approaching the current market environment in the context of our discipline as long-term investors, taking advantage of price volatility to buy attractively valued companies and making investment decisions based on our confidence in the long-term prospects of the individual securities in our portfolios.
The Federal Open Market Committee (FOMC), as expected, did not make any changes to policy, such as raising interest rates from current rock-bottom levels. However, the tone of the statement was a bit more neutral towards the subject, compared to the accommodative language seen in recent years.
Much of the discussion surrounded whether or not the FOMC would remove the key word ‘patient’ from the official statement. As was the case a decade ago when Chairman Greenspan did this, the change implies a rate hike could be appropriate at any upcoming time the committee chooses. Of course, there’s a lot of nuanced semantics here and the Fed remains careful to avoid a misinterpretation or misstep.
April was downplayed as a possible jumping off point for rates, but this entire process as of late has been data-dependent, so it could be June or a bit later. They’ve acknowledged the ‘moderating’ of conditions recently, and weakness in housing, but also the strength in labor growth and potential tailwind from lower oil prices.
In case you were wondering, the FOMC is the monetary policy-making body of the Federal Reserve System. It is composed of 12 members–the seven members of the Board of Governors and five of the 12 Reserve Bank presidents.
The FOMC schedules eight meetings per year, one about every six weeks or so. The Committee may also hold unscheduled meetings as necessary to review economic and financial developments. It issues a policy statement following each regular meeting that summarizes the Committee’s economic outlook and the policy decision at that meeting. Four times per year the Chairman holds a press briefing after the FOMC meeting to present the committee’s current economic projections and to provide additional context for policy decisions.
The U.S. dollar is strengthening against other currencies reflecting a more robust economy as well as the anticipation of higher interest rates in the U.S. Also, other nations have attempted to weaken their own currencies in order to benefit exports and tourism in their regions.The effect of the strong dollar is that investments abroad are worth less for U.S. investors in dollar terms. We saw an extreme example of this as Japanese stocks posted a 9.5% 2014 return in local currency. A U.S. based investor, however, realized a -4.2% loss after adjusting for the strengthening dollar. This dynamic is also having a chilling effect on the earnings of Mutli-national US based corporations.
Interest rates in the US remain depressed despite the unwinding of the Federal Reserves QE (Quantitative Easing) program. In 2014 interest rates actually fell. Much of the rally in bonds was a result of the US being seen as a safe haven for fixed income compared to the rest of the developed world. Whether this trend will continue remains to be seen, though there has been a slight rise in rates over the most recent 30 day period.
On Oil and US equities: Since 1974, there have been seven episodes of 35%+ declines in oil within a short period; equity market behavior was all over the map. When you consider the circumstances behind each, the outcomes make more sense. When the primary issue was increased oil production combined with improvements in oil efficiency, equity markets did well. When the primary issue was a recessionary decline in demand, equities did poorly. As a rough estimate, the current oil price collapse reflects more of the former (supply shock and increased efficiency) than the latter (demand decline in Europe and China due to weak growth). If so, the net impact on US equities should be a mild net positive. Its difficult to predict where the price of oil will settle, but taking into account the lower demand from China and Europe, and the lack of response from OPEC, its difficult to see oil recover to $90+ in the very near future.
The big picture, is broadly positive. The US is in the middle of the economic cycle rather than at the end. Over the next decade, its is expected that the current energy account deficit will narrow, a by-product of reduced oil and gas imports and/or increased exports. Corporate cash flow and cash balances are strong, giving US companies ammunition to hire and invest as the economy improves. In terms of investment, a composite of regional Fed surveys shows a solid rise in corporate capital spending plans in 2015; note that only 10%-15% of business investment ex-software is related to oil & mining.
2013 was a great year for US equity markets, but not for earnings: there was almost no earnings or revenue growth at all that year. Earnings growth began to pick up again in 2014, and based on manufacturing survey signals, S&P 500 earnings growth should be 7%-8% in 2015 after accounting for the drags from a stronger dollar and declines in energy sector earnings.
How much are investors paying for this good news? While P/E ratios computed on a market-cap weighted basis look average compared to the last 30 years, they are distorted by sky-high P/Es during the tech bubble. The P/E on the median stock is more meaningful, and is approaching its historical limits for a mid-cycle period. Its not beyond reason to expect limited (if any) multiple expansion in 2015, and equity market returns to broadly track earnings growth, as they did in 2014. Over the last couple of years, two solid sectors have been Technology and Healthcare. Both outperformed the S&P 500 in 2014, and there is no reason not to expect the same in 2015.
