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January may have been a Goldilocks month, but March Madness may be coming - YouTube

Market Week in Review is a weekly market update on global investment news in a quick five-minute video format. It gives you easy access to some of our top investment strategists. Our experts will keep you informed of key market events and provide you with an easy-to-understand outlook on the week ahead. Subscribe to receive this market review every Monday, straight to your inbox.

In the latest update:

    • Reasons behind January’s market recovery
    • What may be coming in China and Europe in the months ahead

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We believe that embedding ESG factors into an investing strategy can accomplish dual mandates of delivering value and aligning with investor values. Here’s why.

Values vs. value

 
Many investors still see environment, social and governance (ESG) factors as values-oriented and either:

  • The primary object of focus, with investment outcomes somewhat less important; or
  • Distracting from the focus on delivering investment outcomes.

Such a view can be very limiting. In fact, there are different ways of incorporating ESG into portfolios. Some options may, indeed, change short-term performance. However, in many cases, the performance differential may be a positive one.

While it is certainly possible to erode investment returns when strong performance is a subjugated goal, one needn’t start with the assumption that incorporating ESG into the investment process is anything but value-adding when the primary target of the investment process is performance. We believe investing should have sustainable practices embedded within a strategy — with sustainable performance as a primary outcome objective. Investors can incorporate ESG into their investments in a variety of ways, and all of them can accomplish the duality of values and value.

Have an awareness of how ESG factors can improve or erode security value

 
Pure investment focus

Every active investor seeking value should be aware of how environment, social and governance factors can improve or erode security value. Ultimately values matter, therefore they matter to investing. An exploding oil rig in the Gulf of Mexico will cause many problems for the rig owners, the insurance providers, the fishing suppliers close by, the tourist companies along the shores … and anyone who is charged with the clean-up, including the competitors who will replace the intended supply AND offer safer and cleaner alternatives to the choice of oil as an energy source. Some will win, and many will lose with such an event.

This particular example involves environmental issues given the damage induced from the explosion and oil leakage, social issues relating to equipment and worker safety and governance issues that prevented good decisions from being made in the first place. Understanding who the winners and losers will be from this sort of event is a hallmark of seizing potential investment opportunities that may propel portfolios toward strong excess returns. We believe skilled investors should always incorporate an awareness of how to manage risks and capture opportunities from ESG factors in their portfolios.

However, a pure investment focus, without expressing a preference for values, may be unsatisfying for many investors.

Avoiding and advancing focus

Many investors seek to avoid securities that are inconsistent with their values while advancing securities that are consistent. While these practices are unlikely to change how companies operate, drive anyone into bankruptcy or improve any organisation’s balance sheet, there may be merit to raising awareness or exerting political pressure through investment decisions. What is more pertinent to the tie between values and value is often missed. Many will dismiss avoidance and advancement as value-reducing because of a limited choice set and argue that an optimal outcome cannot be achieved. This value-reduction is not necessarily real in all cases. Where investors need to exercise caution is in how such a strategy is implemented and what outcomes they seek to achieve.

  • Implementation is critical to maintain investment value. Ultimately, avoidance and advancement can introduce material unintended risk if not managed well. Therefore, investors should pay special attention to how their investment professionals manage around portfolio restrictions.
  • Outcome orientation is not just about investing. Investors may hope to impact the target of avoidance or advancement. Such impact is possible for (a) very targeted cases where the role of the investor is material to the target, such as in private impact portfolios and (b) a holistic approach, including material political pressure and/or large-scale investor movements.

A skilled investment manager should be able to deliver value to investors while incorporating values. In addition, skilled investors have many opportunities to add value to portfolios and should not be intimidated by challenging assignments. Unintended risks need not drive portfolio performance, and opportunities to add value may exist in organisations aligned with investors’ values. In some cases, a longer-term focus may be appropriate for measuring investment outcomes, and appropriate expectations should always be an element in measuring impact.

Regardless of a pure investment focus, an agenda to avoid or advance, or anything in between, investors are owners of the securities they hold.

Active ownership of securities is an effective tool for improving investment outcomes

 
Ownership focus

Owning shares comes with the potential opportunity to influence how a company operates. Owners can support management on wise decisions and oppose them on poor decision — proxy voting allows for this opportunity. Owners can band together to require decisions that would not have been made in their absence — shareholder engagement allows for this opportunity. Through active ownership, investors may be able to improve both the investment value the company brings, and the values expressed in the operation of the company. Moreover, active ownership may raise the bar for entire industries and foster sustainability along several dimensions. Because large investment shops will always own the market, active ownership can be used vigorously regardless of passive, systematic or active investment type.

