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Q1 2014 update: seven key takeaways

A favorable outlook for U.S. stocks, fewer interest rate headwinds for U.S. bonds.

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Each quarter, Fidelity's Asset Allocation Team (AART) compiles a comprehensive quarterly market update—with analysis of the past quarter and what it may mean for the quarter ahead—to provide asset allocation recommendations for Fidelity’s portfolio managers and investment teams. Here are seven key takeaways from its first quarter 2014 report. For a deep dive into each, read the interactive Quarterly Market Update: First Quarter 2014.

First, a market summary of fourth quarter of 2013. The U.S. and global economies gained strength, while the Federal Reserve (Fed) announced a paring of its quantitative easing (QE) program. The quarter and full-year global stock market rallies were led by U.S. and developed-market equities, which outperformed those in emerging markets. In the U.S., many bond categories struggled as interest rates rose modestly during Q4, with investment-grade bonds posting the worst calendar year since 1994.

1. Q1 2014 theme: less liquidity, potentially more volatility

The unprecedented expansion of central bank balance sheets that began with the 2008 global financial crisis has supported a liquidity boom that helped fuel a terrific five-year span for asset market performance. Only Japan has an undiminished plan for further accommodation in 2014, implying slower global liquidity growth ahead. A steeper yield curve suggests expectations of ongoing Fed tapering, implying the impact may be more pronounced on assets vulnerable to lower liquidity than on U.S. yields.

Countries such as the U.S. that have deleveraged following a burst credit bubble may now have more stable financial backdrops. By contrast, some non-crisis countries such as China have had a massive credit expansion in recent years, which may lead to slower growth and/or rising financial risks.

2. Economy/macro: backdrop steady, but slow, upward growth

The global economy continues on a steady upward trend despite the relatively slow pace of growth. Most developed economies remain in the more favorable early- or mid-cycle phases. Leading indicators have improved in most of the world’s largest economies, with an upswing in manufacturing activity boosting global trade. Amid cyclical improvement in developed European markets, ongoing deleveraging pressures may limit the potential expansionary upside. An upcoming hike in Japan’s consumption value-added tax threatens to disrupt Japan’s cyclical momentum. In China, economic activity improved led by a re-acceleration in government-driven infrastructure construction, but rising interest rates could threaten the trend of rapid credit expansion and sow the seeds for slower growth.

A stronger U.S. dollar and global disinflationary trends have benefitted the U.S. consumer. Employment sentiment and the outlook for real wages have improved, the housing market is transitioning to a more mature expansion underpinned by a balanced supply-demand outlook, and the environment for corporate profit margins remains favorable. The fiscal outlook for 2014 is positive, with less drag from deficit reduction and less budgetary uncertainty.

3. U.S. equity markets: current valuations suggest decent return expectations

After rallying into the fourth quarter, U.S. equities posted their best returns since 1997. Economically-sensitive and domestic-oriented sectors led, while sectors connected to global commodity cycles and dividend-focused sectors lagged. Price-to-earnings (P/E) ratios have risen over the past year and current valuations are slightly above their long-term averages. However, some measures of cyclically adjusted P/E may overstate valuations, especially following the period of large balance sheet write-offs in 2009. Although large caps typically lead during the mid-cycle phase, small-caps outperformed in 2013, likely benefiting primarily from greater exposure to improving domestic trends amid slow global growth. Current valuations suggest decent return expectations.

4. International markets: developed markets stronger than emerging

In 2013, equities in non-U.S. developed markets posted stellar broad-based returns, while emerging-market equities lagged. Commodities faced weaker supply-demand dynamics, while gold plummeted amid rising real interest rates. Non-U.S. equity valuations—particularly in developed Europe and many emerging markets—are relatively inexpensive. Reflecting the better cyclical dynamics, analysts are raising their 2014 earnings expectations for developed markets, while lowering estimates for most emerging markets. While many emerging-market economies continue to face structural reform headwinds in the near term, our long-term outlook is for continued higher gross domestic product growth rates than for advanced economies, providing a solid secular backdrop for asset markets.

5. Fixed income markets: consider short duration bonds and munis

In 2013, most bond sectors showed negative returns as interest rates rose, with the longest duration categories suffering most. However, spread tightening partly offset rising yields in many U.S. credit categories, and riskier credit-sensitive classes such as high-yield corporate bonds and leveraged loans gained. Bond markets held up well following the Fed’s December meeting, and fourth-quarter rates increased modestly but remained historically low, while spreads narrowed further below long-term historical averages. With cash yields extremely low, short-duration categories have provided higher returns and generally outpaced inflation. A steep yield curve offers opportunities for intermediate-term roll-down strategies. After-tax yields on municipal bonds remain favorable to comparable Treasuries.

6. Asset allocation themes: diversify and consider inflation-fighting assets

Combining various non-bond sources of income may create diversification benefits. With current low yields on high-quality bonds, diversifying across a spectrum of fixed income sectors may improve risk-adjusted return. Managing inflation risk is still important, particularly through a diversified mix of inflation-resistant assets.

7. Outlook: positive backdrop for U.S stocks

The markets enter 2014 with solid momentum, but slower liquidity growth, fuller valuations on risky assets, and country-specific risks may increase volatility. Falling correlations between and within asset classes may provide a positive backdrop for active management.

A constructive and stable U.S. macro environment may favor U.S. equities, and U.S. fixed income faces fewer interest rate headwinds. The global economy enters the year with cyclical momentum and broad-based strength in developed economies, but policy risks have become more acute among emerging markets.

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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 macro economic and financial market trends and their implications for asset allocation. Primary contributors to the Quarterly Market update include Lisa Emsbo-Mattingly, director of Asset Allocation Research; Dirk Hofschire, senior vice president, Asset Allocation Research; Craig Blackwell, analyst, Asset Allocation Research; Jake Weinstein, senior analyst, Asset Allocation Research; and Austin Litvak, senior analyst, Asset Allocation Research.
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Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
Past performance and dividend rates are historical and do not guarantee future results.
Investing involves risk, including risk of loss.
Diversification/asset allocation does not ensure a profit or guarantee against a 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.
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.
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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