Every quarter, Fidelity's Asset Allocation Team (AART) compiles a comprehensive quarterly market update. Here are key highlights of the fourth quarter 2013 report. For a complete look at the investment themes, read the entire Fourth quarter 2013 quarterly market update.
During the third quarter of 2013, the Federal Reserve (Fed) and policymakers in China backed away from previous signals of tightening, helping to stabilize global interest rates. Modest cyclical improvements globally underpinned a broad rally in equities, especially in developed markets, which have been outperforming emerging markets on a sustained basis for the first time in more than 10 years. In the U.S., most bond categories reversed into positive territory after the Fed’s surprise move to extend quantitative easing (QE) at its current level. The global outlook appears range-bound amid slow, incremental growth, and high policy uncertainty.
Theme: five years after crisis—monetary stimulus vs. growth
On the five-year anniversary of the 2008 financial crisis, U.S. financial asset prices have recovered but the slow pace of economic repair has left some conditions worse than pre-crisis levels. The Fed appears uncertain about the sustainability of U.S. economic expansion, leading to its surprise September announcement postponing a pullback on QE. Yields dropped after the announcement, but the yield curve remains much steeper than in the early spring.
In China, authorities also appeared to step back from their tightening efforts to curtail shadow financing, and total credit creation rose to its fastest three-month pace in more than a year. Global bond yields have generally stabilized, even if interest rates face upward pressure over the longer term.
The global economy continues to indicate a steady upward trend despite the relatively slow pace of overall growth. Most of the world’s developed economies remain in favorable early- or mid-cycle phases. Many recent economic data releases have exceeded expectations.
New manufacturing orders continue to outpace inventory growth, suggesting a positive outlook for manufacturing activity in developed economies, particularly Europe, which has bolstered global trade and contributed to stabilization in China and other Asian exporters. Financial conditions in eurozone economies have remained stable, and bank lending conditions have been improving despite still-tight borrowing standards. China’s recent economic stabilization has been led by property-market activity and state-led infrastructure investment, broadly improving sentiment but doing little to spur consumer-led growth. Capital outflows from many emerging markets caused currency depreciation and higher borrowing costs, raising risks of stagflation.
In the U.S., late-cycle pressures remain low. Supply-demand fundamentals suggest the housing expansion is likely to continue. Weak employment and low income growth have capped inflation, though upside risks to oil prices may loom and fiscal policy challenges remain.
U.S. equity markets
U.S. equity returns accelerated from Q2, adding to robust year-to-date gains amid solid fundamentals and assurances of continued QE. Economically sensitive sectors beat defensive, dividend-heavy sectors, while industries with more global exposure benefited from the improved outlook and activity. Current valuations are near average, suggesting average intermediate-term return expectations. Healthy balance sheets have allowed corporations to reduce interest expense and boost returns of capital, and dividend payments remain important to investors. Historically, equities have experienced gains following the start of a Fed tightening cycle.
International equity and global assets
Strong returns in Europe spearheaded widespread gains across developed-country equity markets. Emerging markets rose as well, recouping some of their year-to-date losses. Trailing 12-month price-to-earnings (P/E) multiples remained below long-term averages in non-U.S. developed and emerging equity markets, and both markets remain relatively inexpensive relative to peak earnings. Continued human capital accumulation may boost global growth in the future. Headwinds have weighed on commodity prices in 2013. However, price stabilization amid the uptick in global growth, lower marginal costs, and tightening supply-demand conditions suggest a more positive short-term outlook.
Fixed income markets
Most bond categories generated positive returns in Q3 as interest rates stabilized. Credit-sensitive debt led the way, boosted by steady economic data and continued QE. Credit spreads tightened modestly, with most sectors falling further below historical average spreads. Municipal after-tax bond valuations are still favorable, with improved tax revenues. Elsewhere, the sell-off in EM corporate debt has left that market at its cheapest level in a decade relative to credit-equivalent U.S. corporate debt yields.
Asset allocation themes
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. Historically, investment-grade bonds have offered more downside protection than U.S. equities, even when rates were rising. Investing in a variety of sectors may also provide opportunities to enhance inflation resistance.
Outlook: market assessment
The global business cycle appears generally supportive of equities, though the outlook seems range-bound amid slow growth, high policy uncertainty, and mixed outlooks for emerging economies. The outlook for global interest rates and bonds is more balanced. Many developed countries continue to face fiscal and structural challenges. In the U.S., mid-cycle expansion remains resilient, though maturing with only moderate growth. The Fed’s near-term intentions are less than clear, but monetary policy is likely to remain easy.