Ultimately, ESG is now part of the investing toolkit and it is an important contributor to improving and maintaining value-add. Additionally, ESG is important to investors who need strong returns and want to feel that they achieved them in a way that is consistent with their values.

To learn about Russell Responsible Investing beliefs, visit our Responsible Investing webpage and read our Best Practices paper.

Leola Ross – Director, Investment Strategy Research

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Is a global economic cooldown brewing? - YouTube

Market Week in Review is a weekly market update on global investment news in a quick five-minute video format. It gives you easy access to some of our top investment strategists. Our experts will keep you informed of key market events and provide you with an easy-to-understand outlook on the week ahead. Subscribe to receive this market review every Monday, straight to your inbox.

In the latest update:

  • Global growth projections for 2019
  • Potential impacts of the recent U.S. government shutdown on Q1 GDP
  • Is government stimulus helping China’s economy?

Subscribe to receive this market review every Monday, straight to your inbox.

Visit russellinvestments.com/uk to see how we can help institutional investors achieve their goals.

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How did active equity managers fare during Q4? Check out the latest insights from our manager research team.

Equity managers: Who fared best during last quarter’s sell-off?

Defence wins championships, so the saying goes. Did it also help equity managers survive an otherwise bruising fourth quarter?

It appears so. Our manager research team found that defensive managers fared the best among active equity managers during last quarter’s market sell-off. We also observed many managers using the fall in markets as an opportunity to purchase securities at more attractive valuations. In particular, active managers have been finding value in companies that either continue to benefit from secular growth or are in commodity-related sectors, which sold off heavily at the end of the year.1

In addition, a number of active equity managers have highlighted emerging markets as a source of ideas, due to that sector’s attractive relative valuation as well as the high proportion of growth opportunities present. We do note, however, that most managers continue to be mindful of political risks driven by trade tensions and upcoming government elections as they relate to this asset class.

At Russell Investments, our distinct relationship with underlying managers allows us to have unique access to insights from specialists across the manager universe — and there’s arguably no better time to tap into these insights than during bouts of market volatility. With this in mind, we’ve compiled our chief tactical observations from key geographic and equity regions, in alphabetical order, for the fourth quarter of 2018.

Australian equities

Topping up on energy

• Managers have taken advantage of the decline in energy companies to increase their overweight to the sector. Gas exposure is the most favoured, as managers believe that demand will exceed supply.

Increasing allocations to more defensive names

• Managers are wary of the impact of falling house prices on stocks reliant on the Australian consumer. As such, they’ve used the market pullback to increase exposure to healthcare and consumer staples. Due to their exposure to overseas demand, materials are also preferred.

Adding exposure to gold

• Some managers have bought or added exposure to gold companies. This is motivated by their view of the companies’ production ability, with the defensiveness of the sector being secondary.

Canadian equities

Energy lags, but concerns prevent adding on weakness

• With oil prices — specifically the Western Canadian Select oil price — continuing to be challenged, energy was once again one of the biggest sector laggards. However, the average hire-ranked manager did not add significantly on price weakness, as many of these energy stocks — especially the oil producers — could have significant balance sheet issues if oil prices stay at current levels.

Weeds pop up among cannabis stocks

• After the strong outperformance of cannabis-related stocks in the third quarter, these stocks gave back a lot of their gains in the October-to-December time frame. Despite the pullback, managers continue to stay away from these stocks due to concerns around valuation, management quality and competitive dynamics.

Emerging market equities

Valuation upside offers high re-rating potential

• Emerging markets’ relative cheapness to developed markets could attract some rotation from global investors.
• Volatility during the quarter has provided some emerging market managers opportunities in lowly valued cyclicals.

Selective high growth opportunities

• A number of emerging market managers are taking advantage of the sell-off to purchase growth names at more attractive valuations (particularly in Asian consumer and tech).

Country-specific opportunities

• China A-Shares that fell aggressively on trade war fears could benefit from lower valuations, government stimulus and calmer trade tensions.
• H1 elections could act as catalysts in India, Thailand and Indonesia. India could benefit from the low oil price, early capital expenditure cycle and improved capacity utilisation.

European equities

Political risk continues

• Political uncertainty in the UK, Italy, France and Germany continues to impact market sentiment. On the margin, active managers have become more defensive and back traditional growth stories. Cash allocations have also increased.
• Value managers are finding more opportunities, particularly in the financials and energy sectors.

Brexit looming

• European equity managers continue to be underweight the UK, specifically companies with heavy domestic exposures. Many managers are getting exposure to the market via larger cap companies that are more globally oriented.

Value manager capitulation?

• Value, as a style of active management, has struggled relative to growth for many years. We have observed more frequent cases of product closures in the value space.

