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Q3 2014 update: seven key takeaways

A good backdrop for stocks, yields aren’t likely to rise sharply, opportunities in tech.

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Each quarter, Fidelity's Asset Allocation Research Team (AART) compiles a comprehensive quarterly market update to provide asset allocation recommendations for Fidelity’s portfolio managers and investment teams. Here are seven key takeaways from the second quarter of 2014. For a deep dive into each, read the Quarterly Market Update: Third Quarter 2014.

First, let's look at how the markets did in the second quarter of 2014. Global economic expansion remained slow but steady during Q2. Alongside easy monetary policies and low inflation, market volatility fell and most asset prices rose. Low volatility may be breeding investor complacency amid mounting global risks.

Most asset classes posted solid gains during Q2 and were positive year to date. Real estate investment trusts (REITs) led for the second quarter in a row, while Q1 global laggards—such as emerging market (EM) and non-U.S. developed-market (DM) equities—rebounded. Despite low volatility, some equity categories that led heading into 2014—including small-cap, biotechnology, and Internet stocks—experienced corrections, but regained their footing in Q2.

1. Third-quarter theme: A sharp rise in bond yields remains unlikely.

The steepening of the yield curve in 2013 showed that investors had come to expect the tapering of quantitative easing (QE) and stronger U.S. economic growth in 2014. So far this year, yields have come back down as investors have perceived a dovish Federal Reserve (Fed) stance and subpar economic data. The European Central Bank and the Fed continued to emphasize “low for long” policies. Thus, despite QE tapering, investors suspect a Fed rate hike is unlikely in the near term. The net issuance of bonds has been lower in recent years and the demand from the reinvestment of coupon proceeds has nearly soaked up new issuance. Falling real (inflation-adjusted) long-term bond yields have been the main drivers of the decline in long-term nominal rates in 2014. Given our forecast for slower U.S. GDP growth over the next 20 years and the strong historical correlation between yields and GDP growth, we believe 10-year Treasury yields should rise over time, but will stay below the historical average.

2. Macroeconomic backdrop: Global economic growth is slow—but steady—with a mixed outlook among countries and regions.

The world economy continues to grow at a steady pace, supported by the U.S. and Europe. Plunging U.S. economic volatility has contributed to asset-market stability. However, leading indicators for the world’s major economies deteriorated somewhat during Q2, particularly across EMs, which are still facing stagflationary pressures despite recent stabilization. Developed Europe’s cyclical backdrop remains positive. The outlook for manufacturing in most countries is still favorable, although the slowing bullwhip (new orders less inventories) signals that the expansion remains sluggish. Japan faces late-cycle pressures and its outlook remains muddled, as data following the consumption-tax hike has shown a recovery in sentiment but still-difficult current conditions. Late-cycle pressures also persist in China, which may be in a growth recession despite recent policy easing.

U.S. employment gains have boosted the outlook for consumption, and housing fundamentals have slowly improved. Inflation ticked up to around 2% in Q2 as supply disruptions contributed to higher food and energy prices, though late-cycle pressures do not appear imminent.

The probability of financial crises has risen among EMs in recent years—specifically in China, due to its rapid expansion of credit and housing prices. China continues to try to rein in credit excesses while attempting to meet high targets for economic growth. A slump in China’s real estate markets prompted a shift in policy focus away from reform and toward supporting growth in Q2. While global interest rates are low and financial conditions easy, the direction of monetary policy has grown more diverse. Any unexpected shift toward less accommodation could spark market volatility.

3. U.S. equity markets: Opportunities in tech continue, but there's a mixed outlook for small-cap vs. large-cap stocks.

Most equity categories posted solid returns in Q2. REITs, utilities, and materials led, while small caps lagged. Recent indicators signal that the technology sector may benefit from a potential increase in capital expenditures on technology over the next year. U.S. price-to-earnings (P/E) ratios are slightly above historical averages. However, our view is that stocks can sustain the current valuation level on average over the next 20 years, due to our forecast for lower interest rates and equity volatility. Also, the U.S. stock market has high exposure to sectors with consistently higher P/Es. U.S. corporate profitability remains high, amid rising cyclical productivity, muted input cost inflation, and low debt-service obligations.

The outlook for small caps versus large caps is mixed: Though large caps typically outperformed during the mid-cycle and are less expensive relative to history, small caps maintain a lesser exposure to the increasingly uncertain global economic outlook. The correlation between equity returns continued to fall in Q2, signaling there may be more opportunity for active management now than during the past several years.

4. International markets: Long-term growth potential favors emerging markets, despite short-term headwinds.

International stocks posted solid returns in Q2, led by Canada and bolstered by a weaker U.S. dollar and the strongest EM performance in six quarters. Though headwinds persist, EM equity valuations appear attractive relative to both their long-term averages and their current average discount to the U.S. We forecast slower annual global GDP growth over the next 20 years compared with the past 20 years. EMs will likely lead, but poorer demographics and less catch-up potential in emerging Asia signify a slower outlook for this region. By investing in non-U.S. DM equities, investors can access the positive secular economic growth of EMs while retaining the greater liquidity and generally better corporate governance of DM equities.

5. Fixed income markets: Short-duration bond strategies can provide an opportunity to outpace inflation.

All fixed-income sectors posted positive returns in Q2. Longer-duration categories led, supported by lower longer-term rates, and spread compression-boosted performance across credit categories. EM debt continued to outperform in 2014. Yields and spreads of all fixed-income sectors fell further below historical averages, reaching near cycle lows. Most categories benefited from robust investor demand and still-improving credit conditions. Municipal fundamentals generally continue to improve alongside the broader U.S economy and market technicals remain strong, despite some recent negative credit developments. With cash yields near zero, short-duration strategies may provide an opportunity to outpace inflation with minimal interest-rate risk. High-yield debt typically benefits from economic expansion, but a surprise Fed move to a tighter monetary posture may spur volatility.

6. Asset allocation themes: Diversify with high-quality bonds and international stocks.

Correlations between bonds and stocks remain negative on a rolling 24-month basis, suggesting high-quality bonds may provide diversification benefits. Further, correlations between U.S. and international stocks have fallen near prerecession levels, emphasizing the enhanced risk-return profile of a balanced global portfolio.

7. Outlook: The backdrop is positive for stocks, but some risks may cause market turbulence.

The global business cycle remains supportive of risk assets in the U.S. and Europe. Market volatility has been extremely low due to the steady world economy and easy money policies. However, rising geopolitical risks, uncertain outlooks for China and Japan, and any unexpected shifts toward tighter monetary policies have the potential to spur market turbulence.

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The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation recommendations for Fidelity’s portfolio managers and investment teams. AART is responsible for analyzing and synthesizing investment perspectives across Fidelity’s asset management unit to generate insights on macroeconomic and financial market trends and their implications for asset allocation. Primary contributors to the Quarterly Market update include Lisa Emsbo-Mattingly, director; Dirk Hofschire, senior vice president; Craig Blackwell, analyst; Jake Weinstein, senior analyst; and Austin Litvak, senior analyst.
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Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.

Past performance is no guarantee of future results.

Investing involves risk, including risk of loss.

Indexes are unmanaged. It is not possible to invest directly in an index.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market or economic developments, all of which are magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region.

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.)  Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities, including leveraged loans, generally offer higher yields compared to investment-grade securities, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.

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