Russell Investments strategists' quarterly global outlook: A precarious balancing act for the Bank of Canada

• Seminal question for BoC: which way to tilt monetary policy - towards the "hawks" or the "doves"?
• Globally, equities are expected to withstand concerns around geopolitics, U.S. Fed tightening and global deflationary pressures, albeit with an increased risk of market shocks

TORONTO, Oct. 21, 2014 /CNW/ - The Bank of Canada (BoC) appears to be in a precarious situation, according to Russell Investments ("Russell") Strategists' 2014 Global Outlook – Fourth Quarter Update, which reflects the most recent guidance from Russell's global team of investment strategists. With recent economic data suggesting domestic growth is improving, the challenge for the central bank will be to reconcile recent trade-induced exuberance with erratic employment figures. As a result, the BoC remains hesitantly dovish, or on the side of lower interest rates, requiring clarity on two key issues: full-time employment and household indebtedness.

"The BoC faces a real conundrum," according to Shailesh Kshatriya, associate director, client investment strategies at Russell Investments Canada Limited, who authored the Canada Market Perspective section of the global report. "Notwithstanding recent improvement in exports and steady domestic consumption, the seminal question he needs to answer is: which way to tilt monetary policy - towards the 'hawks' or the 'doves'?"

According to Kshatriya, low interest rates underpin strength in housing as well as continued household indebtedness. The obvious "quick fix" would be to raise the target rate, which in turn would reduce housing affordability. "The danger, admittedly, is the potential collateral damage to business investment. In addition, raising interest rates prematurely could create a macro shock which would threaten a disorderly decline of housing and potentially portend a wider downturn in the economy."

For these reasons, Kshatriya believes the timing of the BoC's next move is likely to occur in the second half of 2015, with the central bank staying on hold longer than the U.S. Federal Reserve, which is expected to potentially raise its target rate in mid-2015. "Not surprisingly, the market has already started to price in the potential for this outcome, with the net effect from a currency perspective being a steady depreciation of the Canadian dollar relative to the U.S. dollar."

A declining Canadian dollar may be the silver lining, as a lower Canadian dollar is sorely needed to bolster a manufacturing sector that has shed thousands of jobs. The flip side is that an ascending U.S. Dollar pressures commodity prices lower. Overall, the strategist believes Canadian growth is entering a phase where it is becoming overly dependent and/or influenced by the U.S. economy. "This is not a negative as our southern neighbours gather steam," added Kshatriya. "Admittedly, it would be more encouraging to see signs of this momentum translating into business investment and full-time hiring. We believe both will be crucial to sustain recent improvements in growth heading into 2015."

In terms of global equity markets, the third oldest bull market in the past 50 years is wrought with increasing volatility and stretched valuations, yet Russell's strategists explain in the report why they do not see an imminent turning point. They maintain their core investment strategy views stated in their 2014 Annual Outlook, namely a moderate preference for equities over fixed income, a liking for credit, and a bias against exposure to rising long-term interest rates.

"The equity bull market is approaching its dotage and starting to display signs of unpredictability and irrationality," said Russell's global head of investment strategy, Andrew Pease. "Our models and process tell us it's not about to end just yet, but we expect volatility to increase as we approach the first Fed tightening."

According to the Russell strategists, moderate global economic growth, subdued inflation pressures and single-digit corporate earnings growth all support their moderate pro-equity bias. The report highlights selected geopolitical and economic risk factors that could result in a market pull-back. Specifically, they indicate tensions in the South China Sea, the situation between Russia and Ukraine, the rise of the Islamic State, and the protests in Hong Kong as warranting close monitoring. Secular stagnation and U.S. Fed tightening are also seen as potential causes for a market reversal. Ultimately however, the team concludes that equities should be able to overcome these concerns.

Central to Russell strategists' modest preference for risk assets is an expectation of continued economic growth. Based on their forecasting models, the strategists expect a 2.9% real Gross Domestic Product (GDP) growth in the U.S. and 1% to 1.5% GDP growth in the Eurozone in 2015. They predict that Chinese GDP growth will stabilize to the 7% to 7.5% range into early next year, Japanese GDP will steadily rise, and the healthy GDP figures in Australia will slow, but not dramatically. For the next year, U.S. job gains are forecasted at 225,000 per month and the first Fed tightening is still expected to take place in mid-2015.

To formulate the market predictions in the report, Russell's strategists depend on a set of qualitative and quantitative inputs. Based on their continually updated "value, cycle, sentiment" investment strategy process, the current global market perspectives are as follows:

• Value: U.S., Continental Europe and Japanese valuations stagnant

Russell strategists agree that valuations have been consistent over the last few quarters. U.S. equities are still the most expensive with a price to book value around 2.7 times and cyclically adjusted price-to-earnings ratio of over 20 times. Continental Europe is modestly expensive, but the regional dividend yield of around 3% is attractive. UK equity valuations are still in negative territory due to poor earnings. Strictly from a value perspective, Japan is the most attractive of the developed markets and currently holds a neutral valuation score. Equities in emerging markets (EM) remain undervalued, especially relative to developed markets.

• Business Cycle: Developed markets display positive cyclical indicators, but Japan at risk

The U.S. and UK markets are both showing robust economic growth trends, which are slightly offset by the risks of monetary tightening in 2015. On the other side of the spectrum, the Eurozone is displaying weak data and loss of growth momentum, but further easing of fiscal austerity and European Central Bank (ECB) President Mario Draghi's plan for a €1 trillion of balance sheet expansion is expected to counter these trends. Generally, the strategists see a positive cycle for developed economies, with the exception of Japan, which is at risk of a cycle score downgrade resulting from weak economic data following the consumption tax increase.

As for the cycle in emerging markets (EM), Russell strategists believe that falling commodity prices, downgrades in earnings expectations, slowing growth momentum and a strengthening US dollar are all sources of concerns. While additional stimulus and easing in China and Korea may improve prospects within Asian EM, they feel that there is deep uncertainty in Latin-American, European and Middle Eastern EM.

• Sentiment: Developed markets maintain positive momentum, despite some contrarian signals

Across the developed markets, price momentum is seen as a positive driver.  Out of the various indicators the strategists track, only a few of the indicators – such as the declining market breadth in U.S. stock leadership – signal that markets are in the over-bought territory.

For more detailed information, please see the "Strategists' 2014 Global Outlook – Fourth Quarter Update".

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RETAIL-2014-10-20-1002 Exp. October 2014

SOURCE: Russell Investments Canada Limited

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