Global/international equities

Growth managers confident in secular growers

• Tariff, growth and rate concerns have increased volatility, but most managers see moderating but sustainable growth, which favours secular growers. Growth managers remain committed to their tech holdings, which offer low price-to-earnings growth.

Value managers are sanguine on cyclicals

• Volatility is providing opportunities, including in expensive defensives, but value managers maintain pro-cyclical positioning. They are sanguine on energy given still low capital spending and resilient demand. European banks have proven value traps for some, but U.S. and emerging market banks still offer positive risk reward.

Market-oriented managers

• Quant managers continue to struggle in a volatile environment characterised by sharp changes in market leadership.

Japanese equities

Managers less aggressive due to opaque market

• Given uncertainty over the global economy, especially China, managers have lowered allocations to the capital goods sector. Conversely, they have increased weights in defensive sectors, particularly telecommunications, which plunged following the announcement of plans to lower fees.
• Managers have maintained positions in technology due to their positive long-term view on the sector.

Increased focus on U.S.-China trade war

• Active managers as a whole are increasingly focussed on possible effects from the trade war. While managers were already concerned about the direction of the economy, many believe that the situation will be exacerbated by the trade war. The overall impact is negative for Japan, but some believe that domestic machinery stocks could benefit due to a potential shift in production from China to Japan.

UK equities

Investor concerns about Brexit continue to soar

• Many UK domestic-focussed sectors performed poorly as worries of a no-deal exit from the European Union intensified.
• Managers continue to be split in their reaction to this. Some continue to avoid domestic plays, while others are excited by their cheap valuations and are adding to them.

While Brexit dominated the UK headlines, the UK stock market was stronger than other developed markets, and the economy continued to recover from the very poor start to 2018

• UK GDP (gross domestic product) growth and consumer-related economic indicators were positive toward the end of the year.
• On the margin, growth-oriented managers are becoming more positive on the market. Previously, it was just the value managers who were finding opportunities.

U.S. large cap equities

Trade conflict contributes to risk-off contagion

• Despite several economic indicators suggesting continued growth (Institute for Supply Management surveys, retail sales activity and payroll numbers, among others), fear gripped the market and equity investors sought the exit. Concerns over the U.S.-China trade conflict and the possibility of a yield curve inversion sparked investor panic during the quarter.

Bargain hunting

• With the significant market selloff, active managers sought opportunities in discounted names.
• Russell Investments saw increased portfolio turnover across many active managers seeking to upgrade the valuation potential of their portfolios.2

U.S. small cap equities

Defensive value stocks dominate in a negative quarter

• Value stocks outperformed growth stocks in the fourth quarter. Despite this, the small cap growth index’s valuation premium over the small cap value index (based on trailing and forward price-to-earnings ratios) continues to be above its long-term average.1 This suggests more room for value outperformance.
• The more cyclical value sectors — energy and materials — performed less well during the quarter. On the margin, active managers trimmed their energy positions during the period.

Outlook for high-growth stocks cooling?

• While still overweight high growth stocks, a number of Russell Investments’ ‘hire’ ranked small cap growth managers incrementally trimmed their exposure to the growth stocks with the highest earnings surprise, 12-month price momentum and most expensive valuations.

The bottom line: Identify potential opportunities for outperformance

With markets likely to remain volatile over the next several months, we believe it’s more important than ever to pay attention to the thinking of specialist managers in order to identify potential opportunities for outperformance. As markets wax and wane, the views of active equity managers will likely do the same. Stay tuned as we continue to report on our observations from across the manager universe.

1 Source: Russell Investments equity manager research, Q4 2018. From hundreds of conversations with managers.
2 Source: Russell Investments manager universe analytics.
3 Source: Russell 2000® Growth Index, Russell 2000® Value Index. Data as at 31, December 2018.


Patrick Egan – Senior Research Analyst

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What’s powering January’s market rally? - YouTube

Market Week in Review is a weekly market update on global investment news in a quick five-minute video format. It gives you easy access to some of our top investment strategists. Our experts will keep you informed of key market events and provide you with an easy-to-understand outlook on the week ahead. Subscribe to receive this market review every Monday, straight to your inbox.

In the latest update:

  • 2019 recession fears wane as markets claw back from December lows
  • Brexit watch: 3 potential outcomes
  • How is the U.S.-China trade war impacting consumer sentiment?

Subscribe to receive this market review every Monday, straight to your inbox.

Visit russellinvestments.com/uk to see how we can help institutional investors achieve their goals.

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How might 2019 shape up across the investment landscape? Here’s our countdown for the top five key issues to pay attention to.

