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Investing ideas from our senior leaders

Opportunities from bond market volatility and in info tech, consumer, and biotech sectors.

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The surprise move by the Federal Reserve to delay the tapering of QE3 (reduce the amount of monthly bond purchases), an increase in bond rates, and improvements in the economic picture in the United States, Japan, and Europe, are some of the key themes resonating with the presidents, chief investment officers, and other leaders within the investment divisions at Fidelity Investments. They gather regularly to discuss market conditions, significant risk factors, and other dynamics driving the performance of the financial markets. 

In their September 2013 roundtable discussion, our investment professionals identified certain inflection points in the financial markets that could continue to influence performance in the months ahead. Jacques Perold, president of Fidelity Management & Research Co., moderated the discussion.

Jacques Perold (Moderator): Let’s start with some fixed-income perspectives. Bob, given the Fed’s decision in September to delay cutting back on its existing $85 billion-a-month bond purchase program, what are the implications for the money markets?

Bob Litterst (Money Markets): We were quite surprised by the Fed’s decision, as were most market participants. There was a near unanimous expectation that the Fed would commence “tapering” in September, based on the guidance they provided to the markets over the summer. This outcome indicates how difficult the Fed’s communication challenge has become as it has moved further away from conventional policy. In my opinion, the Fed’s decision reflects concern about a number of factors, including less-than-favorable recent labor market reports, very low inflation readings, and the sharp rise in long-term rates that followed their previous discussion of tapering. While Chairman (Ben) Bernanke clearly feels the need to hammer home the point that a shift in the program will be data dependent, we were surprised that the Federal Open Market Committee would try to fine-tune the process so carefully. For the time being, the Fed will continue to use asset purchases and forward guidance as its main policy tools. However, at some point, guidance will inevitably assume the lead role in policy actions.

The decision to delay the start of reducing purchases—and the accompanying guidance on the likely path of rates going forward—has an impact on money market investors by reaffirming a very aggressive, stimulative policy stance by the Fed, which increases the likelihood that short-term rates will remain near historic lows for the foreseeable future. In addition, the Fed will continue to remove $85 billion in collateral from the market each month, helping to keep short-term financing rates pinned at near zero percent. This will perpetuate the very difficult market conditions for short-term investors that have existed for several years.

Perold: What is the outlook for monetary policy abroad?

Fidelity Investments Roundtable participants:

Ron O’Hanley
President, Fidelity Asset Management

Bob Brown
President, Bonds

Young Chin
Chief Investment Officer, Pyramis Global Advisors

Joseph DeSantis
Chief Investment Officer, Equities

Tom Hense
Group Chief Investment Officer, Equities and High Yield

Bruce Herring
Group Chief Investment Officer, Equities

Brian Hogan
Head of Global Portfolio Management, Pyramis Global Advisors

Bob Litterst
Chief Investment Officer, Money Markets

Charlie Morrison
President, Fixed Income, and Vice Chairman, Pyramis Global Advisors

Jacques Perold
President, Fidelity Management & Research Co.

Stephanie Pierce
Executive Vice President, Investment Business Development

Nancy Prior
President, Money Markets

Christine Thompson
Chief Investment Officer, Bonds

Andy Windmueller
Chief Investment Officer, Global Asset Allocation

Derek Young
President, Global Asset Allocation, and Vice Chairman, Pyramis Global Advisors

David Hamlin
Head of Fixed-Income Research

Tim Cohen
Chief Investment Officer, Equities

Chris Bartel
Senior Vice President, Global Equity Research

Tony Rochte
President, SelectCo

Pam Holding
Head of Global Portfolio Management, Pyramis Global Advisors

Chris Sheldon
CIO, Private Wealth Management

Brian Enyeart
Chief Investment Officer, Global Asset Allocation

Melissa Reilly
Chief Investment Officer, Equities

Litterst (Money Markets): Despite its recent action to push out the start of tapering, I think the Fed is closer to initiating a subtle shift in its policies than central banks in either Europe or Japan, which is consistent with the mainstream view that the U.S. is further along in its policy response to the global financial crisis. The European Central Bank remains concerned about economic and financial risks in the periphery, and still appears willing to provide whatever support it deems necessary to foster stability in the eurozone. The Bank of Japan seems very determined to stimulate growth and inflation in its country, and also appears to be further from a shift in policy than the Fed. Short-term interest rates in these markets incorporate expectations for future rates that support this view. At this juncture, these central banks are exerting unprecedented control over financial market conditions in their respective countries, and seem intent to continue existing policies until their objectives are achieved.

Perold: Christine, how has recent Fed policy influenced the bond markets?

