point of view: record highs, rattled nerves · record highs, rattled nerves point of view capital...

FOR FINANCIAL PROFESSIONAL USE ONLY.

Record highs, rattled nerves

POINT OF VIEW

CAPITAL MARKETSINSIGHTS TEAMJULY 2016

A guide to proportionate responses in an impassioned environment.Two weeks ago, nearly 1000 financial advisor clients dialed to hear our interpretation of an event that was never supposed to have happened: The Brexit. Lately, as our current climate appears increasingly unconventional, we have been learning to take “left-tail “events more seriously and to regard conventional wisdom as less and less useful.

Just last week, several hundred clients dialed in again – this time in order to gain insight into one of the most unconventional aspects of today’s capital markets: record-setting equity market highs (S&P500® Index) combined with low (in some cases even negative) interest rates.

If you tuned in for that discussion, you know that the late stages of the economic recovery that the U.S. finds itself in, coupled with high U.S. equity valuations, have led the Russell Investments strategist team to prefer a more defensive stance.

And yet the U.S. stock market continues to set record highs, consumer confidence1 is robust, personal debt levels and unemployment are at historic lows and oil prices are currently at some of the lowest levels we’ve seen in the past decade.

Low gas prices buoy consumer spending

1 Measured by the University of Michigan Survey of Consumer Sentiment Index as of

July 15, 2016.

NOT FDIC INSURED – MAY LOSE VALUE – NO BANK GUARANTEE

Timothy Noonan,Managing Director

Sophie Antal Gilbert,Program Director

Johann Schneider,Senior Director

Todd LaFountaine,Program Director

Russell Investments // Point of View // Record highs, rattled nerves

FOR FINANCIAL PROFESSIONAL USE ONLY. // 2

Overhanging many of these positive conditions – and compelling us to place less faith in the predictive power of this environment – has been an unsettling series of Black Swan2 sightings: from Brexit to Turkish coups, and terrorism, underlined by episodes of civil disorder in new hybrid forms of craziness that defy our conventional labels. As we watch not just the unexpected, but in some cases multiple repetitions of the unexpected, a sense of skepticism for forecasts is not an illogical response.

2 Black Swans are events that have a low probability of occurring, but that would have a high

impact if they did come to pass.

Short-term return experiences feel very different than long-term forecasts

Risk managers, not risk takers

When you have devoted a lifetime to building a nest egg, it’s hard to be a dispassionate investor in an impassioned world. You have a lot to lose. And if you do suffer losses, you may not have enough time to recoup them. Professional money managers and moms and pops alike are feeling the ations act as a headwind to future market performance.

When it comes to the U.S. stock market, the list of experts calling for caution includes Russell Investments. Essentially our strategists have two primary concerns:

1. The U.S. stock market rally is an “aging bull“: even though economic expansions don’t die of old age, the later we are in the market cycle, the less room left for stocks to run.

2. U.S. equities are expensive and valuations act as a headwind to future market performance.

Generated as of 12/31/2015. Source data: *Balanced portfolio (actual) is 60% stocks (S&P 500 Index) and 40% bonds (Barclays U.S. Aggregate Bond Index); 60/40 Forecast = Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters. The forecasts are the expectations that the Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters had during the time period noted on the chart above. These are 10 year forward looking forecasts. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or any specific investment. Past performance is not a guarantee of future results. Indexes are unmanaged and cannot be invested in directly.



We believe, that as a whole, U.S. equity market valuations are extended, causing us to express caution. However, there still are pockets of opportunity available that may be exploited by utilizing skilled active management.

Over the last 12 months, two extremes of the U.S. equity market (Russell 1000® Index) – software and internet companies on the one end of the typical risk spectrum, and Utilities, Consumer Staples and REITs, on the other end of the typical risk spectrum – have seriously distorted market valuations. These two pockets of the market have outperformed the broad market by 37.5% and 12.5%, respectively, in the 12 months ending May 31, 2016. Everything else – all of the other sectors combined – were basically flat for the same time period. In other words, it’s not the case that all American companies are currently expensive. It is the case that a few of them are terrifically expensive, perhaps unsustainably so.

This has a few important implications for advisors:

1. The “toppiness” of the concentrated club of high flyers contributes to the perception of an unsustainable run, especially for technology.

2. Depending on how sanguine you are in the face of market corrections, exploring different ways to express “defensiveness” in your portfolios makes sense.

It’s not the case that all American companies are currently expensive. It is the case that a few of them are terrifically expensive, perhaps unsustainably so.



Expressing “defensiveness” in your portfolio

There are varying degrees of action one could take when trying to express caution in an overall investment portfolio. Your clients’ responses could range from hysteria (“The sky is falling”) all the way minor concern (“Sooner or later it will rain”) up to “irrational exuberance” (“Blue skies…”).In the table below, we consider some potential strategies for altering the risk characteristics of a client’s portfolio and explore some of the tradeoffs that are inherent in the choice.

Tactics and tradeoffs for adding downside protection

Source: Russell Investments, created and developed by Tim Noonan and Johann Schneider, Private Client Services / Capital Markets Insights group. The table is based on observations of capital market behavior. For illustrative purposes only. Financial Professionals and investors are in the most appropriate position to determine the suitability and fitness of any investment strategies, asset allocations or securities purchases or sales decisions. Russell Investments does not create, endorse or provide investment advice. Financial Professionals are solely responsible for suitability decisions with respect to client circumstances.