Move over 2018

2018 was action packed and volatile with global equity markets, geopolitics and populism dominating the year. The result was that almost all asset classes, with the exceptions of cash and government bonds, posted negative returns.1 A lot of the same themes seem likely to play out in 2019. A significant difference, however, is that the year has begun with widespread investor pessimism, in contrast to the prevailing optimism at the beginning of 2018. From a contrarian perspective, I’m always more comfortable when markets start the year with a bearish bias.

Here is my countdown of the top 5 investment strategy themes for 2019.

2018: Top 5 countdown

5) Brexit will probably be ok.

We’re in the messy final stages of the Brexit process. It looks to be going to the wire, with a range of possible outcomes. These are: a negotiated agreement, a further delay, an election, another referendum or a no-deal exit. It’s tough to pick which it will be, but a soft-Brexit deal looks the likeliest. This outcome could see sterling rise in its fair value against the U.S. dollar, which we think is around 1.40.2 This is not great news for the FTSE100, which depends a lot on overseas earnings, as a rising pound will keep it under pressure. But UK shares do not look expensive.

The economy isn’t about to take off, but we think the Bank of England will probably manage one or two rate hikes if Brexit is indeed okay. 10-year gilt yields have bottomed, but like long-term government yields, we don’t think they are going to rise a lot. Our model puts fair value for gilts at 2.2% — and this is probably about where yields will rise towards.3

4) Italy is very scary.

Italy has the potential to go very wrong. According to the International Monetary Fund, Italian government debt is roughly 130% of GDP and the economy hasn’t grown in the last decade; in fact, it is still 5% smaller than 10 years ago.4 In addition, the banks have a lot of bad debts and the government is a very unstable coalition of the right-wing populist Northern League and the left-wing populist Five Star movement.
To compound matters, Italy has the world’s fourth largest bond market.5 It’s literally too large to fail and too big to save. In other words, it’s in an entirely different league than Greece.

Italian banks own around 20% of the government bonds on issue,6 which means that the value of their assets go down as Italian bond yields go up. Italian 10-year yields are currently around 2.9%.7 We believe that Italy’s banks could potentially become insolvent if the yield rises above 4%8 — they reached 3.6% in late November at the peak of the budget worries.9 The worst-case scenario is the doom-loop, where rising bond yields cause investors to worry that the Italian government will have to bail out the banks, which causes bond yields to rise further.

That’s possible, but in our opinion, unlikely. We think Italy will play out a bit like Greece in 2015 — when the firebrand populist Syriza government was forced to change its policies once it realised what crashing out of the eurozone would mean for its economy. The Italian government has already watered down its 2019 budget deficit plans after bond yields spiked in November

The Italian government can ignore the European commission, but it won’t be able to ignore the bond market. That should prevent a full-blown crisis, but Italy has the potential to provide plenty of excitement over 2019.

3) China is very, very, scary.

Many people have been predicting a Chinese economic crash for a long time. We know the economy is unbalanced. It depends a lot on investment spending and doesn’t have enough consumer spending. It’s an over-simplification, but China’s basic growth model for the past couple of decades has been state-owned banks lending money to state-owned enterprises and local governments at artificially low interest rates.

The result is lots of debt, which means that China’s central bank can’t pump up the economy anywhere close to the extent that it did in 2008 and 2015. China’s share market fell 20% in 201810 — the good news is that this means there may now be plenty of good stock-picking opportunities in China. Nonetheless, we still believe that China’s economy is going to remain lackluster. While the government has enough policy tools to stop it from crashing, we think that China isn’t going to be a source of demand growth for the global economy.

2) Donald Trump is …. unpredictable.

Apart from Donald Trump’s belief in tax cuts, the closest we have to a Trump policy doctrine is his maximum pressure negotiating stance. We saw this on display with his North Korean deal, and we are seeing it play out with the trade war with China.

The G20 summit in Argentina saw Trump and Chinese President Xi Jinping agree on a ceasefire, and there is the possibility that trade tensions will temporarily ease further in the next couple of months. But longer-term, we believe that President Trump will push even harder. In our view, he will probably continue with maximum pressure and announce more tariffs, potentially on the entire $550 billion worth of Chinese exports to the U.S.
The biggest risk with the trade war isn’t the economic impact — although this isn’t exactly good, we see it as manageable. The bigger worry, in our view, is that this trade war leads to increased military tensions.

For example, the South China Sea is an area of hotly contested sovereignty. China claims most of it and has been building military bases on tiny reef islands. However, the U.S. does not recognise Chinese sovereignty over these islands, and the U.S. Navy has been conducting freedom to navigate operations since 2015. In October 2018, a Chinese ship deliberately maneuvered across the bow of a U.S. ship and forced it to take evasive action.11 An actual collision would have been a significant military incident and possibly a risk-off event for markets.

