The Fed hikes rates into mediocrity

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’s Latest Move

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

 

No Great Surprise – Fed Rate Remains Steady

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/)

 

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.

Fed keeps interest rates near zero a little longer

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.

Global markets hit a rough patch

 

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.

Currency devaluations

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.

Commodity prices

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.

Emerging markets

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.

Investment implications

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.

Mid-year outlook: Beware that peaceful, easy feeling

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.

Does a new market high signal that it is too late to invest?

As we close out the first half of 2014, the U.S. equity market (represented by Russell 1000® Index) is positioned near an all-time high.  Market highs are often seen as times to rejoice, but there appears to be as much trepidation as enthusiasm this time around, leading many investors to delay committing additional assets to their investment portfolios until the “inevitable” market correction occurs.

It may be that the last two bear markets (March 2000 – September 2002 and October 2007 – March 2009) are weighing heavily on investors’ psyches. While there is no magic elixir to help people forget those difficult experiences and feel better about investing today, maybe addressing a few common concerns can help ease the apprehension.

Buying near the market high

Timing investment purchases sounds great on paper, but is very difficult to accomplish in reality. When times are good, investors can be concerned about buying in too late. When times are bad, investors tend to hesitate due to fears of things getting worse.You can always find excuses not to invest, but generally markets tend to move in an upward direction over a moderate period of time.

For instance, as shown in the chart below, the U.S. equity market (represented by the Russell 1000®Index) hit 432 new daily market highs between the beginning of 1995 through May 27, 2014. You could argue that hitting a high almost doesn’t feel special anymore. But, when you consider that the market had a cumulative return of over 600% during that period – the equivalent of a 9.9% return per year – it doesn’t look so shabby. In fact, it’s in line with longer-term averages for U.S. large cap equities. We can’t predict the future, but reasonable expectations are that this pattern could continue over the long term.
Russell 1000 Index

Source: Russell Investments. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Worries about valuation levels

Astute investors recognize that price levels alone are not a good indicator of relative market attractiveness. The relative cost an investor pays for each dollar of earnings, book value or cash flow also impact future market returns.  When current valuation measures are lower than past norms,history suggests that future market returns may be higher than historical averages. When valuation measures are higher than historical averages, it suggests that future returns may be lower than long-term averages.

Today’s price-to-earnings (P/E), price-to-book (P/B) and price-to-cash-flow (PCF) for the Russell 1000® Index suggest that valuations are slightly higher than average, but relatively close to historical norms. These results could suggest that future returns may be tempered, but do not foretell a looming market correction.
Russell 1000 index valuations

Source: Russell Investments. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Concerns about the economy

Although markets don’t move in lock-step with economies, markets tend to be heavily influenced by current and anticipated economic conditions. Last year’s strong global equity returns were heavily influenced by the anticipation of positive global economic growth in 2014. This year is anticipated to be the first year since 2010 where positive growth will be experienced across Europe, Japan, the United States and the emerging markets. Delivery on that growth expectation will help to justify 2013’s strong results and hopefully enable markets to keep moving forward.
Imf projected growth

Source: IMF.org

The bottom line

Is the market overvalued? Is it too late to invest? Is a correction coming?

If you are asking these types of questions, consider the following:

  • Although U.S. equity markets (represented by the Russell 1000® Index) are at or near all-time highs, that doesn’t necessarily indicate they’ve peaked. Since January 1995, the U.S. equity market has seen 432 new daily highs and has eventually moved higher after each one.
  • Market valuations are a good indicator to help set future return expectations. At today’s levels, markets appear to be slightly more expensive than historical averages. This does not suggest a correction, but helps establish a reasonable expectation for more modest positive results.
  • The global economic recovery continues to move forward. 2014 is the first year since 2010 where there is an expectation for positive growth across all the major economic regions. Positive economic growth tends to bode well for capital market results.

Source: Russell Investments

 

 

The Dow Hits Record High This Year Mostly Because of This Stock

The Dow Jones Industrial Average is at record highs and it’s mostly because of just one of its components.  Caterpillar is doing a lot of heavy lifting when it comes to moving the Dow index, a huge change from last year when it was up just 1 measly percent against the Dow’s 26 percent gain.

Though it’s just 4 percent of the entire average, the equipment maker is up nearly 17 percent through May 9. To put it in perspective, Caterpillar accounts for more than half of the entire Dow’s gains. And, were it not for Caterpillar, Merck and Disney, the Dow would be down in 2014.

This is a good example of how difficult it can be at times to make heads or tails out of market headlines and sound bites alone.  It also illustrates how challenging it can be to filter short-term market noise.

Just as Caterpillar has returned to favor after a dismal 2013, we have seen other sectors move from the bottom of the heap to the top.  Most notable among these are Real Estate Investment Trusts, or REITs.  This area has gained around 8% through the first part of May.  Another asset class that was beaten down in 2013, commodities, have picked-up 5% so far this year.

Diversification, which was detrimental to performance last year, has helped smooth volatility and, at least so far this year, has been additive to returns.

Source: Yahoo Finance

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.