Glass seen as half-full for equities

Many of the concerns that moderated Russell’s capital market expectations going into 2013 failed to materialize in the first quarter of 2013. The most prominent concerns were over European Union instability and the potentially destabilizing “event” of the U.S. fiscal cliff. The destabilization never came. In fact, U.S. equity values rose by over 10% in the first quarter. One could say that market psychology shifted from “glass half-empty” to “glass half-full” – perhaps partly a reflection of investor fatigue over consecutive politically-oriented (often self-inflicted) wounds.
Moderate – but stable – economic growth, buoyed in the U.S. by resurgence in the housing and energy sectors, proved more influential than short-term consternation over political stalemates, potential long-term costs of government stimulus and lingering questions about the longer-range remedy for “federalizing” Europe. Equivalently, Asia proved the skeptics wrong. The Chinese government continued to demonstrate its ability to transition political power and manage moderating economic growth. The Japanese equity market responded decisively to the transition to the Abe government and its stimulus platform.
The intersection of improving economic strength and decreasing investor anxiety, we think, may yet push equity values further in 2013. While the potential for equity market drawdowns in any given year is significant – the average annual pullback on the Russell 1000® Index (peak to trough) from 1980 to 2012 has been 14.5% – Russell’s strategists believe that the equity market has potential for continuing its overall upward trend. We would be particularly encouraged should America’s corporate executive suite become emboldened to abandon its reticence toward capital expenditures. Mergers and acquisitions, especially, can position corporations competitively for strengthening economic conditions. While it is not known whether we have already seen 2013’s stock market high point, experienced investors are accustomed to as much as a 15% difference between the market’s best and worst moments in any given year.
For clients who have bailed out and now fear “missing the party” by staying in cash or short-term bonds, we continue to see cash as a lesser opportunity. In our view, a decision to await the uncertain event of a future “correction” as a strategy for “bailing back in” to equity markets is a riskier stance than holding a diversified portfolio.