In sum, tensions remain elevated, and this is why we aren’t expecting either side to meaningfully back down.

1) 2020 – the U.S. recession danger zone.

By now, I’m sure you’re sick of hearing people saying how late it is in the cycle. Of course, it could all be different this time around – we could be mid-way through a historic period of uninterrupted growth, but we don’t think so.

In a nutshell, we still think it’s very late in the cycle and while we can’t be sure when it will end, we are pretty convinced it won’t be 2019. Instead, we think that there are danger signals for the U.S. around 2020. Given that bear market markets don’t usually start until around six months before a recession, we’ve probably got another year of okay, but volatile markets ahead of us.

Yet, it’s important to recall the magnitude of the drop typically witnessed in down markets. Since World War II, the S&P 500® Index has experienced an average fall of 33% during bear markets.12 And remember that it takes a 100% rebound to recover from a 50% fall. Therefore, it’s perfectly possible that a burst of late cycle euphoria drives equity markets substantially higher over 2019, but longer-term, we worry that the downside outweighs the upside.

All in all, 2019 seems set to be another interesting year, following in the footsteps of 2018. Stay tuned as we monitor the latest developments.

1 Source: https://www.cnbc.com/2018/12/20/the-year-nothing-worked-every-asset-class-is-in-the-red-in-2018.html
2 Source: Russell Investments, 2019.
3 Source: Russell Investments, 2019.
4 Source: Source: https://www.imf.org/external/datamapper/CG_DEBT_GDP@GDD/CHN/FRA/DEU/JPN/GBR/USA/ITA
5 Source: https://www.theglobeandmail.com/business/article-italys-political-crisis-jolts-markets-rattles-all-of-europe/
6 Source: https://www.research.unicredit.eu/DocsKey/fxfistrategy_docs_2018_164967.ashx?EXT=pdf&KEY=KZGTuQCn4lsvclJnUgseVGkpNcRXR5-WLoNFhsvJBXHbE69WfFEurg==&
7 Source: Bloomberg as at 15, January 2019.
8 Source: Russell Investments, 2019.
9 Source: https://tradingeconomics.com/italy/government-bond-yield
10 Source: MSCI China Index as at 15, January 2019.
11 Source: https://www.bloomberg.com/news/articles/2018-10-02/china-says-navy-drove-u-s-warship-from-south-china-sea-reef
12 Source: https://www.cbsnews.com/news/whats-a-bear-market-and-how-long-might-it-last/


Andrew Pease – Global Head of Investment Strategy

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Are Fed rate hikes still on the table for 2019? - YouTube

Market Week in Review is a weekly market update on global investment news in a quick five-minute video format. It gives you easy access to some of our top investment strategists. Our experts will keep you informed of key market events and provide you with an easy-to-understand outlook on the week ahead. Subscribe to receive this market review every Monday, straight to your inbox.

In the latest update:

  • What’s behind the decline in business confidence across the globe?
  • Will the Fed increase interest rates at all this year?
  • Global equities: Too much pessimism?

Subscribe to receive this market review every Monday, straight to your inbox.

Visit russellinvestments.com/uk to see how we can help institutional investors achieve their goals.

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Not when, but what

What might an economic slump entail?

Markets are struggling. Global growth is slowing. As attention increasingly turns to the possibility of a recession, it’s time to stop pondering when an economic slump will set in, and focus instead on what it may entail.

In short, we believe a recession appears in store for the U.S. by the end of 2020, and possibly sooner. Why? The recent slide in U.S. equities — the S&P 500® Index dropped nearly 14% last quarter1 — suggests that the bull market likely peaked early last fall. In the post-World War II era, markets have reached their high point, on average, roughly six months before a recession. The longest distance from a market peak to a recession has been 12 months (although the 1987 bear market was outside of a recession).

Source: Thomson Reuters Datastream, National Bureau of Economic Research, Russell Investments

While it’s impossible to nail down the precise timing of the next economic slump without a crystal ball, there’s little doubt in our minds that the economy will experience at least two consecutive quarters of declining GDP (gross domestic product) growth i.e. the definition of a recession, by the end of 2020. Although the calendar alone does not drive recessionary risk, this economic cycle has lasted a very long time. If the nation’s economy is still churning in August, the current period of U.S. expansion that began in June 2009 will officially become the longest on record, surpassing the 120-month stretch of growth from March 1991 to March 2001. Put another way, never before in the history of the U.S. will a recession have been avoided for such a length of time. During this time, economic imbalances have built up (as they always do) and these areas of unsustainable economic activity will, in our mind, end in recession. But, will the next U.S. recession be as severe as the last?

