Russell Investments Strategists’ Outlook – Q2 2015 Update: Declining energy prices amplify divergence of central banks
— U.S. wage and inflation pressures threaten modestly positive outlook
— Preference shifts slightly toward Europe and Japan over U.S. markets
SEATTLE, March 31, 2015
Russell Investments released its Strategists’ 2015 Global Outlook – Q2 Update report today, which highlights the most recent economic insights and market expectations from the firm’s global team of investment strategists.
In the report, 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 near 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 labor 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—forecasted by Russell Investments’ Fed Funds Target model to occur in September 2015—will push up 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 favored 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. U.S. profits are growing at a moderate pace, supported by robust economic growth. Japanese profits are also on the upswing as a result of lower energy prices and the likelihood of additional stimulus from the BoJ. 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. The Emerging Markets (EM) have a negative cycle score due to rising U.S. dollar, falling commodity prices and regional political instability.
- 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 over 22 times (according to the U.S. large-cap Russell 1000® Index as of March 24, 2015). Emerging Markets continue to look cheap, according to the Russell Emerging Markets Index.
- Sentiment: Momentum strengthens in Japan and Europe
Many of the contrarian signals – such as investor-sentiment – remain in overbought territory, pointing to a potential 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.
Updated regional exposure forecasts
Based on market shifts since the 2015 Annual Global Outlook report was published in December, the strategists have updated their forecasts across global regions and asset classes, including:
- Asia-Pacific: Even with relatively high EPS growth and supportive monetary policies in China, Japan, India and Australia, the team expects lower returns across the region relative to last year. They see Japan as the preferred Asia-Pacific equity market.
- North America: The aggregate U.S. equity versus fixed income signal is still in favor of equity, but is moving closer to neutral. Also, due to expensive equity and bond valuations, pressure on profit margins, and the impending rate hike, the strategists are now recommending a small underweight for U.S. equities relative to global equities.
- Eurozone: The team’s highest conviction view remains overweight European equities, which is backed by double digit EPS growth, low oil prices, accommodative monetary policy, and cheap valuations relative to the U.S. They also maintain a positive outlook for the European economy, with expectations for 1.5% to 2% growth in gross domestic product in 2015.
- Emerging Markets: Even though EM valuations continue to look attractive, the team is highly cautious because of cycle concerns. As a result, the strategists view EM as a good long-term value opportunity.
- Currency: The USD is now close to parity with the euro and near an eight-year high against the yen. However, the current divergence in central bank policies supports continued momentum for the USD.
- Fixed Income: The strategists believe that 10-year U.S. Treasury yields will rise to between 2.5% and 3% by year-end and the spread to German government bonds may widen even further.
For more information, please see the “Strategists’ 2015 Global Outlook – Q2 Update”.
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