World Markets Review Fourth Quarter 2007 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: Credit Crunch Raises the Odds of Recession This time last year there was some hope that the worst of the housing downturn was behind us. This wishful thinking failed to materialize. Instead, the housing slump deepened in 2007, giving rise to a subprime mortgage crisis, enormous bank losses in the U.S. and overseas and, ultimately, havoc in the global money markets. While third quarter gross domestic profit (GDP) growth of almost 5% indicated overall strength in the U.S. economy, housing and credit-related problems eroded the fourth quarter outlook and raised fears not only that the U.S. might tip into recession in 2008, but also that the global economy might be derailed as well. On the consumer side of the economy, November spending and job creation remained fairly healthy, but concerns mounted toward year-end. While existing home sales edged up for the first time in nine months, new home sales fell 9% in November to the lowest level in over 12 years. An estimated 2.6% of all homes in the U.S. were for sale, a level well above those seen in the recessions of the early 1980s and 1990s. The White House announced a plan to freeze mortgage rates, yet falling house prices, tighter lending standards and oil prices in the vicinity of $100 per barrel all raised expectations that consumer spending would slow. As expected, holiday sales disappointed, and just after month-end, December jobs were reported to be up by only 18,000, a level well below expectations. On the corporate side, banks and other financial firms dominated the news with announcements of huge losses related to subprime loans. The unknown extent of further losses made banks wary of lending to each other, provoking a reprise of the summer's credit crunch. In response, the Federal Reserve orchestrated a joint effort between North American and European central banks to provide liquidity into the money markets, the most aggressive act of global coordination since 9/11. The Fed also cut interest rates twice in the quarter, bringing the federal funds rate down to 4.25%. The decidedly weaker outlook and signs of rising inflation caused tremendous volatility in the equity and bond markets in the fourth quarter. Interest rate cuts (with more expected in early 2008) and efforts to calm the credit markets, together with continued strength in exports, may keep the economy out of recession. However, a host of uncertainties will keep investors wary and volatility levels high well into 2008. Index Returns   Month Ending December 2007   Quarter Ending December 2007   Year-To-Date 2007 Russell 1000® Index   -0.65   -3.23   5.77 Russell 2000® Index   -0.06   -4.58   -1.57 Russell 2500™ Index   -0.62   -4.32   1.38 Russell 1000® Growth Index   -0.36   -0.77   11.81 Russell 1000® Value Index   -0.97   -5.80   -0.17 Russell 2000® Growth Index   0.63   -2.10   7.05 Russell 2000® Value Index   -0.85   -7.28   -9.78 Lehman Brothers Aggregate Bond Index   0.28   3.00   6.97 MSCI EAFE Index Gross (USD)   -2.25   -1.71   11.63 MSCI Emerging Markets Index Gross (USD)   0.36   3.66   39.78 U.S. Stocks: Aging Bull Market Loses Momentum Following third quarter gains, some market indices reached new highs in early October. Yet U.S. stocks ultimately succumbed in the fourth quarter to further deterioration in the housing market, huge losses in the financial sector, a renewed credit crunch and inflation concerns. The Russell 3000® Index fell 3.34%, as fairly good gains among energy, utilities and consumer staples were offset by steep declines in financial services and consumer discretionary. Technology and industrials, market leaders through much of 2007, also lost ground as the economic slowdown in the U.S. threatened to dampen strong overseas economies and demand for U.S. exports. Even so, growth stocks held up considerably better than value due to the large concentration of financial services stocks in the value index. Investors also continued to favor large caps on concerns that small caps would suffer more in an environment of slower growth and tougher credit conditions. The U.S. bull market, now over five years old, lost considerable momentum in 2007. The Russell 3000® Index fell back 6% from its October high to end the year up 5.14%. All sectors advanced except for financial services and consumer discretionary. Sector dispersion was wide, with energy up over 30%, while financial services fell more than 18%. Large cap growth stocks fared relatively well as investors favored beneficiaries of global growth. Small cap value stocks, generally more exposed to the domestic housing, consumer spending or credit markets were severely punished. While financial services, homebuilders and a number of consumer-related stocks ended 2007 considerably cheaper, ongoing housing, subprime and credit concerns will likely keep investors wary of these groups well into 2008. U.S. Bonds: Treasuries Provide Safe Havens in the Subprime Storm (Performance is stated in total returns, unless otherwise noted) The Fed's global liquidity plan and November's strong consumer sales helped pushed Treasury prices down and yields back up in December; however, the trend