Download Don`t let market sentiment derail your portfolio from achieving your

Don’t let market sentiment derail your
portfolio from achieving your goals
17 February 2016
Global equity and credit markets have been very volatile since the beginning
of the year. We believe markets have over-reacted and should rebound when
sentiment improves. In the meantime, focus on your end goals and ensure
your portfolio is well diversified and dynamically managed as market
conditions evolve.
What’s happened in markets so far this year?
2016 has been a very volatile experience for global markets and investors to date.
The year began with a global market shock from China: the Shanghai Composite Index
lost 10% for the first week of January in reaction to Yuan devaluation, regulatory
uncertainty and disappointing manufacturing data. This was followed by global market
weakness, triggered by weak US consumer spending and further declines in oil
prices.
The market had a brief reprieve in late January following the Bank of Japan’s
negative interest rate action. However, volatility returned to the market early February
with a sell-off in eurozone financials, sparked by several high profile bank earnings
disappointments (e.g. Deutsche Bank, Credit Suisse, Royal Bank of Scotland). The
sell-off reflected the markets’ concerns about the stability of the eurozone banking
system, including worries about further decline in interest rates from European
Central Bank action, the level of Non Performing Loans (NPLs) and emerging market
exposures in the eurozone banking system, and the newly enacted eurozone bail-in
regime.
Figure 1 shows the performance of regional share markets for the year to 16
February 2016. Figure 2 provides perspective on the inherent volatility of share
markets over the longer term.
Russell Investments // Market Update
February 2016
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Figure 1: Share market returns (local currency) YTD 2016
Figure 2: Share market returns (local currency) 2008-2016
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What are Russell Investments’ strategy views?
What is driving the market downturn?
We believe it’s a combination of China fears, the Federal Reserve (Fed) tightening,
US recession concerns, bank balance sheet worries and soft corporate profits. The
move to negative interest rates in Europe and Japan has triggered fears that central
banks have run out of easing options, and by hurting bank profitability, could make
things worse.
How much risk is there of a US recession?
We believe the risk is much less than is being priced in by markets. Our economic
risk model gives a low recession probability for the US and expects GDP growth of
around 2% this year. The economic outlook has softened and we have reduced our
2016 US GDP growth forecast from 2.5% to 2.0%. US manufacturing is undoubtedly
weak and net exports are a drag, but households are benefiting from solid income
growth and lower energy costs. Government spending should add just under half a
percent to economic growth this year. Low inflation and wages growth means the
economy is only just returning to normal capacity. This is usually the safe part of a
typical expansion.
Credit spreads are the main indicator that points to elevated recession risk. These are
being pushed higher by energy sector defaults and liquidity concerns.
There is a risk that the economy could be weaker than we expect and grow by 11.5% (a mid-cycle slowdown). This could result from the strong US dollar, weak
exports, and a confidence hit from Wall Street volatility that causes businesses to
delay spending and hiring and makes consumers more cautious. This would justify
some of the market action so far this year.
But on the other side of the ledger, strong jobs growth and low inflation are boosting
real household incomes. Low commodity prices are a net positive for the US
economy and monetary policy is still accommodative. The economy could still
surprise with growth in the 2.5% to 3% range this year (although this has a lower
probability than the mid-cycle slowdown).
In summary, we believe the risk of a US recession is much less than is being priced
in by markets.
What is the US Federal Reserve likely to do now?
Ultimately, the US Federal Reserve (the Fed) has a difficult decision to make over the
coming months. There are several competing cross-currents in the economy and
markets. Even with just 151,000 new jobs created in January 2016, payroll growth is
sufficient to continue pushing the unemployment rate lower. There are tentative signs
that a tighter labour market is finally feeding through into wage pressures (exactly
what the Fed expected to see). And there are signs that core PCE (Personal
Consumption Expenditures) inflation has already bottomed out. So in terms of
observable progress towards full employment and price stability, the Fed should feel
reasonably confident. On that basis, we see a high chance of at least 2 rate rises
through 2016.
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The challenge is that monetary policy decisions are impactful on the real economy
with a lag and the medium-term outlook for the economy – which the Fed cares the
most about – is more clouded than it was in December 2015. Market-based
measures of inflation expectations continue to slide lower, although a strong labour
market still suggests that future hikes will come through on schedule through 2016.
Inflation remains finely balanced (with realised inflation progress offset by a slippage
in expectations), the Fed's confidence in the economic outlook is likely downgraded
(from “uncertain” to “a reason for pause”), and financial conditions – while easier at
the margin – remain volatile and uncertain. On net, we now expect that the Fed will
still be in "wait and see" mode at its March meeting.
Fed Chair, Janet Yellen, struck a cautious tone in her recent semi-annual monetary
policy outlook presentation that neither rules out nor confirms subsequent rate
increases. Her perspectives on the growth outlook and her read on the conflating
signals from actual and expected inflation will be most influential. If growth
stabilises at 2%+ we could easily see the Fed hiking 2 or 3 more times this year.
If a soft patch is realised, it could be slower than that. It's difficult to say precisely
what the Fed is going to do at this juncture.
The key message is that the current risks warrant a delayed and more gradual
process; the scenarios around that view remain tilted towards an even slower
process; but also from an investment strategy perspective, current market pricing has
moved too far towards an extreme recession scenario in terms of both the path for
rates (30% chance of a hike at all this year) and the term premium (-17 basis points
st
on the 10yr Treasury, which is below the 1 percentile dating back to 1961 according
to New York Fed statistics).
What is Russell Investments’ outlook for global equities over the remainder of
2016?
Our sentiment indicators still say that markets are oversold. However, downgrades to
our assessment of the business cycle outlook, as well as our quant models, have
returned our overall view on global equities to neutral. We are now neutral on
the US, but still overweight Europe and Japan, and underweight emerging
markets. We are becoming more cautious, and unless the business cycle
improves a lot from here, we are likely to stay cautious.
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How should investors feel, think and act in such volatile times?
Feeling rattled is normal
It can feel very confusing and unsettling to wake up to headlines such as “Global
stocks sink into bear market” and “Investors fret markets could be heading for 2008
all over again” one week, followed by “European bank shares extend their rebound”
and “World stocks rally after Japan’s Nikkei jumps 7.2%” the following week.
Fear and extreme risk aversion are very natural responses in times of market stress
and understandably, a very normal reaction is to flee from the ‘danger’ immediately
and join the crowd in getting out of the market. Even the most seasoned investors
can be rattled by the levels of volatility we’ve seen in recent weeks.
But panic and cashing out is risky, not risk-free
However, it is important to remember that when markets overreact and hit the ‘panic’
button, this can become a self-fulfilling negative spiral where investors become
increasingly bearish in response to startling news headlines and market fluctuations,
which in turn, further reduce investor confidence and reinforce selling pressure.
All investors want to achieve their desired objectives for their investment portfolios,
which can be expressed as a required rate of return to pursue their end goals.
Unfortunately, investors want more certainty than they can afford and often need to
take on more risk than they want to in order to achieve that required return. They
would prefer to focus on lower volatility investments, but those strategies usually don't
offer enough return to meet their long-term objectives.
While cashing out can reduce further exposure to markets, the danger is in assuming
that this is a ‘risk-free’ decision that can be maintained indefinitely. Yes, cash returns
are usually more stable than equity returns, but they also tend to be lower, so many
investors need the higher returns offered by shares to achieve their objectives in the
longer term. This creates a fundamental tension between the preferred level of risk
and the need for return. In times of volatility and panic, fight-or-flight survival instincts
switch on and because investors can't fight the market, they often flee by selling.
Nonetheless, when investors cash out and lock in losses when markets are falling,
they are unlikely to be able to accurately time re-entry to the market and miss out
when the market recovers and hence, risk failing to achieve their long term
objectives. For example, missing just the single best month in the Australian shares
1
market over the last 35 years lost investors approximately 15% .
How can you think and act rationally to achieve your objectives?
To avoid the buy-high, sell-low cycle that investors as a group predictably follow over
a market cycle, it is important to have a disciplined investment process to distinguish
between noise and true market signals. Market fluctuations can lead to behavioural
pitfalls such as loss aversion – during periods of market volatility investors experience
the sense of loss more acutely, with research showing that a loss causes about twice
as much pain as a gain causes pleasure. The temptation to succumb to this trap can
be resisted by developing and committing to a well-defined long-term investment plan
(and a risk-controlled framework to make any changes) to maximise the chances of
achieving your investment goals and desired outcomes.
1
From February 1980-July 2015. Represented by returns from the ASX All Ordinaries Accumulation Index.
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At Russell Investments, our portfolio managers use a disciplined and risk-controlled
process, informed by strategist insights and our Cycle, Valuation and Sentiment
(CVS) quantitative toolkit. This involves looking at both fundamentals such as the
business cycle and economic data of each region, share and bond market valuations,
as well as taking market sentiment into account.
Using this high-conviction process and a strong governance framework, the team
continually assesses portfolios in light of market conditions to ensure that:

Portfolios are well diversified across sources of returns that are not related
to each other. This is especially important in times of high market volatility, as
market drops and recoveries become more uncertain and timing in and out of
the market even harder to predict.

Portfolios use the best-of-breed active managers and strategies to capture
market opportunities and avoid emerging risks. This is particularly critical with
increased market volatility as the differential between the best and worst
stocks are greater, hence the greater the benefit (cost) of picking
outperformers (underperformers).

Portfolios are dynamically managed and employ downside protection
strategies when appropriate. An active approach to asset allocation is even
more vital in periods of market stress to ensure that portfolio protection is
implemented ahead of market downturns using the most efficient and costeffective tools available.
Summary
As stated in our 2016 Global Market Outlook, we expect this year to present a
challenging environment. However, we expect the global market to recover from
these lows as market fears of an impending global recession fade, much like we saw
following the weakness in August 2015.
While global markets remain very jittery, Russell Investments' strategists and portfolio
managers are keeping a close eye on daily activity from both a macro-economic and
portfolio management perspective. As market conditions change, investors can
expect that Russell Investments will adapt portfolios to both protect returns (if weaker
market conditions persist) but also position portfolios for any resulting market
recovery.
Despite global market volatility and the larger than expected sell-off in global equity
markets, we are inclined to look through market volatility at this stage and focus on
underlying economic fundamentals, which for now in our view, remain intact.
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transferred or distributed in any form without prior written permission from Russell Investments.
First used: February 2016.
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