Our answer: Highly unlikely.

The next recession: No 2008 sequel

Today we’re in better shape

Mere mention of the word recession sends shivers down the collective spine of many in the industry, as the first thought that comes to mind is 2008: the global financial crisis (GFC) and the staggering Great Recession that accompanied it. But, remember that 2008 was the second-worst pullback in the U.S. economy on record, topped only by the Great Depression. In other words, from a recession standpoint, it was much more of an anomaly than a norm.

What’s more, the Great Recession was consumer-driven, sparked by record levels of debt. Consumer-led recessions, in particular, tend to be extraordinarily painful. Why? Because as personal debt levels rise, people are forced to use income to pay down debt. This, in turn, leads to a sharp reduction in consumer spending — a real problem in the U.S., where consumer spending accounts for roughly 70% of the economy.3

10 years removed from the Great Recession, the picture today looks much brighter. For starters, the American consumer is in far better shape than a decade ago — ironically because of the Great Recession. In its aftermath, debt-burdened consumers were forced to massively alter their spending habits, and they did. In general, this has led to a much more financially-responsible consumer — one who generally has focused on paying off debt, rather than borrowing additional money. Broadly speaking today’s consumer is not over-leveraged , in stark contrast to 2008.

The same holds true for banks. It’s no secret that over-leveraged financial institutions leading up to the GFC played a large part in the nightmare of 2008. Fortunately, banks today are on much more solid footing, with capital ratios drastically improved in the ten years since.4

All things considered, the parallels between today’s economic backdrop and 2008 look to be few and far between. In order to gain a more accurate portrayal of how we think the next recession will unfold, let’s travel back in time a bit further. Back to the halcyon days of the late 1990s during the peak of the dot-com era.

Soaring economy, skyrocketing stock market. Sound familiar?

The booming 90s

Think back to Y2K… As the clock ticked towards the 1st of January 2000, America was flying high. The U.S. economy, powered by the rise of a booming tech sector and the explosion in popularity of the internet, was soaring to new heights. Annual GDP growth rates from 1997-1999 had exceeded 4%. The unemployment rate had tumbled from 7% at the start of the decade to approximately 4% by 1999 — the lowest for the nation since the late 1960s.6

Not surprisingly, the stock market had also gone fully stratospheric, with the Dow Jones Industrial Average tripling in value by the end of the decade, rising from 5,000 points in the early 90s to roughly 16,000 by the time Y2K arrived.7 The NASDAQ Composite® Index charted a similarly meteoric path, closing out 1999 at over 4,000 points — a four-fold increase in value in less than five years.8 The late 90s represented the icing on the cake of a historic bull market: one that began in October of 1990 and grew into the nation’s longest on record (at the time) by the summer of 1998.

This, of course, sent stock valuations through the roof, with Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio hitting an all-time high of 44.20 in December 1999 — a mark which still stands to this day.9 In fact, for nearly two years centered around the turn of the century, the CAPE ratio for U.S. equities stood above 40. Contrast that with today’s stocks, which we believe are still expensive, and yet have never exceeded a value of 33 (reached in January 2018). This just goes to show that the equity market of the late 1990s was more than expensive. It was historically expensive.

And yet, just three months after the calendar flipped to the year 2000, a bear market was underway in the U.S., with a recession arriving the following year.

Is the same fate in store for today’s bull market?

Someone (apparently it was not Mark Twain) once said that although history may not repeat itself, it often rhymes. To wit, it’s hard not to note the plethora of eerie parallels between the dot-com era and today. Recent GDP growth, punctuated by a 4.2% year-over-year increase in the second quarter of 2018, has been stellar. Unemployment rates have been nothing short of spectacular, plummeting to levels below those observed in the late 90s and matching 1969’s mark of just 3.7%.10 As for the country’s seemingly never-ending bull market? Last August, it topped the previous record of 3,452 days set in the 90s and despite a Christmas Eve scare, is now closing in on 3,600 days.11 Just like back then, the tech sector has powered the steady gains. And, don’t forget about the length of the U.S. economic expansion, on track to take down yet another dot-com era record in a few months.

