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Q2 2014 market update: seven key takeaways

The backdrop is supportive of stocks; issues in Japan and China may mean volatility.

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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 Quarterly Market Update: Second Quarter 2014.

First, a market summary of the first quarter of 2014. The global business cycle remained on steady footing during the first quarter, providing a generally benign backdrop for asset markets. However, divergences between emerging-market (EM) economies continued to expand, and rising global risks increased the likelihood of higher market volatility. Most asset categories had positive returns for the quarter, despite a rocky start. Equities in the U.S. and other developed economies posted modest results following large gains in 2013, while bond markets benefited from a slight decline in interest rates and from spread tightening. Developed-market (DM) equities continued to outperform EM equities.

1. Theme: five-year U.S. bull market

The U.S. stock rally has outlasted the average bull market, with higher returns. However, the preceding bear market was much steeper than average, and round-trip gains are currently near the median and below the average. Economic expansion during the current bull market has been more muted, likely extending this business cycle—which could give fundamental support for the stock market run to outlast historical averages. Amid a stable outlook for corporate revenues, profit margins remain near historic highs, benefiting from rising cyclical productivity, muted input cost inflation, and extremely low debt-service obligations. Although valuations are now modestly higher than historical averages, price-to-earnings ratios have historically shown little correlation with near-term stock performance.

2. Economy/macro backdrop: steady growth led by developed economies

The global economy continues to grow at a slow, steady pace, led by developed economies. Leading economic indicators in all of the largest DMs were higher than six months ago, compared to only about 60% of EMs. Credit conditions—a key driver of phase changes within the business cycle—are near their highest post-crisis levels in the U.S. and Europe, but hit new cycle lows in EMs in Asia. Europe’s expansion continues to become more broad-based. Modest wage growth in DMs continued to mute inflation, while EMs may face inflation pressures from rising agricultural prices. The tapering of quantitative easing contributed to slowing global liquidity growth, but central banks in Japan and Europe remain inclined toward additional easing. In Japan, a looming consumption-tax hike and a current account deficit are potential sources of wider market volatility. China continues to struggle with economic reform, and rising inflows of foreign capital may increase vulnerability to shifts in global capital flows. Slowing growth in many EMs has highlighted rising political risk in many countries, often exacerbated by looming national elections.

Inclement weather across much of the U.S. dampened economic activity, and residual effects such as higher utility prices and elevated auto inventory levels may create headwinds. However, consumer sentiment and labor-market leading indicators remained positive. The outlook for real wages has improved amid low inflation and a steady recovery. Solid earnings growth in the corporate sector continues, driven primarily by domestic profits rather than foreign.

3. U.S. equity markets: modest gains

Major equity categories experienced moderate returns in the first quarter. Real estate investment trusts (REITs), utilities, and health care led, while the more economically sensitive industrials and consumer discretionary sectors trailed. A cyclical rebound in private retail construction suggests that some industrial subsectors may be positioned to benefit from the trend. Price-to-earnings (P/E) ratios have risen over the past two years, but despite market indices near all-time highs, valuations are only slightly above long-term averages. The often-cited Shiller CAPE (cyclically-adjusted P/E) ratio may be overstating valuations. Low interest rates and strong profits have allowed U.S. corporations to return capital to shareholders through dividends and share buybacks.

4. International markets: mixed returns

Modest gains for DM equities were partially offset by negative returns in Japan. EM equities were relatively flat. Mild currency appreciation overall slightly boosted non-U.S. equity returns. Non-U.S. equity valuations remained relatively inexpensive, though the low valuation for EM equities may be influenced by a small number of large companies. Commodity prices rose overall, amid supply risks and political uncertainty. However, prices for industrial metals declined with slowing demand in China. Many EM currencies stabilized after significant declines during 2013. Downward-trending correlations between U.S and international equities may signal increasing diversification benefits from a diversified global portfolio, while lower intra-stock correlations may provide opportunities for active security selection.

5. Fixed income markets: broad gains

Bonds posted positive returns during Q1. The decline in long-term yields supported bonds with longer durations, while most non-government categories benefited from tightening credit spreads. U.S. debt spreads tightened amid higher investor demand and solid corporate fundamentals, while EM spreads benefited from a stable global economy. Investment-grade bonds are now 74% of the EM index, but a few low-quality issuers account for much of the index’s higher overall spread. With cash yields extremely low, short-duration categories have provided higher returns and generally outpaced inflation. After-tax yields on municipal bonds remain favorable to comparable Treasuries.

6. Asset allocation themes: bonds for diversification

Investors who frequently review their portfolios tend to shift toward more conservative exposures, demonstrating a bias called “myopic loss aversion.” Correlations between bonds and stocks remain negative on a rolling 24-month basis, suggesting bonds may provide important diversification benefits. Further diversifying across a range of fixed income sectors may improve risk-adjusted return and/or enhance inflation resistance.

7. Outlook: positive backdrop for stocks, despite volatility

The global economic backdrop remains constructive, led by the U.S. and developed Europe. However, risks to the outlooks for Japan and China have increased. Volatility in global asset markets may continue to rise, but the economic backdrop remains generally supportive of risk assets in the U.S. and Europe.

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