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World markets review
Third quarter 2009
 Aran Murphy, Senior Consulting Analyst for Russell Investment Services, 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.
Lower quality stocks lead recovery
Equity markets in the U.S. and abroad continued to recover through the third quarter, with the Russell Global Index gaining 18 percent as of September 30, up markedly — nearly 70% — from the year's low set on March 9¹. U.S. markets experienced their strongest two-quarter rebound since the 1970s.² Some of the strongest performing securities had surprisingly poor fundamentals, including high debt ratios and poor earnings, causing some portfolio managers to call recent performance a "low quality recovery."
Spreads in the credit markets continued to tighten, though at a slower rate than experienced earlier in the year. As U.S. Treasury prices gain in the face of weak inflation reports, the potential exists in that market for a large round of buying to cover short positions.
A mix of economic news gave reason for guarded optimism. The International Monetary Fund says that Asia is emerging from the global downturn faster and stronger than any other region, with growth in the region expected to reach 2.8 percent this year, increasing to 5.8 percent in 2010. World growth is expected to contract by about 1 percent in 2009, then expand by about 3 percent in 2010.
U.S. economy: Companies slowly push ahead
U.S. jobless claims increased over the quarter, manufacturing declined, and short-term expectations for inflation declined. These helped lower 30-year Treasury yields to below 4 percent for the first time since April.
Lagging economic data released by the National Bureau of Economic Research showed that second quarter growth in company profits was down: Profits before tax increased $90.6 billion in the second quarter, compared with an increase of $186.4 billion in the first quarter. Note that this indicates not a decline, but a slower rate of growth. Real gross domestic product (GDP) decreased at an annual rate of 0.7 percent in the second quarter of 2009, according to the third estimate released by the Bureau of Economic Analysis. This is markedly better than the first quarter, when real GDP decreased 6.4 percent.
U.S. stocks: Riskier securities prevail
Investors in U.S. stocks appear to be seeking riskier securities with weaker fundamentals. Lower-priced stocks dramatically outperformed higher-priced stocks both year-to-date and in the third quarter. More aggressively positioned investors fared better than those positioned defensively. Some manager researchers and portfolio managers believe the market is transitioning from a "P/E" (price to earnings) to an "E" driven market, meaning that the emphasis will return to company earnings over recent price momentum. If so, this could benefit active managers, and the risks may be moderate, as investors focus less on lower-quality stocks that perform more in line with the broader market.
U.S. fixed income: Inflation expected to remain subdued
U.S. corporate credit spreads have narrowed over the past three months. Credit rating upgrades are poised to exceed downgrades for the first time since early 2007. The trend in narrowing credit spreads is expected to continue, though the rate of change is not as rapid as that seen in the second quarter.
Worldwide, the yield differential between corporate bonds worldwide and government debt narrowed to 2.1 percent in September. The U.S. Federal Reserve Bank voted to maintain its target rate at 0 to ¼ of a percent, citing sluggish income growth, ongoing job losses, lower housing wealth, and tight credit. The committee noted resource slack and longer-term stable inflation expectations as the reason it anticipates inflation will remain subdued "for some time." The committee also decided to slow the rate at which it purchases U.S. government assets.
Non-U.S. stocks: International equities gain strength
Non-U.S. equities had a relatively stronger third quarter than U.S. equities, with a 20.2 percent gain on the Russell Global ex-U.S. Index compared to a 16.3 percent gain for the U.S. Results in Japan were not as strong as those in other regions, with third quarter return on the Russell Japan Index of 6.9 percent. Value outperformed growth 21.3 percent to 18.9 percent, with small cap holding a 100 basis point advantage over large cap. Financial sector firms showed the strongest returns at 27.6 percent, and utilities were the weakest with a still respectable sector return of 14.7 percent.
In line with the low quality of U.S. performing stocks, non-U.S. cyclical stocks outperformed defensive stocks, and levered companies with negative earnings revisions performed best. Stock selection was a positive contributor to actively managed returns, though it was partially offset by adverse allocation results, particularly in non-U.S. funds. Value managers delivered significant excess returns, while their market-oriented and growth peers struggled. International and global funds remain "barbelled" with both cyclical and defensive holdings, though investors are returning to higher risk sectors as they increase their positions in industrials and consumer discretionary stocks.
Emerging markets: Developing countries see record year-to-date gains
Emerging market equities enjoyed another strong quarter as evidence that the global economic recovery was gaining traction fueled global stock market gains. The MSCI Emerging Markets Net Index gained 20.9 percent after notably robust returns in July and September more than offset a China-led pull back in August. Emerging market stocks have now posted record year-to-date gains, driven onwards by higher commodity prices (oil is up over 50 percent over the year, copper has more than doubled) and continued stimulus spending in China. While emerging markets remains the best overall equity asset class year-to-date, valuation levels are cause for concern.
1 March 9, 2009 value for the Russell Global Index was 686.71, compared with the September 30, 2009 close of 1162.08.
2 S&P 500 had a 34% gain from first quarter to third quarter 2009, the largest two quarter move since the 1970s.
Copyright © Russell Investments 2009. All rights reserved.
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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.
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 and 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.
Russell Global ex-U.S. Index measures the performance of the world's largest investable securities, based on market capitalization, excluding securities in the Russell 3000®. The index includes approximately 7,000 securities and covers 61% of the investable global market.
Gross Domestic Product (GDP): The market value of the goods and services produced by labor and property in the United States.
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.
Treasury Bills (T-bills) are short-term debt securities issued by the U.S. government with maturities of usually one year or less.
Emerging market debt (EMD) may include obligations of governments and corporations in countries with emerging markets.
Financial services sector consists of companies that provide financial services including banking, finance, life insurance, and securities brokerage, and services companies.
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For information on the Financial Industry Regulatory Authority, go to www.finra.org.
First used October 2009
RFS 09-2445
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