As usual, Russell Investments has released its Global Outlook for the third quarter of 2014, with the latest insights into its multi-asset portfolios and market view.
In the report, the team confirms the overall view already set out in the annual outlook: a modest preference for equities over fixed income, albeit with a slightly tighter spread for the US market. The combination of volatility on the US market, at historic lows according to the CBOE Volatility Index (Vix), and the calm attitude of investors, as well as fairly tight valuations on equities, prompt Russell's strategists to signal that the markets are particularly vulnerable to shocks.
In the report, the team highlights the impact on the outlook of three unexpected events that occurred in the first half of 2014: the 2,9% contraction of US GDP in the first quarter, the sharp rise in core inflation in the US and the reduction of volatility on all asset classes to levels deemed unsustainable in the long term. In addition, the strategists cite a list of geopolitical risks, such as an escalation of events in Iraq and the China-Japan dispute over the East China Sea. Finally, the possibility of a fear linked to inflation is highlighted, after the rise in the Consumer Price Index (CPI) in the USA, which went from 1,6% in January to 2% in May, in addition to the PCE deflator which in the same period passed from 1,1% to 1,5%.
To update market forecasts, Russell's Strategists use a process based on three elements – value, cycle, sentiment – which combines qualitative views and quantitative factors. Based on that process, Russell's predictions for global markets are as follows:
Value: the US looks quite expensive, Europe a little cheaper and valuations on Japan are back to neutral
Russell's strategists agree that market valuations have remained virtually unchanged over the past three quarters. The US has become slightly more expensive, with the market hitting all-time highs, as reflected by the cyclically adjusted price/earnings ratio on the Russell 1000®, the US large-cap index, which is over 20x and the price-to-book around 2,8x. According to strategists, European equities are slightly expensive, while valuations on Japan are neutral. Emerging markets continue to be around 30-40% undervalued relative to developed markets.
Cycle: Eurozone growth expectations are improving, while the United States is picking up pace
The strategist team believes business cycle indicators are favorable for developed economies. For the remaining part of the year, growth should consolidate in the United States and Europe, but a certain uncertainty remains on the other markets. In support of this view, the Institutional Broker Estimate Service's (IBES) earnings per share growth consensus for Russell 1000 companies stabilized at around 8% in early July. As for the United States, the strategists do not attach particular importance to the first quarter GDP data, while they believe that this indicator will remain between 2,5% and 3% for the next quarters. Russell's team has increased confidence on the growth outlook for Europe after the recent stimulus package adopted by the ECB. If credit constraints have been a drag on European economic activity, access to funds should increase now that banks have tidier balance sheets ahead of the asset quality review and with the more than €400 billion that will be returned available thanks to the Tltro program.
In Japan, growth appears to be picking up after the consumption tax hike in April. That said, however, strategists believe it is too early to make a definitive judgement. Within emerging countries, China is starting to stabilize thanks to the effect resulting from the adoption of some stimulus measures, but uncertainty remains about the extent of the decline in the real estate sector.
Sentiment: Positive momentum continues for equity markets in developed countries
This indicator, which reflects price momentum, provides an opinion on market sentiment based on many elements of positioning, fund flows, investor confidence, risk appetite and other technical factors. Strategists continue to see momentum as a major positive – particularly in the US and Europe – with Europe slightly better positioned than other regions thanks to the ECB's stimulus package. In general, strategists agree that the low level of the Vix is a concern, even if most of the other indicators they use are not yet in dangerous territory.
Updating market forecasts and positioning tipsBased on the changes from the second quarter outlook published in April, the strategists updated their forecasts and related exposures across geographies and asset classes.
Asia-Pacific area – Russell's strategists believe equity market valuations are good and expect equities in this region to perform in line with the modest global preference for equities over fixed income. Despite a slow start to the year, Russell expects solid economic growth in the Asia-Pacific region for the remainder of 2014. The strategist team's expectations for China, give GDP growth stabilizing within a range of 7% to 7,5% for the beginning of 2015. “In China, we are carefully watching the situation in the manufacturing sector in general and, more specifically, of exports to understand if the country can absorb the impact of the downturn in real estate. Japan's GDP started 2014 with a jump to 6,7% annualized and, after a period of adjustment mid-year, we expect the recovery to firm up, albeit at a more regular pace. Australia will slow down compared to the current situation - just over 3% - even if the thing is not dramatic”.
North America – Russell's strategists believe that for the remainder of the year, US economic indicators will continue to confirm equity market returns in 2013. While valuations are not cheap, US equities remain relatively attractive relative to fixed income. The team believes the expected increase in volatility could present a buying opportunity.
Eurozone – As a result of decisive policy action by the ECB last June, the team believes the time has returned to buy risky eurozone assets and get a slight overweight. Looking forward, strategists will continue to monitor the recovery closely, paying particular attention to credit growth during this fragile recovery.
Emerging markets – Strategists' models regarding emerging markets have become more positive in recent months. The rating is more neutral based on the improvement in relative attractiveness, as well as an equally balanced set of risk and opportunity elements. With a continued improvement in valuations, emerging markets could rebound, also thanks to an increase in confidence on China's prospects and a strengthening of global demand for exports. Nonetheless, developing countries could face a meltdown if China disappoints or Fed policy concerns lead to another liquidity crisis for economies with the largest balance-of-payments imbalances. .
and – although we believe this asset class is expensive, the positive outlook for economic growth – and consequently the low default rate – keep the view of strategists positive, with a slight preference for high yield over investment grade, mainly for the lower risk on interest rates (duration) of high-yield securities.