Christine Thompson (Fixed Income): During the past several months, as the bond markets have anticipated and adjusted to expectations for the Fed’s policy and guidance, the yield curve for U.S. Treasury bonds has been repriced, steepening dramatically as rates have increased. This steepening has been particularly pronounced at the seven-to-10-year range of the curve. For example, the 10-year Treasury bond yield has increased roughly 110 basis points since April (through Aug. 31, 2013).1 

Looking ahead, we must assess whether rates will potentially rise further from current levels, looking at economic growth and inflation expectations that are priced into the yield curve today. When we assess our strategy as bond portfolio managers, we regularly focus on yield curves for various bond sectors because the curves don’t typically move in a parallel fashion. There are many different interest rates, and bond prices adjust based on a variety of factors—fundamental and technical. Given recent rate increases, we feel yields have backed up enough to justify the level of inflation targeted by the Fed (about 2%), and reflect realistic assumptions for economic activity.

Perold: Has the increase in bond yields influenced supply/demand conditions?

Thompson (Fixed Income): In assessing flows in and out of different bond sectors, it appears that the recent increase in yields has shaken out some of the crowded trades in the market, particularly in areas where valuations were driven higher in a search for yield. I believe there have been a growing percentage of investors that have purchased longer-duration bonds with a short-term mindset. Bond price volatility incented some of these investors to exit the market. 

Outflows in various sectors created some challenges for managers who did not adequately assess liquidity needs, and increased performance differentiation in the bond market. For managers with strong liquidity, the broadening valuation differentiation provided a positive dynamic by surfacing opportunities to acquire bonds that were temporarily mispriced relative to their fundamentals.

Another area where supply-and-demand conditions have shifted is in the mortgage market. It is fairly clear that many yield-seeking investors previously purchased mortgage securities as higher-income alternatives to very stable assets, such as money market securities and short-term bonds. However, the incremental yield of mortgage bonds exists because the structure of those securities entails uncertainty as to when the bonds’ principal will be returned to an investor. With the upward movement in rates that we’ve had in recent months, mortgage securities clearly will return principal more slowly as refinancing activity slows. As a result, mortgage bonds have performed increasingly like longer-duration assets, with greater price declines than had been anticipated by some investors. This has led to growing investor outflows. Again, while it is important to carefully consider the specific nature of different mortgage securities, we feel that market volatility has created some unusual opportunities to position our portfolios for strong future return potential.

Perold: How are bond managers reacting to the market dynamics?

Thompson (Fixed Income): In this environment, we are managing our fixed-income portfolios with consistent focus on portfolio liquidity and on using that liquidity to invest in bonds where selling pressure has created valuation opportunities. We favor bonds identified as having strengthening fundamental profiles. We are aware that economic and political uncertainties may result in further upward rate adjustments in coming months, but we haven’t seen conditions that would justify sharply higher rates or trigger a rout in the bond market. In fact, we expect that those same uncertainties may well cause concern for the growth outlook and could trigger a decline in yields. 

Looking into 2014 and beyond, we’re mindful of historical return patterns where challenging years for bonds are typically followed by strong performance years.2 This pattern repeats partly because investors tend to sell assets after prices decline and cause pricing dislocations that are reversed when flows stabilize. We believe that the best approach to the bond market is to select portfolios considering both income needs and volatility tolerance and to maintain a multiyear horizon. This allows investment strategies to benefit from valuation swings across cycles.

Perold: What risks are bond managers concerned about?

Bob Brown (Fixed Income): The bond markets have absorbed the recent increase in rates fairly well. The 10-year Treasury yield has essentially doubled since the beginning of the summer, and we haven’t seen a serious disruption in our ability to trade securities across bond sectors.3 To me, the real risk going forward may be on the front end of the yield curve. The steepness between two-year and 10-year Treasury yields has been approaching historical highs (as of Aug. 31, 2013).4 If a new Fed chairman is appointed and if conditions are improved so that the chairman wants to return to more traditional monetary policy, yields on the front end of the curve could spike higher while longer rates adjust less. We continue to see strong inflows to many short-duration strategies, indicating that there are many investors currently not focused on this particular risk. Although I don’t see this scenario unfolding over the next six months, it may be one to assess looking forward to the intermediate term.

Chris Sheldon (Private Wealth Management): During the past several years, many investors had been reaching for yield, without considering other factors. With the recent sharp increase in rates, there were some investors that may have learned the hard way how overpriced certain equity-income sectors had become. Many of these sectors sold off amid the uptick in bond yields in the spring. Despite this fairly significant short-term increase in yields, we have not seen panic selling among our high-net-worth clients. Some investors are taking advantage of pricing disparities created with the recent bond market volatility. 