While this doesn’t necessarily mean today’s bull market is going to crumple dot-com style in the next few months, we strongly believe that the better days for U.S. equity investors are solidly in the rear-view mirror for a long while. After all, U.S. stocks have outperformed all international developed stocks and emerging market equities for the past one-year, three-year, five-year and ten-year periods. Zooming out to a wider timeframe, history tells us this won’t last. During the nearly 40 year-period from 1970-2007, for example, U.S. markets and non-U.S. developed markets had an almost identical performance, with the U.S. charting a 11.06% gain, compared to 10.86% on the part of non-U.S. developed markets.12 In other words, looking at today’s bull market in the context of a greater time horizon strongly argues that what’s in store for the future of the U.S. stock market is a reversion to the mean. It probably goes without saying that this is very close to how the story played out in the early 2000s. Following a remarkable run where U.S. equities outperformed all other asset classes seven out of ten years in the period from 1991-2000, the script reversed, with non-U.S. markets beating U.S. markets seven out of ten times from 2001-2010.13

The next recession: Shades of 2001?

The parallels between today’s economic backdrop and that of the late 90s lead us to predict that the next U.S. recession will taste a lot like 2001. Fortunately, that’s about the best type of bad news there is. Why? In a nutshell, the U.S. recession of 2001 was very mild and also lasted only eight months. That’s just two months longer than the minimum requirement needed for an economic downturn to be officially classified as a recession.

So, will the next recession play out in much the same fashion, fading in less than a year’s time? What impacts are possible on Main Street — is daily life for most at any risk of serious disruption? And, how about life on Wall Street — just how bad could the next market pullback be? How much pain may lie ahead for investors?

We’ll dig deep on all of these issues in a follow-up post. Stay tuned.

1 Source: https://www.wsj.com/articles/the-battered-bull-market-is-limping-into-2019-11546425000
2 Source: https://www.bloomberg.com/news/articles/2018-05-01/as-u-s-expansion-hits-endurance-milestone-here-s-what-s-next
3 Source: https://fivethirtyeight.blogs.nytimes.com/2010/09/19/consumer-spending-and-the-economy/
4 Source: https://www.federalreserve.gov/publications/files/financial-stability-report-201811.pdf
5 Source: https://www.thebalance.com/us-gdp-by-year-3305543
6 Source: https://www.thebalance.com/unemployment-rate-by-year-3305506
7 Source: https://www.macrotrends.net/1319/dow-jones-100-year-historical-chart
8 Source: https://www.npr.org/sections/thetwo-way/2015/04/23/397113284/15-years-after-the-dot-com-bust-nasdaq-closes-at-new-record
9 Source: http://www.econ.yale.edu/~shiller/data.htm
10 Source: https://tradingeconomics.com/united-states/unemployment-rate
11 Source: As at 9, Jan 2019.

Erik Ristuben, Chief Investment Strategist, Client Strategy

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What’s driving the market whiplash? - YouTube

Market Week in Review is a weekly market update on global investment news in a quick five-minute video format. It gives you easy access to some of our top investment strategists. Our experts will keep you informed of key market events and provide you with an easy-to-understand outlook on the week ahead. Subscribe to receive this market review every Monday, straight to your inbox.

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U.S. markets tumble to yearly lows after Fed guidance projects more rate hikes for 2019

U.S. markets react to talk of some further rate hikes

Markets hit the rewind button yesterday (19, December 2018) as the U.S. Federal Reserve (the Fed) talked about the need for some further rate hikes in 2019.

While the Fed raised interest rates again by 25 basis points, Chair Jerome Powell reiterated that the central bank will adopt a data-dependent approach when it comes to weighing future rate hikes going forward. Major indexes, which had stumbled to their worst December start since the Great Depression , were rallying on the morning of the 19th in anticipation of a more dovish outcome, but have since given up all of those gains and then some. The S&P 500® Index fell over 1.5% to 2,506, while the Dow Jones Industrial Average sank over 350 points to 23,323 — both hitting new lows for the year (as at close of play yesterday).

In our view, the Fed threaded the needle yesterday — raising rates and forecasting “some” further hikes, but marking down the anticipated number of rate increases for next year from three to two as concerns over the health of the global economy and financial markets have grown.
This rate hike, the fourth of 2018, means that the Fed has now — somewhat boringly — taken tightening steps at every quarterly press conference meeting dating back to December 2016.
Those decisions, in our view, have been well justified. At the risk of oversimplifying U.S. monetary policy, Chair Jerome Powell really appears to only care about two things:

• First, he wants U.S. workers to have jobs. With the unemployment rate hovering around a 49-year low, Powell should feel pretty good about the full employment component of his dual mandate.

• Second, he wants to make sure the economy doesn’t overheat (translation: keep inflation stable at around 2%). The next batch of core personal consumption expenditures (PCE) inflation data will be released on Friday 21st December. Our expectation is that it will come in at 1.9% on a year-over-year basis. Admittedly, that’s a smidgeon below the central bank’s price stability target, but for all practical purposes, inflation is where the Fed wants it to be as well.

For a U.S. central banker, satisfying both of these mandates pretty much means mission accomplished. The Fed’s goal now becomes keeping the economy right here, forever (good luck!). How?

