Russell : The 'great re-moderation' defines mid-year 2014 global market, according to Russell Investments Strategists' Outlook

- Increased confidence on the growth outlook for Europe after the latest ECB stimulus package

- Potential for market shocks given investor complacency, unsustainably low volatility and stretched equity market valuations


Russell Investments Strategists' 2014 Global Outlook – Third Quarter Update, has highlighted a modest preference for equities over fixed income globally, though with a slightly diminished spread for the U.S. market. However, the combination of U.S. market volatility at near all-time lows as measured by the CBOE Volatility Index (VIX) and investor complacency, as well as stretched equity market valuations, are leading Russell's strategists to caution that the markets are especially vulnerable to shocks.

"We're calling current market conditions the 'great re-moderation' as they appear similar to the low volatility, high return markets we saw prior to the 2008 global financial crisis," said Russell's Global Head of Investment Strategy, Andrew Pease. "This time though, we think recession risks are low and a major market reversal seems unlikely. However, volatility could easily spike, creating a temporary shake-out, which we'd see as a 'buy-the dips' opportunity."

The team's investment strategy views remain largely unchanged, in part due to strong economic growth in the first half of 2014 and positive economic forecasts. The team predicts the U.S. Federal Reserve's (the Fed) interest rate hikes to be held off until mid-2015.

"Mid-year data points support our outlook that U.S. 10-year Treasury yields are likely to rise, U.S. credit default rates will stay low and support credit spreads, and equities can continue to outperform fixed income," Pease summarized. "The CPI rise appears to be more noise than signal. Our models suggest core inflation will stay close to 2% through 2015."

Russell's strategists continuously update their market forecasts amid a changing market environment by implementing a three-pronged "value, cycle, sentiment" investment strategy process, which combines qualitative views and quantitative inputs. Based on this process, Russell's current global market perspectives are as follows:

- Value: U.S. appears more expensive, Europe less so and Japan's valuation shifts into neutral

Little has changed on market valuations in the past three quarters, and the team believes the U.S. has become marginally more expensive as the market reaches record highs, with the cyclically adjusted price/earnings ratio for the U.S. large-cap Russell 1000® Index at more than 20 times and the price-to-book value at around 2.8 times.

They also see European equities as modestly expensive and score Japan's valuation as neutral. Emerging markets (EM) remain undervalued in their view by 30% to 40% relative to developed markets equities.

- Cycle: Eurozone growth expectations improving, U.S. regains its footing

The team sees business cycle indicators as positive for the developed economies and expects growth will strengthen across the U.S. and Europe over the remainder of the year, but uncertainty remains in other markets.

For the U.S., the strategists are not placing much weight on the first-quarter 2014 GDP growth figure, believing the indicator should track between 2.5% to 3.0% for the next few quarters.

"As a result of decisive policy action by the ECB in June, the team believes that it is time to buy back into euro-zone risk assets and move back to a small overweight position. Going forward they will continue to monitor the recovery closely, paying particular attention to credit growth during the fragile recovery," said Wouter Sturkenboom, Investment Strategist, EMEA.

In Japan, the growth figures seem to be recovering from the April consumption tax rise, but that said, the strategists think it's still too early to make a firm conclusion on the outcome.

Within EM, the team believes China is starting to stabilize as stimulus measures take effect, but uncertainty remains around the extent of the housing downturn.

- Sentiment: Positive momentum continues for developed equity markets

This signal, which reflects price momentum, is based on a range of indicators on positioning, fund flows, investor confidence, risk appetite and technicals to judge market sentiment. The strategists still see momentum as a strong positive driver – particularly in Europe and the U.S. – with Europe just ahead of other regions due to the ECB stimulus package. Overall, the strategists agree that the low VIX level is concerning, but that most of the other indicators they track are not yet in dangerous territory.



Updated Market Forecasts and Exposure Recommendations
Based on market shifts since the Second Quarter Update report was published in April, the strategists have updated their forecasts and exposure recommendations across global regions and asset classes.

Asia-Pacific region:
Equity markets undemandingly priced, and regional equities likely to perform in line with their modest preference for equities over bonds globally.

Chinese GDP growth to stabilize, expected to stay at the 7.0% to 7.5% range through early 2015.

"We look for firming Chinese manufacturing in general, and exports in particular, to fully take up the slack from a weakening property sector," said Graham Harman, senior investment strategist, Asia-Pacific. "In Japan, GDP growth started 2014 with a rush, at 6.7% annualized, and following a period of adjustment mid-year we expect that recovery to persist, although at a steadier pace. Australia likely will slow from its current clip—just over 3.0%— but not dramatically."

North America:
U.S. economic indicators for the remainder of the year will continue to validate 2013 equity market gains.

While valuations aren't cheap, U.S. equities remain relatively attractive to U.S. fixed income.

Anticipated increase in volatility could be a buying opportunity.

Eurozone:
Decisive policy action by the ECB in June, means it is time to buy back into euro-zone risk assets and move back to a small overweight position.

Credit growth will be a key factor to watch during the fragile recovery.

Emerging Markets:
More positive outlook on EM in recent months, with an evenly balanced set of upside and downside risks.

Continued strong valuation, could see EM rebound on confidence in China's outlook and stronger global export demand.

However, EM could drop if China disappoints or if concerns about Fed tightening cause another funding crisis for the current-account-deficit economies.

Credit:
While credit is expensive, the positive outlook for economic growth—and hence low default rates—keeps the strategists positive on the asset class.

Slight preference for high yield over investment grade, mainly due to the lower interest rate (duration) risk in high yield exposure.

In summary, Pease said, "High equity market valuations tell us that the longer term return outlook is subdued, but for now our value, cycle, sentiment process and models tell us to favor equities over fixed income and maintain some credit exposure."

For more detailed information, please see the "Strategists' 2014 Global Outlook – Third Quarter Update".



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