At one extreme end of the spectrum is the belief that an equity market crash is imminent. The correct response would be to reallocate the portfolio to cash, therefore providing perfect downside protection. The hidden cost, however, is opportunity. The expected return for cash is less than expected inflation, effectively eroding future purchasing power and guaranteeing that clients won’t meet their long-term goals. And what if you are wrong? A knee-jerk reaction nearly always leads to a sore chin.

Exploring ways to express defensiveness in your client’s portfolios can make sense.



One option that many have gravitated toward is buying defensive sectors as a part of their equity allocation. Market sectors like utilities and consumer staples have excellent downside capture ratios, meaning that they tend to fall much more slowly than the broad market when US equity returns are weak. But a drawback of this sector is that the trade is already crowded driving these particular sectors up and accordingly making them over-valued.

Two strategies that are less likely to sabotage long-term investment goals are shifting the equity allocation towards defensive factors and increasing overall portfolio allocation to bonds. The use of defensive “factors” like those used in the Russell 1000 Defensive Index can help offset some of the negative valuation risks associated with defensive sectors. Bonds are by far the best “diversifier” to stocks and can be effective in limiting downside. Bonds tend to have the lowest correlation to stocks of all major asset classes.

Proportion not distortion: Are you unflappable or hysterical or somewhere in between?

We’ve been doing our own thinking about proportionate ways to “set defensive.” We are gravitating, unsurprisingly, to strategies that depend the least on market timing or overpriced portfolio insurance. Our opinion of a sound, proportionate path to a more defensive portfolio can be observed in the asset class weights for our recently rebalanced Model Strategies.

If your clients are beginning to crowd into the “hysteria” side of this spectrum, you might consider doing for them what we’ve done for ourselves: a more defensive stance, and shifting some equity risk to credit risk might prove to be smart strategies to trim the risk sails without bailing out of the regatta.

Buying portfolio insurance effectively limits downside, but is prohibitively expensive to implement.



Comparison of current and new allocations for the Model Strategies

Source: Russell Investments, as of July 11 2016.

The key insight is that the range of options at your disposal to help reduce portfolio risk for your clients is broad and need not equate to eliminating exposure to stocks (U.S. or otherwise). Finding a proportionate response appropriate for your clients’ mood and timeframe may be the best way to earn your advisory fee in the coming months.

As we move into an increasingly surreal political season, atop an aging bull market, amid a series of unfolding scenarios, some of which were “never supposed to have happened” – we want to equip you to conduct that conversation with confidence.

All the best, Your Capital Markets Insights Team at Russell Investments

Model Strategy reallocation Part of annual asset allocation

review*

Summary of changes:

Reduction in risk assets Less equity exposure Reduction of large cap U.S. equity due to valuations and aging business cycle.

Greater allocation to credit within fixed income

Increase credit exposure due to improving valuations Shorten duration

Removal of the Russell Multi-Strategy Alternative Fund**

*Further information is available on RussellLINK.

**Effective on or around July 26, 2016, the Russell Multi-Strategy Alternative Fund will be liquidated



Model Strategies are exposed to the specific risks of the funds directly proportionate to their fund allocation. The funds comprising the strategies and the allocations to those funds have changed over time and may change in the future.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the cover page.

Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets.

Indices and benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Index return information is provided by vendors and although deemed reliable, is not guaranteed by Russell Investments or its affiliates. Due to timing of information, indices may be adjusted after the publication of this report.

The information, analyses and opinions set forth herein are intended to serve as general information only and should not be relied upon by any individual or entity as advice or recommendations specific to that individual entity.

Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (Specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).

Michigan Consumer Sentiment Index – MCSI: A survey of consumer confidence conducted by the University of Michigan. The Michigan Consumer Sentiment Index (MCSI) uses telephone surveys to gather information on consumer expectations regarding the overall economy.

Russell 1000® Index: Measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.

Russell 1000® Defensive Index: Subset of top 1000 U.S. equities with companies that demonstrate less than average exposure to certain risk. (lower stock price volatility, higher quality balance sheets, stronger earnings profile).

The S&P 500® Energy Index is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500® are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ.

These views are subject to change at any time based upon market or other conditions and are current as of the date of first use. The opinions expressed in this material are not necessarily those held by Russell Investment Group, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

Risks of asset classes discussed in this presentation: Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market

With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise and conversely when interest rates rise, bond prices typically fall. When interest rates are at low levels there is risk that a sustained rise in interest rates may cause losses to the price of bonds. Bond investors should carefully consider these risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries. When interest rates are at low levels there is risk that a sustained rise in interest rates may cause losses to the price of bonds.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

Securities products and services offered through Russell Investments Financial Services, LLC, member FINRA, part of Russell Investments.

Copyright © Russell Investments 2016. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

First used: July 2016

RFS - 17685

For more information, contact your Russell Investments sales and service team at 800-787-7354 or visit www.russellinvestments.com.

Fund objectives, risks, charges and expenses should be carefully considered before investing. A prospectus containing this and other important information can be obtained by calling (800) 787-7354 or visiting www.russellinvestments.com. Please read the prospectus carefully before investing.

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