World markets review: Coming up for air Second 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. The rebound in world equity markets that began in the final weeks of March continued through the second quarter. Following the stress tests for U.S. banks in March, credit market conditions improved from the short through to the long end of the yield curve. Volatility declined as the Chicago Board Options Exchange's VIX Index, the closely followed benchmark for market volatility, fell June 25 to a new eight 1/2 month low of 26.30%, the lowest level seen since mid-September 2008. That said, the World Bank forecasts a less encouraging picture for the global economy: global output falling by 2.9% and world trade by nearly 10%. Non-public capital flows are expected to decline from $707 billion in 2008 to an anticipated $363 billion in 2009. Market commentators fret that Federal Reserve Board Chairman Ben Bernanke's "green shoots of recovery" observation, made in March, was premature. U.S. economy: Thin rays of recovery shine, but dark clouds remain In line with Bernanke's view that less-than-catastrophic economic reports represent the first "green shoots" of a return to growth, some rates of economic decline are indeed slowing. After adjustments, the final reading on U.S. Gross Domestic Product (GDP) indicates that the economy declined 5.5% in the first quarter, an improvement over the 5.7% previously estimated. According to the Institute for Supply Management (ISM), U.S. manufacturing output in June shrank at its slowest pace for 10 months. The ISM index rose to 44.8 (readings below 50 indicate contraction). U.S. savings rates are reported to be at a 15-year high, of 6.9%. New York University economist Noriel Roubini forecasts that U.S. savings rates will eventually climb to 10 or 11 percent. The International Monetary Fund (IMF) believes that higher savings rates will lead to a strong increase in total household savings, bringing a sustained reduction in the U.S. current account deficit. Those thin rays notwithstanding, dark clouds remain. The U.S. federal budget deficit of nearly $1.5 trillion is more than 10% of GDP, a ratio not seen since the Great Depression in the 1930s. According to RGE Monitor, many forecasters predict unemployment will continue to rise, with economist Roubini committing to an expected range of 10.5 to 11% by the end of the year. U.S. stocks: Automakers and financials dominate the news Automakers dominated economic news in the U.S., as General Motors (GM) declared bankruptcy on the first of June. Although GM had earlier received $19.4 billion in federal assistance, the company announced that it would seek bankruptcy protection while it closed approximately 17 facilities and cut 20,000 jobs. Expectations for another $30 billion in federal aid will mean, when transacted, that the U.S. government, provincial and federal Canadian governments, and the United Auto Workers union will emerge as primary owners of the new company. Pre-bankruptcy equity holders will be left out. The U.S. federal government assisted Chrysler in courting Italian automaker Fiat as a buyer. Fiat purchased most of Chrysler's assets, closing a deal in June that saved the U.S. automaker from liquidation. In the financial sector, 10 U.S. banks were authorized by the Treasury to buy back government shares, thus repaying emergency funds received from the Troubled Asset Relief Program (TARP). Although a bank's ability to raise alternative funding in the private market was one of the preconditions of repayment, and as such should be considered a positive sign, IMF chief Dominique Strauss-Kahn cautioned that the financial system remains distressed. Ten of the 19 largest lenders in the U.S. had failed the Fed's stress tests of capital adequacy. U.S. fixed income: Risk rewarded in non-Treasury sectors Treasuries fell, heading for their steepest first-half loss in three decades. Fixed Income manager Pacific Investment Management Company observed that in a recent effort to support prices, the Fed engaged in near daily purchases of Treasuries and Agencies at a $400 billion annual rate. The result was a slight uptick: U.S. debt moved in a positive direction as reflected by the 1.90% year-to-date return of the Barclays Capital U.S. Aggregate Bond Index. Banks are now buying the mortgage-backed bonds that had seen such sharp price declines in the previous quarters, helping to sustain higher prices for the debt, according to Federal Reserve data, investors, and traders. Large U.S. commercial banks held $154.6 billion in mortgage securities that lack government backing on June 17, an increase of 5.6 percent since April. Typical prices for the most-senior such securities backed by prime-jumbo mortgages have risen to 75 cents on the dollar from 63 cents in March, according to Barclays Capital. Banks are investing more in securities, as deposits rise faster than lending. Bank loan funds realized gains in the fixed income markets as loan prices climbed 27%, to 78.8 cents on the dollar since December 31. With average year-to-date returns of 26%, bank loan funds are outperforming all fixed income investments, followed by high-yield bond funds with emerging markets bond funds up 22% and 16%, according to data from Morningstar, Inc. Loan prices are benefiting from signs the economy is recovering from a recession, and an increasing number of companies able to sell bonds to repay their bank debt. The likelihood of default in the credit markets appears to be easing, as the Markit CDX North America Investment-Grade Index (for credit default swaps), linked to 125 companies in the U.S. and Canada, fell 0.6 basis points to a mid-price of 130.75 basis points for the second quarter. The index declined by more than 66 basis points since the end of the first quarter. The second quarter saw the biggest gains since 2002 for emerging market bonds — so much so — that debt from Ukraine to Ecuador appeared expensive. The rally caused the yield spread on emerging-market bonds over U.S. Treasuries to narrow by 2.45% since December 