July 23, 2014
Canadian economic growth remains steady
Toronto, ON – Improving profit margins and firm commodity prices have led to an increase Russell Investments' year-end target for the S&P/TSX Composite Index from 13,800 to 15,300 according to the firm's Q3 2014 Strategists' ‘2014 Global Outlook Update’, which reflects the most recent guidance for the firm's multi-asset portfolios and services from Russell's global team of investment strategists, including commentary specific to the Canadian equity market.
"Our upgrade is not necessarily a reflection of being more or less bullish; rather, it's a reflection of improving profit margins," says Shailesh Kshatriya, associate director, client investment strategies at Russell Investments Canada, who authored the Canada Market Perspective section of the global report. "While this shift occurred sooner than we anticipated, we believe the improving outlook is being supported by several notable trends, including: rising oil prices, continued strong results from the banks, and market multiples - which have been aided by the strength in the energy and financial sectors."
In addition, Kshatriya believes increased economic activity as the U.S. rebounds over the course of the year should also reinforce domestic trends. "As such, we no longer expect multiples to contract for the balance of the year, but remain stable. And pertaining to economic growth, we expect it rebounds from weak Q1 levels, finishing the year between 2-2.3 per cent." At the same time, Kshatriya believes the market is susceptible to a mild correction before it moves forward, and remains cautious in the interim.
In terms of the direction of the loonie, Kshatriya believes the Canadian dollar is in a losing battle and has tightened the fair-value range for the CAD/USD exchange rate to 0.89-0.94 USD per CAD, versus the prior range of 0.90-0.98. According to Kshatriya, the days of the Canadian dollar trading near parity to the U.S. dollar are over, and the loonie most likely needs to be lower for longer in order to improve competitiveness and add some life to the fading manufacturing sector.
For the global equity markets overall, Russell's global team of investment strategists maintain their point of view stated in the 2014 Annual Global Outlook - a modest preference for equities over fixed income globally - though with a slightly diminished spread for the U.S. market. However, the combination of volatility near all-time lows (as measured by the VIX Index), investor complacency and stretched equity market valuations, is leading them 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," says 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."
In the report, the team highlights the impact on their outlook of three surprises that were seen in the first half of 2014: the -2.9 per cent contraction in first-quarter U.S. Gross Domestic Product (GDP), the large rise in U.S. core inflation, and the decline in volatility across all asset classes to levels believed to be unsustainable in the long run. In addition, they cite a list of geopolitical risks, such as the events escalating in Iraq, the ongoing China- Japan dispute in the East China Sea as well as the Urkaine-Russian conflict. Finally, the strategists highlight the possibility of an inflation scare, beyond the rise of the core U.S. Consumer Price Index (CPI) from 1.6 per cent in January 2014 to 2.0 per cent in May and the Personal Consumption Expenditure (PCE) deflator from 1.1 per cent to 1.5 per cent in the same time period.
Despite these changing considerations, 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 going forward. The team predicts monthly gains in U.S. non-farm jobs to average 230,000 over the next 12 months and 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, default rates will stay low and support credit spreads, and equities can continue to outperform fixed income," says Pease. "The CPI rise appears to be more noise than signal. Our models suggest core inflation will stay close to two per cent 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
Russell's strategists agree that little has changed on market valuations in the past three quarters. They believe 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 is around 2.8 times.
They also see European equities as modestly expensive and score Japan's valuation as neutral. Emerging markets (EM) remain undervalued by 30 per cent to 40 per cent relative to developed markets equities.
Cycle: Eurozone growth expectations improving, U.S. regains its footing
The team of strategists sees business cycle indicators as positive for the developed economies, and they believe growth should strengthen across the United States and Europe over the remainder of the year, but feel that uncertainty remains in other markets.
Supporting this view is the fact that Institutional Broker Estimate Service (IBES) consensus earnings-per-share growth forecasts for the Russell 1000 companies have stabilized near 8 per cent as of early July 2014. For the U.S. specifically, the strategists are not placing much weight on the first quarter 2014 GDP growth figure, and believe the indicator should track between 2.5 per cent to 3.0 per cent for the next few quarters.
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 is concerning, but that most of the other indicators they track are not yet in dangerous territory.
In summary: "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," Pease says.
For more detailed information, please see the " Strategists' 2014 Global Outlook – Third Quarter Update"