Russell Investments’ Strategists’ Outlook - Q2 2015 Update: Modest Growth Expected Despite Low Oil Prices

Impact of lower oil prices taking a toll on the Canadian economy

  • Additional target rate cut can’t be ruled out
  • Outlook for equities remains cautious, as earnings expectations down dramatically
  • U.S. wage and inflation pressures threaten modestly positive outlook

TORONTO, March 31, 2015

The negative impact of lower oil prices is being felt in many sectors of the Canadian economy – from housing and the prices of goods and services, to employment levels, according to Russell Investments’ Second Quarter 2015 Strategists’ Outlook.

“The most immediate shock was to the once-hot housing markets in the Prairies, where home sales have declined and price increases have moderated,” said Shailesh Kshatriya, associate director, client investment strategies at Russell Investments Canada Limited, who authored the Canada Market Perspective section of the global report. “This has occurred despite the Bank of Canada’s reduction in its target interest rate at the start of the year. Ironically, this same rate reduction may further support the buoyant Toronto and Vancouver real estate markets.”

At the same time, the prices of many goods and services other than energy have been rising due to the lower value of the Canadian dollar, according to the most recent outlook. “When you exclude the price of gasoline, we saw a 2.5% rise in inflation. We believe the BoC will tolerate inflation approaching the upper threshold of its 1-3% inflation band in order to dispel worries about potential tightening of monetary policy,” added Kshatriya.

The report notes that employment will be the indicator most closely monitored going forward, and if labour market slack persists or accelerates over the next several months, an additional cut in the target rate should not be ruled out. Kshatriya believes the implications of the recent reduction in capital expenditures by the resource sector, and how that might impact employment, are more disconcerting. “This comes at a time when it’s unclear if employment has, in fact, improved as much as is implied by the official unemployment rate of 6.8%,” Kshatriya said. “When using the labour market indicator, the unemployment rate is closer to 7.5%.”

The report also notes that five months ago the observed industry consensus expected earnings to grow a robust 20% in 2015, but that has since been marked down dramatically to -7%.

With regards to the economy, “Although we expect modest growth, the ambiguity due to low oil prices keeps us cautious, but positive, on the business cycle over the medium term as recession is not our central scenario,” added Kshatriya.

Global Outlook Overview

From a global perspective, the team continues to highlight the importance of two key watch points in 2015: The divergence in central bank policies and the amount of spare capacity in the U.S. economy—both of which have been amplified by a 50% drop in oil prices since June 2014. According to the strategists, fears of deflation are underscoring the European Central Bank (ECB) and Bank of Japan's (BoJ) intentions to make monetary policy even more accommodative, while the likely economic boost in the U.S. from low energy prices may result in an earlier start to Fed tightening. As for spare capacity in the U.S. economy, the strategists' current forecast of 230,000 average monthly U.S. job gains in 2015 would take unemployment to nearly 5% by year-end, adding pressure for wage gains.

"The most important indicator currently to watch is hourly earnings in the Bureau of Labor Statistics' monthly employment report," said Russell Investments' Global Head of Investment Strategy, Andrew Pease. "This will provide the first evidence that labour market conditions are tightening enough to hurt profit margins, push up inflation and make the Fed more hawkish."

The team's central scenario outlines a modest uptick in equity markets through 2015 with a preference toward Eurozone markets. In this scenario, the strategists see U.S. earnings per share (EPS) growth in the single digits, while Europe and Japan deliver double-digit EPS gains. In the U.S., they feel low oil prices likely will reinforce consumer spending as a growth driver and the rate hike—predicted by Russell Investments' Federal Funds Target model to occur in September 2015—will push 10-year Treasury yields above 2.5%.

However, the strategists are also on high alert for U.S. wage and inflation pressures, which threaten this modestly positive outlook. Wage gains would squeeze profit margins and generate fears of aggressive Fed tightening, which could lead to a spike in volatility and bond yields.

"We see a potential for higher market volatility through 2015, driven by both price momentum and the economic cycle. If wage gains jump, then equities, bonds and credit could all post negative returns," added Pease. "However, thus far, U.S. employment gains have not triggered wage gains, and our favoured scenario of moderate inflation, jobs growth and profit gains is still on track."

To update their market forecasts, Russell Investments' strategists use their "cycle, value, sentiment" investment strategy process, based on a mix of qualitative and quantitative inputs. Their current global market perspectives are as follows:

  • Business Cycle: Europe stands out

    While the U.S. and Japan have a moderate cycle score, Europe is currently very positive. Corporate profits in Europe, which have been sluggish over the past four years, are now very promising due to improving economic indicators and the ECB's QE program.
  • Valuation: U.S. equities are very pricy

    Both Japanese and European equities are moderately expensive after strong runs in both markets. The U.S. remains a relatively expensive equity market, with a price-to-book value at 2.9 times and the cyclically adjusted price-to-earnings ratio of more than 22 times (according to the U.S. large-cap Russell 1000® Index as of March 24, 2015).
  • Sentiment: Momentum strengthens in Japan and Europe

    Many of the contrarian signals – such as investor-sentiment – remain in overbought territory, pointing to a potentially modest pullback in equity markets. However, momentum, which strengthened in Japan and Europe, continues to act as a positive driver in most equity markets. Within the U.S., momentum weakened, but a separate indicator—the declining level of margin debt at the New York Stock Exchange—suggests that the U.S. is not yet over-exuberant.

For more detailed information, please see the 2015 Global Outlook: Q2 Update

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