World markets review Second quarter 2008 Ann Duncan, Portfolio Manager, Balanced Funds, provides analysis and reporting on the U.S. and international markets. Now you can benefit from Russell's extensive research expertise, with timely commentary on the U.S. economy and equity markets, bond markets, and international markets. U.S. economy: Testing times for the Fed After a disastrous start to 2008, credit conditions appeared to be on the mend as the second quarter got underway. The U.S. Federal Reserve Board's aggressive actions—from cutting interest rates to orchestrating the sale of Bear Stearns to J.P. Morgan Chase to creating new lending facilities for banks—collectively signaled a strong intent to do whatever possible to prevent a meltdown in the financial system and bolster the sagging U.S. economy. Investor sentiment perked up and global markets rebounded from April through early May. But as the quarter progressed, more bad news across the financial services sector and the increased reluctance of banks to lend to each other, businesses and consumers indicated that credit conditions were far from healthy. Meanwhile, much of the economic data continued to alarm. Home prices fell sharply, job losses pushed the unemployment rate from 5 percent to 5.5 percent and consumer confidence fell to a 16-year low. Crude oil prices continued their upward surge, ending the quarter near $140 a barrel. Soaring food and fuel prices sparked riots in developing countries and routs across global markets in June. As inflation rates accelerated, a number of central banks around the world raised interest rates. In the U.S., Fed policy continued to err on the side of bolstering growth. While "headline" inflation moved up to 4 percent, well beyond the Fed's target range, "core" inflation (excluding energy and food) remained fairly moderate at near 2 percent. But real world necessities—such as paying over $4 a gallon for gas—caused consumer expectations about future inflation to jump significantly. A June Conference Board survey reported that Americans believed that inflation would reach 7.7 percent over the next 12 months. And in the corporate world, Dow Chemical's announcement of 25 percent price hikes illustrated the pressures on profit margins as raw material costs accelerate. Inflation concerns prompted a transition in Fed policy near quarter-end. After nine months and a cumulative 325 basis points in interest rate cuts, the Fed held the federal funds rate steady at 2 percent. Fed Chairman Ben Bernanke also resorted to tough talk about the dollar. Down 40 percent relative to the euro in the past eight years, the weak dollar has contributed to inflation pressures and, more recently, to the surge in oil prices. There were few bright spots during the quarter, though higher exports continued to help the economy and the tax rebates boosted personal income and retail sales. If there is a silver lining to the economy's dark cloud, it's that slower growth—both here and overseas—may act as a brake on rising inflation. Fed Chairman Ben Bernanke's statement that monetary "policy seems well positioned to promote moderate growth and price stability" will be tested in the coming months. Index returns   Month ending June 2008   Quarter ending June 2008   Year to date 2008 Russell 1000® Index   -8.31   -1.89   -11.20 Russell 2000® Index   -7.70   0.58   -9.37 Russell 2500™ Index   -8.15   1.39   -8.11 Russell 1000® Growth Index   -7.20   1.25   -9.06 Russell 1000® Value Index   -9.57   -5.31   -13.57 Russell 2000® Growth Index   -5.96   4.47   -8.93 Russell 2000® Value Index   -9.60   -3.55   -9.84 Lehman Brothers Aggregate Bond Index   -0.08   -1.02   1.13 Russell Global Developed ex-U.S. Index (USD)   -7.70   -1.23   -9.30 MSCI EAFE Index Gross (USD)   -8.16   -1.93   -10.58 Russell Emerging Markets Index (USD)   -10.37   -2.62   -14.31 MSCI Emerging Markets Index Gross (USD)   -9.96   -0.80   -11.64 U.S. stocks: Crude awakening Through mid-May, stocks recouped much of their first quarter losses. Investors hoped that the worst was over for the major banks and were also encouraged by some better-than-expected earnings within the technology sector. Energy and materials sectors also rallied in concert with commodity price gains. But renewed concerns about banks and credit conditions, runaway oil prices and expectations of rising inflation reversed sentiment decidedly as the quarter progressed. The Russell 3000® Index returned -1.69 percent and -11.05 percent for the quarter and six-months, respectively, ending down more than16 percent from its October 2007 high. Financial services led the late quarter rout with diversified financials, commercial and investment banks and insurers all down sharply. Bank of America, Wachovia, Lehman Brothers and AIG were among the hardest hit stocks, down by 36 percent to 47 percent due to huge losses and fears of more to come. Turmoil in the financial industry cost some prominent managers and thousands of employees their jobs during the quarter. Consumer-related stocks also fared poorly. High oil prices and worried consumers dented sales at General Motors, pushing its stock price down to 1955 levels. Consumer staples, normally defensive in volatile times, also underperformed as rising transportation and raw materials costs threatened to erode profit margins. Industrial stocks were pulled down by General Electric, which declined nearly 28 percent. Often regarded as recession-proof given its business diversity and geographical scope, GE 's disappointing first quarter earnings raised concerns about the outlook for corporate earnings in general. Companies with the strongest, most stable growth prospects fared best in the quarter. Energy stocks rose by over 19 percent and materials also advanced. Other outperforming sectors were either defensive in nature, such as utilities, or beneficiaries of global growth, such as technology. These trends favored growth stocks, while value stocks struggled due to the greater weight of financials. In a reversal of recent trends, small caps, which were helped by strong energy stocks, fared better than large caps. U.S. bonds: Inflation takes a toll on treasuries Improving conditions in the credit markets reduced the appeal of U.S. Treasuries in April and May, causing investors to venture back to riskier securities. Rising inflation and expectations that the Fed might