Establishing the neutral rate

Most policy rules will tell the Fed it should set its interest rate at a level that is neither restrictive nor accommodative for economic growth. Economists call this interest rate r-star, or the neutral rate of interest. The problem is that nobody knows where r-star is. The Fed has an informed guess about it—back in November, Powell said that rates are “just below the broad range of estimates of … neutral.”

The Fed’s latest projections put this neutral interest rate at somewhere between 2.5% and 3% in nominal terms. We’d tend to agree. The current Fed funds target range of 2.25% to 2.5% is still slightly below neutral. As such, we think the next hike (probably in March) to get rates up into the neutral zone should be relatively easy. The decisions from there get a lot more interesting.

The Fed has transitioned its guidance on rates as we approach that point. In September, a large majority of FOMC participants advocated for a restrictive monetary policy setting (hiking beyond neutral). In November, the FOMC instead emphasised a flexible and data-dependent approach when considering further rate increases. Jerome Powell reinforced that tone in his press conference today. To be clear, data dependence does not mean dovish — it means that monetary policy decisions will be guided by data. In other words, if numbers from the first quarter of 2019 indicate a sharp slowdown in growth, the Fed is more likely to use this data as justification to hit pause on its interest-rate increases come June. On the flip side, if the data indicates a pickup in inflation, the Fed may use that to justify the need for further rate hikes.

U.S. growth and inflation outlook for 2019

Against this backdrop, the outlook for U.S. growth and inflation will prove pivotal for the Fed’s decisions in the new year. On the growth side of the ledger, incoming data continues to come in well ahead of the U.S. economy’s long-term potential (see first three rows in the table below). Put differently, there appears to be a significant cushion for a moderation in economic growth rates before the Fed should consider pausing. The slowing of global growth and the tightening of financial conditions are risks in this regard — but solely through their impact on domestic fundamentals. We believe that for now, the damage has not been severe enough to call into question the tightening cycle.

The inflation outlook is more uncertain. As noted above, our expectation is for core PCE inflation to log in at 1.9% for November — a tenth of a percentage point below the Fed’s target. We believe that a case can certainly be made for the Fed to wait for greater evidence that inflation is breaching its 2% inflation target before transitioning to a restrictive monetary policy setting.

Why? There are several cross-currents buffeting U.S. inflation

On the downside:

• Recent dollar strength is likely to prove disinflationary in early 2019 as it lowers the price of imported goods;
• The sharp decline in crude oil prices is a headwind;
• Perhaps most importantly, the U.S. housing market and rental price inflation show some early signs of slowing as higher mortgage rates have dented affordability for would-be new buyers.

On the upside:

• The labour market is historically tight;
• This is (finally) translating into accelerating wage inflation (see chart below);
• Producer prices are picking up; and
• Measures of output prices in the business surveys are generally inflecting higher as well.


Source: Bureau of Labor Statistics, Federal Reserve Bank of Atlanta. Data as of November 2018.

While the verdict is not clear-cut, the balance of evidence in our view points to inflationary pressures gradually building as we get later in the U.S. cycle. Put differently, with growth comfortably above trend and with inflation creeping higher, the balance of evidence suggests the Fed will need to hike beyond March.

Key investment takeaways

From an investment strategy perspective, this is important because fed fund futures are now pricing less than one hike through the end of 2019. To reiterate our view: we think the next hike to get rates into the neutral zone will be relatively easy. And while we’d note the outlook from there is more uncertain, we see the balance of risks as being skewed to further hikes. The gap between our view on the likely path of Fed policy and what is priced into fixed-income markets is currently at its widest since August of 2017.

Cyclically, we see potential for higher 10-year U.S. Treasury yields over the next six months. From a sentiment perspective, investor positioning has also normalised. Speculators were overwhelmingly betting on rising rates three months ago. We find speculative positioning to be a powerful contrarian indicator. A few months ago, that indicator was advocating for us to express an overweight preference for U.S. Treasuries. It has now been neutralised. From a valuation perspective, 10-year Treasury yields have transitioned from being slightly cheap (3.25%) in November to now being within the vicinity of our 2.6% fair-value estimate.

Bottom line

Our cycle, valuation and sentiment framework suggests upside risk to Treasury yields over the next six months. Tactically, we see an opportunity to trim allocations to risk-avoiding fixed income and other rate-sensitive assets.

Related posts

Q4 2018 Global Market Outlook: Maximum pressure
Q3 equity managers report: The froth has left the market
Year-end fixed income survey 2018: Opposing viewpoints from global credit and interest rate managers

Paul Eitelman and Graham Harman 

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