The Federal Reserve is expected to raise interest rates in 2015. While not set in stone, if a rate hike occurs it is expected to be gradual. The reasons: The US is in the middle of the cycle not the end, and depressed oil prices and a strong dollar should tame inflation. Additionally capital spending and durable goods purchases are still relatively low, and the output gap (a proxy for excess capacity) is still large. Recessions tend to happen when rising investment and scarce capacity drive up inflation and force the Fed to raise the cost of money well above the rate of inflation to cool things off. That’s not widely expected in 2015 or 2016.
The 2015 outlook is likely to continue to be dominated by the potential impact of central bank decisions. A key difference from recent years is that we are likely to see bankers heading in different directions as the U.S. begins to raise rates while European and Japanese central bankers are likely to pursue more quantitative easing (QE) and keep rates low.
Stocks tend to be a leading indicator of the economy. However; if there is a US rate hike, equities will likely react quickly, then settle and watch for the real economic impact of such hike. As long as the U.S. continues on a moderate growth path, stocks could still provide modestly positive returns even from today’s elevated levels, and should outperform bonds. Additionally, even though their P/E levels are elevated, foreign stocks could benefit from QE programs in the EU and Japan.
The importance of adequate savings rates and proper diversification, based on risk tolerance and/or time horizon, must continue to be reinforced. When investors and retirement plan participants experience the multi-year euphoria of a bull run, it can be tempting to deviate off course by chasing performance and taking on excessive portfolio risk.
The following is an excerpt from a recent report produced by Russell Investment’s Editorial Team.
Each quarter, Russell’s global team of investment strategists releases an update to our Annual Global Outlook, which outlines our views and expectations for the global markets and economies for the year. Global Head of Investment Strategy, Andrew Pease, recently examined how Russell’s 2014 outlook has changed and remained the same as we go into the third quarter.
Has a sense of unfounded complacency settled in among investors as we move through the second half of 2014?
The most widely used volatility indicator, the CBOE SPX VOLATILITY INDEX, more commonly known as the VIX index (often called the fear index), has fallen to near record lows. These levels reflect the reality that many of the issues investors were anxious about earlier in the year have become less worrisome to them:
- Tensions have eased in Crimea.
- China’s economy appears to be stabilizing.
- The U.S. Federal Reserve’s (the Fed’s) tapering has not caused a financial collapse.
- Europe is on the mend.
- First quarter U.S. GDP contraction looks an aberration.
Such developments could easily lull investors into a more settled state of mind, especially amid the low volatility, slightly up market conditions of 2014. For example, the U.S. broad-market Russell 3000® Index reflected a relatively calm 6.9% gain for the first half of 2014, though it maintains a more celebratory annualized return of 19.3% for the past five years as of June 30, 2014.
Amid quieter markets at mid-year 2014, perhaps the primary risk that investors face isn’t geopolitical per se, but instead how they react to some future shock that rattles markets, shattering their sense of complacency.
The combination of complacency and stretched equity market valuations means that markets are especially vulnerable to shocks. Geopolitics is one obvious risk, with events escalating in Iraq and the ongoing China-Japan dispute rumbling in the East China Sea.
The equity market upswing is getting old compared to previous cycles, but shows no sign yet of ending. Bull markets typically end for one of three reasons: restrictive Fed policy, extreme overvaluation, or excess leverage. We’re a long way from tight Fed policy, valuation is stretched but not extreme, and although firms are levering up, overall leverage in the developed economies is still declining. 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. Still, the risk of a market correction is rising, and in our view an inflation scare or adverse geopolitical events will be the most likely culprits.
That said, our sentiment indicators are not signaling an imminent risk of a pull-back.
Regarding bond markets across the world, we believe in recent months they are increasingly priced for complacency. In Australia, for example, the spread of 10-year Treasuries over the U.S. are trading at 7-year lows as of June 30, 2014. That’s in line with the relative pricing of early 2007. In other words, they’re expensive in historical terms. As an investment, we would view both long bonds, and credit, as being vulnerable to any increase in market volatility or risk aversion, from whatever cause.
While unsustainably low volatility and high equity valuations make us wary of a pullback, our overall views on the direction of markets are broadly unchanged. We still have a modest pro-equity bias and think that global growth and earnings are on track to validate last year’s large gains in global developed equity markets. Yes, volatility is at worryingly low levels, but at the same time we still think mid-2014 offers buy-the-dips market conditions. So, perhaps complacency is OK for now; just watch yourself if (and perhaps I should say when) markets rattle your peaceful, easy feeling.