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Key takeaways for the third quarter 2013

Volatility returned, global growth improved, stocks gained a bit, and bonds sold-off.

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Every quarter, Fidelity's Asset Allocation Team (AART) compiles a comprehensive quarterly market update. Here are key highlights of the third quarter 2013 report. For a complete look at the investment themes, read the entire Q3 2013 quarterly market update.

Market summary

Global markets suffered a bout of extreme volatility, and bond yields rose on the perception that monetary conditions would tighten sooner than expected in the U.S. and China. The sell-off has improved the risk-return outlook for some asset categories, and equities in developed economies have been supported by better cyclical trends.

U.S. stocks added to their strong one-year gains during the quarter—evidence that investors' aversion to equities may be softening—but most other assets suffered negative returns. Rising interest rates and widening credit spreads led to losses across bond categories, while commodities and emerging markets suffered from China’s slower outlook.

Theme: The end of low volatility?

Complete third quarterly market update

Quarterly Market Update
A 50-page report with charts and commentary on what's behind the international and U.S. markets.

There are signs that the recent sustained period of ultra-low market volatility may be coming to a close. Bond-market volatility spiked in the U.S. on the expectation of an earlier end to quantitative easing from the Federal Reserve (Fed). Aggressive monetary policies in Japan have made its bond and currency markets into additional sources of volatility, as have attempts to tighten credit conditions in China. Bond yields and economic growth tend to correlate highly in the long term. Given our forecast for slower U.S. growth over the next 20 years than during recent decades, we expect 10-year Treasury yields to rise but remain below historical averages.

Economy/macro backdrop

Developed economies have been driving cyclical global improvement, while growth in developing countries has been disappointing— especially for those closely tied to China and commodity prices. Deepening current account deficits in several emerging economies highlight the growing risks. Though the eurozone remains relatively stagnant, manufacturing appears to be stabilizing, and even in the periphery the worst of the recession may have passed.

The U.S. economy’s solid mid-cycle expansion has been underpinned by the housing market’s ongoing recovery. Consumer sentiment continued to rise amid solid housing fundamentals, higher stock prices, improving labor markets, and better credit availability. Despite weak overseas demand and government sequestration cuts that have weighed on the manufacturing sector, increased business capital spending may point to a growing willingness to invest.

Though the U.S. economy is expected to endure the greatest fiscal drag from the federal sequester in the second and third quarters, the deficit outlook has improved significantly in the near term. Range-bound commodity prices and slow wage growth have limited inflation, and unemployment also remains far from the implied threshold for the Fed to raise interest rates. If the trend of modest growth continues, the risk of aggressive Fed tightening is low.

U.S. equity markets

Despite higher market volatility, U.S. equities generally posted modest gains in the second quarter. Sectors tied to the domestic economy fared well, while more global industries suffered from China’s lackluster growth. Using equity sectors as building blocks for portfolio construction may enhance the potential for active returns. Current valuations are near average, suggesting average intermediate-term return expectations. Though earnings growth has decelerated on slowing revenue and productivity growth, U.S. corporations have continued to return value to shareholders through both dividends and share buybacks, which have boosted total yields and helped to sustain equity gains. Rising bond yields pressured some high dividend-paying stocks during the second quarter, but stocks with higher payout ratios continued to enjoy relatively high valuations.

International equity and global assets

Losses were widespread as global volatility and weak growth in China weighed heavily on emerging-market stocks and commodity prices. Despite a bear-market correction, Japan experienced equity gains amid upward revisions in analysts’ earnings estimates, while revisions were negative throughout the rest of the world. Global currency markets were tumultuous, and the U.S. dollar strengthened against commodity-dependent, emerging-market currencies.

Disinflationary trends, rising real (inflation-adjusted) interest rates, and lackluster global demand put pressure on precious metals, industrial metals, and agriculture prices. Earnings multiples in both developed and developing markets dropped during the equity sell-off and remain well below long-term averages. However, many developing countries are likely to benefit over the next 20 years as their youthful populations mature into more productive workers.

Fixed income markets

The second-quarter bond sell-off was broad-based. Interest rate-sensitive and credit-sensitive categories all posted losses. Treasury Inflation-Protected Securities (TIPS) fared particularly poorly as real interest rates rose and inflation expectations fell, while only short-duration, floating-rate leveraged loans held steady. Credit spreads widened from historically tight to roughly average. With investment-grade yields at the low end of past observations and in line with current rates of inflation, bond investors continue to face a challenging environment. Macroeconomic uncertainty and sovereign indebtedness have made active management of risk exposures across fixed income categories even more important. Expectations of increased volatility may make investment-grade bonds more attractive for their downside protection potential, despite their interest-rate sensitivity.

Asset allocation themes

In the current environment of low inflation and still relatively low yields, diversifying a portfolio across bond sectors and non-bond sources of income with varied risk exposures may lower volatility and raise the expected risk-adjusted return. Fixed-rate bonds have struggled when inflation is rising—especially when interest rates have been low—while the real (inflation-adjusted) returns of equities have remained positive. Nevertheless, the low correlations of stocks and investment-grade bonds have the potential to provide important portfolio diversification benefits.

Outlook: Market assessment

The asset market outlook is mixed. Supported by the housing recovery and credit availability, the U.S. expansion remains resilient to fiscal tightening. Several non-U.S. developed economies are also improving, with Japan’s cyclical recovery gaining steam, and Europe moving toward the early-cycle phase. At the same time, the prospects for China and several developing economies are deteriorating, and the world’s major economies face structural challenges. While uncertainty around China and policy in general clouds the outlook, recent volatility has improved some asset valuations, leading to selective opportunities.

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The Asset Allocation Research Team (AART), which 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. Lisa Emsbo-Mattingly, director, Dirk Hofschire, senior vice president, and Craig Blackwell, analyst, contributed to this article.
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.
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Payout ratio is the dividend paid out over the year divided by the earnings over the year. A low payout ratio indicates dividend growth potential, while a high payout ratio indicates less cash to increase dividends.
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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.
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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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