for yields was decidedly down in the fourth quarter as the expanding subprime mortgage crisis and credit crunch prompted investors to seek the safety of Treasuries. The two-year Treasury yield fell from 4.01% at the start of October to 3.09% by quarter-end, while the10-year yield dropped from 4.55% to 4.07%. The Lehman Brothers Aggregate Bond Index returned 3.00% in the quarter to end 2007 just under 7.00%. Treasuries outperformed all spread sectors, returning 3.96% and 9.01% for the quarter and year, respectively. Despite strong balance sheets and low corporate default rates, investment-grade corporates delivered more modest returns of 1.97% and 4.56%. Outside of the Lehman Brothers Aggregate Bond Index, the extended sectors of high yield and emerging markets debt also underperformed Treasuries. High-yield debt returned -1.30% to end 2007 with a 1.87% return. The strength of developing economies supported the better returns for emerging market debt of 2.71% and 5.15% for the quarter and year, respectively. Non-U.S. Markets: Currency Gains Boost Returns (Performance is in U.S. dollars, unless otherwise noted) Non-U.S. banks' exposure to subprime mortgage-related securities, credit market turmoil and a loss of economic momentum in Japan contributed to the fourth quarter setback for international stocks. Though the MSCI EAFE Index fared better than U.S. stocks, the performance advantage came largely from currency gains. Relatively good growth prospects and stable earnings streams helped utilities, telecommunications and consumer staples advance; rising oil prices also boosted energy stocks. These gains were offset by steep declines in financials and other cyclical and consumer-related sectors. As in the U.S., technology also struggled. On a tear for much of 2007, the Pacific Basin ex-Japan fell 1.52% in the fourth quarter, hurt by weak financials in Australia. Japan continued its run of disappointing performance, falling 6.07% due to weaker economic data, political mishaps and better opportunities elsewhere in Asia. Rising global risk aversion also took a toll as the unwinding of carry trades pushed up the yen and pressured the outlook for Japan's exports stocks. Europe fared best, falling only 0.43%. Strong German industrials stocks and good returns in Spain's banking sector helped offset weakness in the U.K., Sweden and Ireland. While economic growth has been relatively healthy in Europe, the strong euro (up almost 11% against the dollar in 2007), rising oil prices, the weaker U.S. economy and recent credit market turmoil rattled business and consumer confidence toward year-end. Housing conditions also started to weaken in some markets, notably Ireland and Spain. International stocks continued to reward U.S. investors in 2007, yet much of the gains came through dollar weakness. The Pacific Basin ex-Japan gained almost 32%, due to Hong Kong's proximity to China and strong resource stocks in Australia. Europe returned over 14% with help from German exporters and the strong euro, while Japan lagged far behind, falling 4.14%. Emerging Markets: Strong Growth Produces a Fifth Remarkable Year (Performance is in U.S. dollars, unless otherwise noted) Though the ride was rocky, the MSCI Emerging Markets Index ended the fourth quarter in positive territory, a rather surprising outcome in an environment of rising global risk aversion. Yet robust growth prospects and soaring commodity prices kept sentiment positive towards emerging markets, particularly toward energy stocks. Telecommunications also outperformed. In stark contrast to their developed market peers, financials advanced with help from strong economies and the absence of subprime exposure. Technology and materials underperformed. The Europe, Middle East and Africa (EMEA) region returned almost 9% in the quarter with help from Russian energy and telecommunications stocks. Latin America gained just over 7%, as demand remained strong for Brazil's metals, oil and food exports, and as its currency appreciated against the U.S. dollar. Asia ended the quarter virtually flat (up 0.20%) as a setback in China on bubble fears and concerns of an overheating economy were offset by gains in India, particularly among its financials and energy sectors. India surged over 23%, due in part to strong foreign investment and more attractive valuations relative to China. Led by Brazil, India, Russia and China, emerging markets delivered a fifth year of gains in excess of 30%. While rising valuations may leave emerging markets vulnerable to economic slowdowns, growing middle classes and greater demand for consumer products may boost those stocks focused on their domestic economies in 2008. 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. Gross Domestic Product (GDP) is the market value of the goods and services produced by labor and property in the United States. 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. 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 January 2008 RFD 08-7337			Past COMMENTARY November   Investment PRODUCTS LifePoints Funds Russell Funds Separate Accounts   Printer friendly version of this page Send feedback or comments Site Search

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