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Optimistic prospects for new year, but a bumpy ride

News Release
For Immediate Release

26 November 2012

Russell Investments optimistic about prospects for new year, but cautions it will continue to be a bumpy ride

Modest profit growth, low inflationary pressures and continued recovery in the housing market point to single digit U.S. share market returns over the next 12 months, as long as the fiscal cliff is navigated, according to the Russell Investments November Market Commentary.

“The post-election sell–off in the U.S. has helped return some value to the U.S. share market. The S&P 500 is currently around 5% undervalued, while Australian shares and emerging markets shares have been estimated to be about 10% undervalued,” says Russell Investments’ Global Head of Investment Strategy, Andrew Pease. “We’re warming to emerging market shares following their underperformance throughout 2012. Because of heightened risk aversion by investors, emerging market equities have been priced at a discount and we see attractive levels of undervaluation”, Pease adds.

Sovereign bond yields look unsustainably low and remain extremely expensive, with the U.S. 10-year treasury yield sitting around 1.7% and Australian bond yields at just above 3%. Pease has predicted that sluggish economic growth, low inflation and bond buying by the Federal Reserve will limit increases in yields and leave them at low levels into the foreseeable future. Corporate credit spreads are also still attractive, with the global investment grade spread at 150 basis points, close to the long term average of 135 basis points.

Share market gains will be moderated by high profit margins, but modest upward pressure on government bond yields over the next 12 months will see that shares should still out perform fixed income investments.

Risk-on risk-off here to stay

Overall, Russell is cautiously optimistic about the prospects for investment returns over the next 12 months, despite predictions that the risk-on, risk-off pattern is expected to remain a feature of markets into 2013. On the positive side, improved conditions in Europe, China’s stabilising growth indicators and the valuation upside to Australian and emerging market shares should lead to increased performance of the share market. However, ongoing efforts by policy makers to resolve underlying structural issues mean that markets will continue to cycle between pessimism and optimisim, bouncing between fears of European disaster and policy moves to avert further crisis episodes.

“Both Australia and New Zealand have better medium term outlooks than the U.S. and Europe. New Zealand’s soft commodity exposure arguably puts it in front of hard commodity Australia when thinking about the outlook for the next five years. Although overall commodity demand is likely remain strong, prices for the hard commodities (iron ore, coal) have peaked amid rising supply and slower demand growth. Soft commodity prices, by contrast have better medium term price support” says Pease.

From here to QEternity: fiscal tightening and quantitative easing

Generating economic growth is still the biggest challenge for Europe, despite increasing confidence that the Euro-zone will hold together. Sustained recession means that many countries will be unable to achieve targets for reducing fiscal deficits and debt to GDP ratios. The implications are that debt concerns are likely to be with us for many more years.

“The next phase of the crisis is likely to lead to difficulties in achieving growth targets and result in missed deficit reduction targets, high unemployment, concerns about long-term solvency and political instability, particularly across the Euro-zone. The magnitude of fiscal tightening also means that quantitative easing policies are likely to remain in place for a while longer, even though it looks to be losing potency in terms of the impact on currencies, share markets and bond yields,” Pease argued.

The Aussie dollar

Closer to home, fiscal policy in Australia is expected to tighten by 1% of GDP per annum on average over the next 3 years, with most of this (around 1.8% of GDP), happening in 2013. The full impact of fiscal tightening is yet to be felt and economic growth is likely to be below trend over the remainder of the fiscal year, which will leave the RBA more open to ease interest rates further.

“The Australian dollar is still significantly overvalued and these rate cuts should act as a catalyst to reduced components of Australian dollar demand through decreased bond issuance. As a result, we should see a weakening of the AUD,” predicts Pease.

Russell’s November 2012 Market Commentary “From Here to QEternity” can be found here.


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