Russell Investments' Strategists' Outlook - Q4 2015 Update: Economic Recovery will be Unconvincing and Riddled with Risks

• Volatility and uncertainty around price of oil makes it difficult to determine how brief recession will be; strategists remain hopeful for 'mild' recovery over the second half of 2015
• BoC ready to act if economy continues to stagnate; however, having capacity to act next year means they hold rates this year
• Housing market continues to pose the greatest long-term threat

TORONTO, Oct. 5, 2015 /CNW/ - While the Canadian economy has been in a mild recession over the first half of this year, Russell Investments expects it will regain some lost momentum by year-end, although the recovery will be unconvincing and riddled with risks, according to the company's Fourth Quarter 2015 Strategists' Outlook.

"While we remain hopeful for a marginal recovery, we are mindful of the headwinds as well as the risks of continued stagnation of the domestic economy," explained Shailesh Kshatriya, director, Canadian strategies at Russell Investments Canada Limited, who authored the Canada Market Perspective section of the global report. "What curbs our enthusiasm is that business investment remains elusive on two fronts: capital investment in the energy sector, which has been stunted by low oil prices, and in the manufacturing sector, which has not yet had enough time with a weak loonie to bring manufacturing capacity back online."

Kshatriya also believes that while investor attention may be fixated on oil and the energy sector, it is the housing market that continues to pose the greatest long-term threat to the domestic economy.

On a positive note, the report highlights that employment growth nationwide is low but positive on a six-month trend basis and household spending has held up, as the depreciating Canadian dollar relative to the U.S. dollar may reduce the incentive for Canadian consumers to cross-border shop.

The report also indicates that if the domestic economy continues to deteriorate, the Bank of Canada ("BoC") will not stand idle. But in order to do so without getting into unconventional monetary policy, keeping rates steady for the remainder of this year allows the BoC to have capacity to react next year.

Global outlook: China and U.S. Fed rate hikes dominate

Considering uncertainties around China and the prospect of U.S. Federal Reserve tightening, the strategists describe the markets as 'struggling to find direction" and underscore the importance of separating 'market noise from signal.' Volatility reached its highest level in four years in August as markets around the world pulled back, including a 10% retreat in the U.S., and about 15% in the U.K., Europe, Australia and Japan. However, the strategists believe the U.S. economy is robust and do not believe China will derail the global economy.

"The key question for investors now is whether the market turbulence is simply a retreat from overbought conditions or the beginning of a new bear market. Our view is the former," said Russell Investments' Global Head of Investment Strategy Andrew Pease. "U.S. domestic growth is back on track and we don't expect a recession any time soon. That said, Europe is still our most preferred equity market, followed by Japan, and we remain cautious on the U.S., U.K. and emerging markets."

US Federal Reserve still poised to hike rates later this year

The strategists continue to expect the Fed will hike interest rates in December and they believe the pace of future interest rate hikes will be more important than the initial timing. This expectation is based largely on the fact that the U.S. economy is big enough, domestically oriented enough and strong enough to shrug off downside risks from abroad. U.S. gross domestic product (GDP) growth is forecast to stay in the 2.0% to 2.5% range, while a 2.8% 10-year Treasury yield is expected over the next 12 months.

The team is, however, watching two key developments from a market perceptive: the extent to which the increased volatility in stock prices ripples through the real economy and the sustainability of U.S. corporate earnings.

"We expect economic momentum in the U.S. to fade over the next 12 months to a more modest pace in the face of upward pressure on wages amidst the tightening labor market and an erosion of profit margins," said Paul Eitelman, investment strategist. "We maintain our underweight preference to the U.S. equity market in global portfolios at Russell Investments because despite the recent market selloff, U.S. equities remain quite expensive."

Managed slowdown in China

According to the report, the Chinese economy is decelerating but not collapsing. Real GDP growth in China in the first half of 2015 was the slowest since the end of the 2008 financial crisis, which stirred investor fears that Chinese weakness may undermine global growth.

The strategists see three key scenarios that could play out, with the most likely one being that the Chinese economy will continue to decelerate, but policy instruments will forestall major financial distress and prevent a threat to global growth.

"A formidable array of policy instruments is being activated in China, and we believe the Chinese economy continues to be an engine for world growth, expanding at a rate in excess of 6% per annum," said Pease.

Strategy Outlook

Russell Investments' strategists employ the firm's three-pronged "cycle, value, sentiment" investment strategy process to update their forecasts. Currently, their global market perspectives include:

• Business Cycle:
  • Moderately positive on the U.S. cycle, although views have been downgraded in light of modest earnings per share (EPS) growth prospects and the anticipated Fed tightening.
  • Continue to be favorable on Japan where EPS growth is relatively strong and there is potential for Bank of Japan policy support.
  • Strongest cycle view is for Europe, with the tailwinds of euro depreciation, credit growth and less fiscal austerity, along with the European Central Bank's quantitative easing (QE), all supporting EPS growth.
  • The cycle is still negative for emerging markets amid U.S. dollar strength, falling commodity process and the economic slowdown in China.
• Valuation:
  • The U.S market remains the most expensive among major developed markets.
  • The strategists view both Japanese and European equities as moderately expensive.
  • Emerging market equities are still considered moderately cheap.
• Sentiment:
  • Momentum is now neutral across most equity markets and negative for the U.K. and emerging markets.
  • Contrarian indicator suggests that most markets are oversold following the declines in August and early September.
• Conclusion:
  • Aggregating the CVS framework leads us toward Europe as our preferred equity market, followed by Japan. We remain cautious on the U.S., U.K., Canada and emerging markets.

In summary, Pease said, "The volatility created by uncertainty over the Fed and China is unlikely to subside anytime soon. Our medium-term outlook for the U.S. and global economy is still positive though, and global equities should deliver moderate returns. Markets are going through an inflection point rather than a turning point, and market pullbacks can be an opportunity to add more risk exposure to globally diversified multi-asset portfolios."

Global Outlook Overview

For more information, please see the "Strategists' 2015 Global Outlook – Q4 Update."

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