Overstimulated?
Since the Global Financial Crisis, governments and central banks around the world have responded with one of two thematic policy responses: austerity or stimulus. Austerity usually comes in the form of tax increases and cuts in government spending towards balancing government budgets. Stimulus can come in the form of tax cuts and expansion of government deficit spending to stimulate domestic demand, or it can come in monetary form, when central banks lower interest rates and purchase their debt.
Most governments have chosen stimulus over austerity. In the countries where austerity was chosen, or imposed by external authorities (Greece, and to some extent Spain), economic contraction and heightened unemployment has been the result. Countries that have tended toward stimulus have generally maintained above-zero growth rates and have often experienced capital market asset value appreciation.
The equity market has room to run.
The price paid for any investment is the baseline for its ultimate return potential. Given current market levels, many investment strategists are suggesting that equities are more attractive than fixed income. Given the pockets of unresolved macroeconomic uncertainty around the world, some investors remain nonetheless uncomfortable with equity market valuations. Some are concerned that they will be buying high, after the strong run up at year end and in the first quarter.
In the lowest quartile of historical P/E’s (7.7–11.2), the average annualized return for the next 10-year period for markets starting at that level of P/E was +14.6% – which is higher than the historical market average.
For the highest historical quartile range of U.S. market P/E’s (18.7–28.5), the average annualized return for the next 10-year period for markets starting at that level of P/E was +7.7% – which is lower than historical market averages, but nevertheless a positive average return that is superior to expected returns in bonds.
So with the equity market’s P/E of 16.4 (12/31/2012), the number is only marginally higher than the historical average. Looking backwards, the average annualized equity return for such a P/E in the following 10-year period was in the range of +7%. Incidentally, that is consistent with the 12-month view of Russell’s Global Strategist Team. According to Andrew Pease, Global Head of Investment Strategy at Russell, the team’s current view is “positive gains likely limited by a mature earnings cycle, reasonably full valuations and moderate economic growth.”
Because of the difficulties inherent in economic modeling and forecasting, we temper our optimism with the recognition that large macro risks could disappoint the equity markets. Hence our continued emphasis on investing in a well diversified portfolio.
Russell’s view is that we are not in a bond market bubble.
We think interest rates will go up eventually. Russell and the Blue Chip panel of 50 top forecasters, including Russell, are forecasting rate increases into 2014.
A belief in rising future interest rates has many investors worried about their allocations to bonds within their portfolios. Based on the premise that rising rates must spell trouble for fixed income, many worry that rising rates will diminish, or even eliminate, the benefits of diversifying their nest eggs with bonds. This worry fails to account for some important features of bonds.
Duration can help measure the risk to a bond portfolio of changes in interest rates and can be helpful to those concerned about their bond portfolios. While it is true that bond prices move in the opposite direction of rates and are a function of the duration of the portfolio, it is also important to remember that most bonds make coupon payments as well (with the exception being zero-coupon bonds, or those that default on their payments). Total returns, which are what investors should care about, will include these coupon payments. Rising rates, in and of themselves, do not necessarily mean a negative bond portfolio return. The return characteristics of the bond portion of a portfolio depend upon the magnitude of the rate increase and the duration and coupon rate of the portfolio, with longer duration bonds typically experiencing the most impact on price. And to a degree, expectations for future rate increases are already priced into the bond market.
Of course, it’s worth noting that, although interest rates often rise during a strong or recovering economy, it is possible that rates could stay low for longer than investors anticipate. Indeed, the strong returns enjoyed by bond investors in recent years come in part from rates going lower yet than what was previously thought to be likely.
For instance, consider the most recent news surrounding Cyprus. The events triggered a “flight to safety” (i.e. Treasuries) trade among many investors, causing the 10-year Treasury yield to go down (and Treasury prices to move upward). We’ve been talking about what happens when interest rates rise since late 2008 and they haven’t moved off their historic lows yet.
That being said, Russell’s economists project that the benchmark 10-year Treasury yield will be about 2.25% at the end of 2013. This forecast assumes that the economy neither overheats nor undershoots toward recession.
To help illustrate potential bond market behavior, we can play out the bond math of a potential market scenario: What if interest rates were to rise by 1%, twice Russell’s forecasted amount? A portfolio similar to the Barclays U.S. Aggregate Bond Index, the benchmark investors typically use for U.S. fixed income, with a duration of 5 years and a 3.5% coupon, could lose -1.5% percent of its market value.
While losing -1.5% may not be obviously desirable, it is important to remember that fixed income is often used as a diversifier for the volatility or risk in an equity portfolio. Being down -1%, -2% or even -5% likely doesn’t change this role for fixed income.
In addition to the diversifying effects of bond exposure within a portfolio, active fixed income management can help balance the effects of rising interest rates on bond prices. Three of the levers active bond managers have in a rising rate environment include:
Active management strategy #1: Decrease duration
Prices of bonds with shorter durations don’t decline as much when interest rates rise.
Active management strategy #2: Adjust credit exposure
Investing in bonds with higher yields and higher risks means portfolios earn more income, which adds to a bond’s total return. This can help offset price declines coming from interest rate increases.
Since rising rate environments are typically associated with an improving economy, issuers of bonds with higher credit risks may be more likely to be financially stable and able to make future interest payments.
Modestly increasing allocations to these sectors, and selecting attractive securities within them, can be a way to take advantage of higher return opportunities without undermining the diversification benefits of bonds.
Active management strategy #3: Go global (Increase country and currency exposure)
Non-U.S. countries have different economic conditions and business cycles. While this may introduce country-specific risk to a portfolio, it also helps diversify the portfolio against some of the effects of rising interest rates in the U.S.
While global bond investing does increase currency and country risk, currency exposure also offers diversification opportunities because many currency market participants are focused on hedging future currency transactions (e.g., a multi-national firm needs to pay a supplier in local dollars three months from now). This creates inefficiencies in the market that skilled managers can try to profit from.
A map of the fixed income (bond) market environment, below, shows the sectors where there may be better yield opportunities in a low interest rate environment. In Russell’s view, opportunities exist in bank loans, emerging markets debt and other sectors that are outside of the Barclays U.S. Aggregate Bond Index.
As do our portfolio managers, bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, nonpayment and increased default risk, is inherent in portfolios that invest in high-yield (“junk”) bonds or mortgage backed-securities, especially mortgage-backed securities with exposure to subprime mortgages. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.
Concerns remain, which is why we diversify.
Despite the double-digit returns of the first quarter, we believe equity markets have room left to run this year. Although priced at historic highs, we do not believe the bond market is in a bubble. Indeed, despite expectations of decline, for several weeks bonds climbed further yet. Many macro-economic distortions remain, such as under-funded social obligations, sluggish developed economy growth, and youth unemployment. Those, however, are longer term concerns. With strong official support for the capital markets, we remain cautiously optimistic regarding investment returns.
These views support the following approaches to investing:
If in, consider staying in.
Concerns that there may be a stock market correction sometime this year may or may not be correct. Two things, however, argue for maintaining position: corrections have historically been paired with strong returns for the year overall and moving an entire portfolio to cash is to forego potential return opportunities in the other assets.
If in big, consider trimming the sails.
Investors making large contributions to savings might, if feeling prescient, try to time their equity investments for after a stock market pullback. This approach could be a problem if the waited-for pullback never materializes. We suggest a more steady approach of dollar cost averaging through the short-term ups and downs. While not as exciting as calling the market’s peaks and troughs, this approach is more likely to deliver a satisfactory outcome.
In other words – for the diversified investor, what we have to say is this: if you haven’t flinched yet, don’t flinch now.

Timothy Noonan is managing director, Capital Markets Insight, and chairman of the Strategic Advice Committee of U.S. Private Client Services at Russell Investments

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