31 to a spread of 4.45% June 30, the biggest contraction since 2003. Non-U.S. stocks: International markets stimulated for growth (All returns are in U.S. dollars unless otherwise noted.) The Organisation for Economic Co-operation and Development (OECD) expects GDP among its 30 developed-economy members to decline by 4.1% in 2009, but to recover and grow by 0.7% in 2010. In Asia, Taiwan's industrial output increased by an annualized rate of 80% in the three months to May 2009, compared to the three months prior. Signs of weakness remain, however, with Singapore and South Korea's first quarter spending down 4.5%, compared to the first quarter of 2008. Japan's industrial production increased by a preliminary 5.9% for month-on-month output growth for May, according to the Ministry of Economy, Trade and Industry (MITI). It was the highest recorded increase since March 1953, though manufacturers produced nearly 30% less than they did a year ago. Overnight to one-year euro LIBOR rates set new lows, with the 1-year LIBOR rate reaching a low of 1.44%. This rate decline followed the European Central Bank's (ECB) move to pump €442bn ($621bn) of 12-month loans into the markets on Wednesday, June 24. Euro LIBOR rates for 12-month lending have also fallen below those for equivalent dollar rates in spite of a U.S. Federal Reserve fund rate near to zero compared with official eurozone rates of 1%. Some have called the action "stimulus by stealth", via action taken without formal policy support. Emerging markets: Developing economies surge ahead (All returns are in U.S. dollars unless otherwise noted.) According to the World Bank, developing economies should expect growth of only 1.2% this year, compared to last year's 5.9% growth rate. Strong growth rates in emerging markets are seen as essential for sustaining growth in per-capita demand in regions of rapid population growth. Emerging market equities continued to outperform their developed peers in the second quarter of 2009. Working in favor for developing market equities, JP Morgan estimates that emerging Asia's GDP has grown by an annualized 7% in the second quarter. The MSCI Emerging Markets Index gained 34.7%, its best quarterly return since data collection began in 1988. Most emerging market currencies outperformed the U.S. dollar on speculation that their economies would recover soonest. Eastern European markets—notably Poland returning 37% and Hungary at 69.7%—enjoyed the benefits of increased funding, after governments worldwide pledged to shield vulnerable developing countries from the worst of the financial crisis. Resource-rich Latin American markets grew as investors shifted their assets to emerging markets, such as Chile, up 34.7%, that supply China, up 38.2%, with raw materials. Despite The World Bank's forecast that Russia's economy would shrink by 7.9% this year, Russian equities gained 37.8%. Brazilian equities climbed 41%, as crude oil enjoyed its best quarter since 1990, helped by a steep decline in U.S. inventories, a weaker U.S. dollar and expectations of rising inflation. The Indian rupee rallied strongly, and the country's stocks surged 59.8%, as overseas investors flooded into the country amid speculation that the country's ruling Congress Party would reduce barriers to foreign investment. Equity market gains were pared back in June amid concerns over the sustainability of economic recovery and a surprising drop in U.S. consumer confidence. Analysts also expressed concerns over the durability and accuracy of valuations, which have risen sharply in recent months. Speculation persists, however, that developing markets are better positioned to weather the global recession given that their financial systems are better capitalized and less leveraged than developed countries. All sectors finished in positive territory, but the lower risk sectors—among them health care and telecoms, up 15.7% and 23.0%, respectively—underperformed the more cyclical sectors, including basic materials and industrials, up 38.0% and 37.8%, respectively. Financials enjoyed a notably strong quarter, gaining 47.1%, as the level of risk within the industry appeared to diminish. Copyright © Russell Investments 2009. 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. Barclays Capital U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. CBOE VIX (Chicago Board Options Exchange Volatility Index) measures annualized implied volatility as conveyed by S&P 500 stock index option prices and is quoted in percentage points per annum. For instance, a VIX value of 15 represents an annualized implied volatility of 15% over the next 30 day period. The VIX measures implied volatility, which is a barometer of investor sentiment and market risk. Markit CDX family of indices is the standard North American and Emerging Markets tradeable credit default swap family of indices worldwide covering multiple sectors including the Markit CDX North American Investment Grade (125 names). The Markit CDS indices roll semi-annually in March and September. Credit events that trigger settlement for individual components are Bankruptcy and Failure to pay. Credit events are settled via credit event auctions. 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. Mortgage-backed securities are bonds backed by a pool of mortgages. Investors receive payments out of the interest and principal of the underlying mortgages. 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. Health care sector consists of companies involved in medical services or health care including biotechnology research and production, drugs and pharmaceuticals, and health care facilities and services. Securities products and services offered through Russell Financial Services, Inc., member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. First used July 2009 RFS 09-2185			Past commentary 1st quarter 2009   Investment products LifePoints funds Russell mutual funds Separate accounts   Printer friendly version of this page Send feedback or comments

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