raise interest rates later in 2008 helped push Treasury yields back up in April and May. However, Treasury yields swung wildly in June on alternating concerns of economic weakness, worsening credit market conditions and rising inflation. After falling significantly in the first quarter, the two-year yield rose from 1.59 percent back to above 3 percent before ending at 2.63 percent. With the 10-year yield making a less dramatic increase from 3.41 percent to 3.97 percent, the spread between short- and long-term rates flattened, making conditions tougher for financial institutions. Renewed credit fears prompted another flight to safety in June, yet Treasuries underperformed all major sectors during the quarter. The Lehman Brothers Aggregate Bond Index returned -1.02 percent, compared with -2.10 percent for Treasuries. The Fed's numerous actions to ease the credit crunch and bolster the economy helped corporates and mortgages perform better in April and May, and aided in the issuance of more than $300 billion of corporate investment-grade bonds during the quarter. Commercial mortgage-backed securities and investment-grade corporates returned 0.18 percent and -0.69 percent, respectively. Extended sectors also fared better with high-yield up 1.76 percent while emerging market debt returned -0.42 percent. Non-U.S. stocks: The ECB takes aim at inflation (All returns are in U.S. dollars unless otherwise noted.) Non-U.S. stocks, as measured by the MSCI EAFE Index, underperformed U.S. stocks for the first time in seven quarters, as a 4.45 percent decline in Europe offset a 2.39 percent gain in Japan. The energy and materials sectors advanced while most financials and consumer stocks fell sharply. In another reversal of recent trends, signs of slowdowns in overseas economies helped the dollar gain 6 percent against the Japanese yen and rise modestly against the euro. The U.K. fell 0.79 percent, with big losses in financials mostly offset by strong energy and materials stocks. Though the eurozone has held up better than the U.S. and U.K. in recent years, its economic outlook deteriorated in the second quarter under pressure from rising oil prices and struggling banks, notably UBS. The eurozone fell more than 5 percent, with Ireland and Spain down sharply on credit and housing concerns. Germany fared better, declining less than 2 percent. While materials stocks, such as fertilizer manufacturer K+S, made strong gains, Daimler's over 25 percent fall reflected the multiple challenges of rising input prices, the weaker U.S. economy and anemic consumer spending. Despite signs of a slowdown across the region, the European Central Bank (ECB) raised interest rates just after quarter end as inflation reached a 16-year high of 4 percent, which was double the ECB's target. While it can't control commodity prices, the ECB hoped to check inflation expectations and forestall wage-price spirals, which were so damaging in the 1970s. But across the Channel, weak housing and consumer data caused the Bank of England to hold interest rates steady at 5 percent. Japan was one of the quarter's few bright spots, helped by currency factors, healthier banks and better valuations. Though the weaker yen muted Japan's over 9 percent local currency return when translated into U.S. dollars, it enhanced the outlook for exporters. And in contrast to their global peers, Japanese banks ended the quarter in positive territory, helped by their reduced exposure to subprime loans and healthier balance sheets after years of recovering from their own excesses during the bubble years of the late 1980s. Elsewhere in the Pacific Basin, currency strength and strong mining stocks pushed Australia above 4 percent. Rio Tinto negotiated price hikes of more than 90 percent for its iron ore from China, adding to inflationary pressures, while BHP Billiton attempted to secure even greater price gains. Emerging Markets: Surging prices submerge Asia (All returns are in U.S. dollars unless otherwise noted.) Losing almost 10 percent in the first quarter, emerging markets had an almost equivalent rebound through early May but tumbled again in June on mounting inflation concerns. While 3 percent to 4 percent inflation levels worried central bankers in the developed world, their emerging market peers grappled with significantly higher price pressures. Inflation levels reached 8 percent to 11 percent in China and India, and spiked above 25 percent in Vietnam. A number of central banks raised interest rates and bank reserve requirements in attempts to curb inflation and slow credit growth in the quarter. With food and energy accounting for 30 percent or more of consumer-price indexes across emerging markets, The Economist estimated that two-thirds of the world's population may suffer double-digit rates of inflation this summer, meaning that more interest rate hikes may be on the way. All regions fell sharply in June, yet quarterly returns diverged considerably. The commodity-heavy Latin America and Europe, Middle East and Africa (EMEA) regions gained 10.96 percent and 6.26 percent, respectively. Surging energy and materials prices helped Brazil rise by over 18 percent and Russia by just under 11 percent. Brazil was also supported by an upgrade in its debt to investment-grade status and the strength of its currency. Asia, with higher exposure to industrials and the U.S. economy, fell 9.08 percent. Inflation accelerated in Asia along with the escalation of food and energy prices, and as governments reduced fuel subsidies. China and India lost more than 3 percent and 19 percent, respectively, ending the quarter roughly 40 percent to 45 percent off their 2007 highs. A disastrous earthquake, which further dampened consumer and business sentiment, also added to China's challenges during the period. India's central bank raised interest rates to 8.5 percent to curb inflation. Growth expectations for China and India remain robust, but rising inflation, higher interest rates, slowing global growth and still high valuations are likely to keep these markets volatile in the near-term. And while resource-oriented markets have done well this year, they too have their own inflation concerns and may well be vulnerable to any slowdowns or declines in commodity prices. Note: Sector returns are based on Global Industry Classification Standards (GICS). Russell Investments Copyright© Russell Investments 2008. All rights reserved. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Russell Investments is the owner of the trademarks, service marks, and copyrights related to its indexes. The Russell logo is a trademark and service mark of Russell Investments. Unless otherwise noted, the source in this material is Russell. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market. 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, non-payment 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. Large capitalization (large cap) investments involve stocks of companies generally having a market capitalization between $10 and $200 billion. The value of securities will rise and fall in response to the activities of the company that issued them, general market conditions and/or economic conditions. Small capitalization (small cap) investments involve stocks of companies with smaller levels of market capitalization (generally less than $2 billion) than larger company stocks (large cap). Small cap investments are subject to considerable price fluctuations and are more volatile than large company stocks. Investors should consider the additional risks involved in small cap investments. Growth investments focus on stocks of companies whose earnings/profitability are accelerating in the short term or have grown consistently over the long term. Such investments may provide minimal dividends which could otherwise cushion stock prices in a market decline. Stock value may rise and fall significantly based, in part, on investors' perceptions of the company, rather than on fundamental analysis of the stocks. Investors should carefully consider the additional risks involved in growth investments. Value investments focus on stocks of income-producing companies whose price is low relative to one or more valuation factors, such as earnings or book value. Such investments are subject to risks that their intrinsic values may never be realized by the market, or, such stock may turn out not to have been undervalued. Investors should carefully consider the additional risks involved in value investments. Specific sector investing such as real estate can be subject to different and greater risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments. Fund investments in non-U.S. markets can involve risks of currency fluctuation, political and economic instability, different accounting standards and foreign taxation. Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and to political systems, which can be expected to have less stability than those of more developed countries. Securities may be less liquid and more volatile than U.S. and longer established non-U.S. markets. Non-U.S. markets entail different risks than those typically associated with U.S. markets, including currency fluctuations, political and economic instability, accounting changes, and foreign taxation. Securities may be less liquid and more volatile. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Index performance is not indicative of the performance of any specific investment and is provided for general comparison purposes only. Index return information is provided by vendors and, although deemed reliable, is not guaranteed by Russell or its affiliates. Federal funds rate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight. Lehman Brothers Aggregate Bond Index is an index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an "as is" basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the "MSCI Parties") expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance in 21 developed market countries in Europe, Australasia, and the Far East. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market. Russell 1000® Growth Index measures the performance of those Russell 1000® Index securities with higher price-to-book ratios and higher forecasted growth values, representative of U.S. securities exhibiting growth characteristics. Russell 1000® Value Index measures the performance of those Russell 1000® Index securities with lower price-to-book ratios and lower forecasted growth values, representative of U.S. securities exhibiting value characteristics. Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, representative of the U.S. small capitalization securities market. Russell 2000® Growth Index measures the performance of those Russell 2000® Index securities with higher price-to-book ratios and higher forecasted growth values, representative of U.S. securities exhibiting growth characteristics. Russell 2000® Value Index measures the performance of those Russell 2000® Index securities with lower price-to-book ratios and lower forecasted growth values, representative of U.S. securities exhibiting value characteristics. Russell 2500™ Index measures the performance of the 2,500 smallest companies in the Russell 3000® Index, representative of the U.S. small to medium-small capitalization securities market. Russell 3000® Index measures the performance of the 3,000 largest U.S. securities based on total market capitalization. The Russell Global Developed ex-U.S. Index measures the performance of developed market securities in the Russell Global Index outside of the United States, based on market capitalization. The index includes approximately 4,800 securities and covers 46% of the investable global market. The Russell Global Index is constructed to provide a comprehensive and unbiased barometer for the global segment and is completely reconstituted annually to ensure new and growing equities are reflected. The Russell Emerging Markets Index measures the performance of emerging market securities in the Russell Global Index, based on market capitalization. The index includes approximately 2,800 securities and covers 20% of the investable global market. Treasury Bills (T-bills) are short-term debt securities issued by the U.S. government with maturities of usually one year or less. Securities products and services offered through Russell Financial Services, Inc. (formerly Russell Fund Distributors, Inc.), member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. First used July 2008 RFD 08-0501			Past Commentary 1st quarter 2008   Investment Products LifePoints Funds Russell Funds Separate Accounts   Printer friendly version of this page Send feedback or comments Site Search

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