Another interesting market dynamic is that performance correlations among many asset categories have declined, and performance dispersion has increased in certain assets, such as bonds and equities. If that trend is sustainable, it may bode well for active managers who rely on fundamental research.

Bruce Herring (Global Asset Allocation): Historically, when volatility has risen, as it did back in the spring when interest rates began to rise, dispersion within asset classes increased as well. Since peaking in June, however, equity market volatility declined to lower levels and has remained relatively low for several months, yet dispersion has remained wide in the bond and equity markets.5 As Chris said, if this trend is sustainable, it’s a positive dynamic for active managers.

Andrew Windmueller (Global Asset Allocation): I see the recent increase in bond yields across intermediate and longer-term durations providing an attractive opportunity across asset allocation portfolios. If economic growth is weaker than expected, and the bond market has overreacted to the fear that economic growth is going to accelerate, then intermediate and long-term bonds are going to provide a much better source of diversification than they have in a while.

Perold: What themes are currently driving the equity markets?

Joe DeSantis (Equities): As Chris mentioned, the backup in interest rates was an inflection point for certain higher-dividend-yielding sectors that served as bond proxies, such as utilities, REITs, telecommunication services, and even consumer staples. As rates rose, these sectors performed poorly.6 These were not areas where we had excessive exposure in most of our diversified equity strategies. 

In addition, growth stocks started performing quite well relative to value stocks beginning in midsummer, providing a performance tailwind for many of Fidelity’s equity strategies.7 Several of our largest strategies had a bias toward growth-oriented sectors, such as information technology, consumer discretionary, and biotechnology. Given the positive momentum in the domestic economy, we continue to see growing investor confidence in growth-stock companies.

Tom Hense (High Yield and Equities): Generally speaking, most of our diversified strategies were well in front of the recent sell-off in high-dividend-yielding sectors, as many portfolio managers felt these sectors were expensive relative to the rest of the equity markets. Another trend that we continue to see is companies redeploying their capital much more efficiently and in the interests of shareholders, as opposed to making acquisitions. In a slow-growth environment, it’s much more challenging to make acquisitions that will effectively grow a business. And many companies that are using shareholder capital wisely have been rewarded for doing so.

Young Chin (Pyramis Global Advisors): As the year began, I think more investors became more comfortable owning equities, and many did so in the safest way they could—the high-dividend-yielding sectors, which typically are among the least volatile. There also was a diminishing trend of bad news, and an increasing amount of good news. As demand for equities grew, corporate fundamentals started to become a differentiator in stock performance, and this contributed to the overall broader demand for other equities, including growth stocks.

Perold: What portfolio strategies are our equity managers focusing on?

Pam Holding (Pyramis Global Advisors): Our expectation is for a gradual backup in rates from current levels, which would be positive for the positioning of our equity portfolios. From a regional perspective, we’ve moved our positioning from an expectation that the European economy is becoming less worse to an expectation that it is slightly improving. In many cases, valuations for some European stocks are priced at a significant discount to U.S. competitors. Elsewhere, our analysts are seeing signs that business is improving at the corporate level in China. And in Japan, we are monitoring whether the expected increased construction activity tied to the recent announcement of Tokyo as the winning bidder for the 2020 Olympic Games will lead to investment opportunities. Collectively, these inputs point to gradual improvement in the business climate for equities.

Windmueller (Global Asset Allocation): That view of general improvement abroad is consistent with the view of many of our research analysts in the global asset allocation division. In Europe, there has been an expansion in consumer activity, corporate sentiment, and manufacturing, and European stocks have recently outperformed U.S. equities.8 In our multi-asset-class portfolios, this recognition is driving a shift in our asset allocation. For more than a year, our strategies generally have been underweight foreign developed-country stocks, and recently we’ve begun to close the gap in the underweight relative to our benchmarks.

Perold: Andy, what other common themes are you seeing across the asset allocation strategies?

Windmueller (Global Asset Allocation): The other notable shift among our multi-asset-class strategies is an increase in investment-grade, fixed-income securities. As I mentioned earlier, the primary reason for this shift is an increase in yields and an improvement in the risk/return profile of fixed-income assets, which makes them much more attractive sources of portfolio diversification. For many strategies, holdings in short-term assets were reduced to pay for the increase in these fixed-income positions. Meanwhile, we continue to remain overweight U.S. equities relative to their benchmarks, believing U.S. economic fundamentals remain stronger than in other parts of the world.

