2016 Begins With A Global Market Shock From China

[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
the downside.

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.

Looking ahead

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
heightened.

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.

December market review: Wrapping up a strong year for equities

By Mike Smith, Russell Investments

December put a bow on what turned out to be both a strong fourth quarter and year for equity asset classes. U.S. equity1 posted the best asset class results for the month, quarter, and year ending December 31, 2013. The Russell 3000® Index’s 10.1% return in the fourth quarter provided an appropriate bookend for its 11.1% return in the first quarter of the year. Unlike earlier quarters, U.S. large cap stocks nosed out U.S. small cap stocks for market leadership in the fourth quarter, with the Russell 1000® Index returning 10.2% and the Russell 2000® Index returning “only” 8.7%. Developed international stocks also finished the year in impressive fashion: the Russell Developed ex-US Large Cap Index returned 5.8% during the quarter, adding to a 21%+ return for the year. All in, developed markets global equity markets, as measured by the Russell Developed Large Cap Index, were rewarded with an 8.1% quarter and a 27.4% 2013.

Capital market returns chart

Sources: US Equity: Russell 3000 Index, Non-US Equity: Russell Developed x-US Large Cap Index, Emerging Markets: Russell Emerging Markets Index, US Bonds: Barclays Aggregate Index, Global REITs: FTSE EPRA/NAREIT Developed Real Estate Index, Commodities: DJ UBS Commodities Index, Balanced: 30% US Equity, 20% Non-US Equity,5% EM,35% Bonds, 5% REITs, 5% Commodities. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

In contrast, the rest of the capital markets generally did not fare as well during the last quarter or the year. Emerging markets equities were probably the biggest disappointment for the year as much was expected of them going into 2013. Bonds finished the year out much as they performed for the majority of the other nine months: the Barclays U.S. Aggregate Bond Index posted a -0.6% return for December, -0.1% return for the quarter, and -2.0% return for the year. Rising rates also impacted global REITs: the FTSE EPRA/NAREIT Developed Index returned -0.7% during the fourth quarter. Commodities posted a solid December, but it was not enough to generate a positive return for either the quarter or the year, as the Dow Jones UBS Commodity Index was down -1.1% during the quarter and -9.5% for the year. Commodities were hurt by concerns about rising rates and concerns about the direction of economic growth in the developing markets.

Global Equity Markets Reaped Big Returns in 2013

Developed market equities had a historically strong year in 2013. Major indexes have been tracking global equity performance since 1970 and 2013’s return of 27.4%2 was the seventh best calendar year result in that 44-year period. Even more dramatic was the spread between global equities and fixed income. The 29.3% difference between these two asset classes was the second largest spread since 1970, trailing the largest calendar year difference by only 40 basis points (0.4%).3 For perspective, the average annual spread between global equities and bonds since 1970 has been 4.1%. The combination of improving economic expectations and rising interest rates created an environment for equity markets to excel and bond markets to struggle.

Chart growth of dollar 2013

Source: Global Equity represented by Russell Developed Large Cap Index; Bonds represented by Barclays U.S. Aggregate Bond Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

The Bottom Line

Developed equity markets delivered historically strong results and drove double digit market returns in 2013. Unfortunately having exposures to additional diversifiers, such as fixed income and commodities, wasn’t as clearly beneficial. Such disparity can tempt investors to question the value of being invested in “these other asset classes.” Of course, markets can turn quickly – and that’s when “these other asset classes” can be helpful.

1Represented by the Russell 3000® Index

2 Represented by Russell Developed Large Cap Index

3 Global Equities represented by Russell Developed Large Cap Index and Fixed Income represented by Barclays U.S. and Aggregate Bond Index.

Diversification does not assure a profit and does not protect against loss in declining markets.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.