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Before investing, consider the fund's investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
Views expressed are based on the information available as of Sep. 30, 2013, and may change based on market and other conditions. There is no guarantee the trends discussed will continue.
Past performance is no guarantee of future results.
Neither diversification nor asset allocation ensures a profit or guarantees against a loss.
Generally, among asset classes stocks are more volatile than bonds or short-term instruments and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Although the bond market is also volatile, 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. The securities of smaller, less well known companies can be more volatile than those of larger companies. 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. Sector investments can be more volatile because of their narrow concentration in a specific industry.
Content has been provided for informational purposes only and should not be considered investment advice or an offer for a particular security or securities. These views should not be relied on as investment advice and, because Fidelity’s investment decisions are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity product or service. Fidelity does not assume any duty to update any of the information. Fidelity cannot be held responsible for any direct or incidental loss incurred by applying any of the information offered. An individual’s investment decisions should take into account the unique circumstances of the individual investor. Please consult your tax or financial advisor for additional information concerning your specific situation.
Equity market references generally refer to S&P 500® Index, unless otherwise noted.
All indices are unmanaged and performance of the indices includes reinvestment of dividends and interest income, unless otherwise noted, and are not illustrative of any particular investment. An investment cannot be made in any index.
Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.
1. The yield on the 10-year U.S. Treasury bond rose from 1.67% on April 30, 2013, to 2.78% on Aug. 31, 2013. Source: Bloomberg, as of Sep. 30, 2013.
2. From 1990 through 2012 there were two calendar years when bonds declined. In 1994, The BC U.S. Aggregate Bond Index fell 2.92% in 1994, and returned 18.47 in 1995; the index fell 0.82% in 1999, and returned 11.63% in 2000. Source: Bloomberg, as of Sep. 30, 2013.
3. The 10-year U.S. Treasury bond hit a year-to-date low of 1.62% on May 2, 2013, and stood at 2.99% on September 5, 2013. Source: Bloomberg, as of Sep. 30, 2013.
4. The spread between the two-year U.S. Treasury bond yield and the 10-year U.S. Treasury bond yield rose from 1.46 percentage points on Apr. 30, 2013, to 2.38 percentage points on Aug. 31, 2013. Source: Bloomberg, as of Sep. 30, 2013.
5. The Chicago Board Options Exchange Volatility Index was 11.3 on March 15, 2013. It rose to 20.5 on June 20, 2013, and fell to 11.8 on Aug. 5, 2013. Source: Bloomberg, as of Sep. 30, 2013.
6. Sector performance during May 2013: utilities (-8.1%), telecommunication services (-6.6%), consumer staples (-1.8%). REITs: The FTSE NAREIT U.S. Real Estate Index fell 5.9% in May, 2013. Source: MSCI U.S. IMI sector indexes, Fidelity Investments, as of Sep. 30, 2013.
7. From July 23, 2013, to Sep. 26, 2013, the Russell 1000® Growth Index advanced 3.85%; the Russell 1000 Value Index fell 1.07% during the same period. Source: FactSet, as of Sep. 30, 2013.
8. From July 1, 2013 to Sep. 24, 2013, the MSCI® EAFE® (net MA tax) Index returned 11.0%, and the S&P 500® Index returned 5.6%. Source: FactSet, Fidelity Investments, as of Sep. 30, 2013. European household consumption rose 0.69% on an annualized basis in Q2 2013, the first positive contribution to GDP since Q3 2011. Source: Statistical Office of the European Communities/Haver Analytics. Corporate business climate indicator has risen in 2013. Source: European Commission/Haver Analytics. Eurozone manufacturing (PMI new orders minus inventories) activity has increased from a negative GDP contribution to a significantly positive GDP contribution from April to August 2013. Source: Markit/Haver Analytics, as of Sep. 26, 2013.
The S&P 500®, a market-capitalization-weighted index of common stocks, is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation.
The Chicago Board Option Exchange Volatility Index is an indicator of the market’s expectation of 30-day volatility.
The MSCI U.S. Investable Market 2500 Index represents the investable universe of companies in the U.S. equity market. Sector indexes of the MSCI U.S. IMI 2500 are classified according to the Global Industry Classification Standard (GICS®).
The FTSE NAREIT U.S. Real Estate Index is designed to present investors with a comprehensive family of REIT performance indexes that spans the commercial real estate space across the US economy.
A basis point is equal to .01%; therefore, 100 basis points is equal to 1%.
Pyramis Global Advisors LLC is a division of Fidelity Investments.
Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC.
Fidelity Portfolio Advisory Service® is a service of Strategic Advisers, Inc., a registered investment adviser and a Fidelity Investments company.
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