Economic recovery riddled with risks: Russell Investments

While the Canadian economy has been in a mild recession over the first half of this year, Russell Investments expects it will regain some lost momentum by year-end. However, there is risk.

“What curbs our enthusiasm is that business investment remains elusive on two fronts: capital investment in the energy sector, which has been stunted by low oil prices, and in the manufacturing sector, which has not yet had enough time with a weak loonie to bring manufacturing capacity back online,” says Shailesh Kshatriya, director, Canadian strategies at Russell Investments Canada Limited.

Read: Global upheaval to continue into 2016

Kshatriya also believes that while investor attention may be fixated on oil and the energy sector, it is the housing market that continues to pose the greatest long-term threat to the domestic economy.

On a positive note, the report highlights that employment growth nationwide is low but positive on a six-month trend basis and household spending has held up, as the depreciating Canadian dollar relative to the U.S. dollar may reduce the incentive for Canadian consumers to cross-border shop.

Read: Canadian economy grew in July

The report also indicates that if the domestic economy continues to deteriorate, the BoC will not stand idle. But in order to do so without getting into unconventional monetary policy, keeping rates steady for the remainder of this year allows the BoC to have capacity to react next year.

Global outlook

Considering uncertainties around China and the prospect of U.S. Federal Reserve tightening, the strategists describe the markets as “struggling to find direction” and underscore the importance of separating “market noise from signal.” Volatility reached its highest level in four years in August as markets around the world pulled back, including a 10% retreat in the U.S., and about 15% in the U.K., Europe, Australia and Japan. However, the experts believe the U.S. economy is robust and do not believe China will derail the global economy.

Read: Economy more productive than you think, says expert

“The key question for investors now is whether the market turbulence is simply a retreat from overbought conditions or the beginning of a new bear market. Our view is the former,” says Andrew Pease, Russell Investments’ global head of Investment Strategy. “U.S. domestic growth is back on track and we don’t expect a recession any time soon. That said, Europe is still our most preferred equity market, followed by Japan, and we remain cautious on the U.S., U.K. and emerging markets.”

U.S. still poised to hike rates later this year

The strategists continue to expect the Fed will hike interest rates in December and they believe the pace of future interest rate hikes will be more important than the initial timing. This expectation is based largely on the fact that the U.S. economy is big enough, domestically oriented enough and strong enough to shrug off downside risks from abroad. U.S. gross domestic product (GDP) growth is forecast to stay in the 2.0% to 2.5% range, while a 2.8% 10-year Treasury yield is expected over the next 12 months.

Read: U.S. home prices increased at steady pace in July

The team is, however, watching two key developments from a market perceptive: the extent to which the increased volatility in stock prices ripples through the real economy and the sustainability of U.S. corporate earnings.

“We expect economic momentum in the U.S. to fade over the next 12 months to a more modest pace in the face of upward pressure on wages amidst the tightening labor market and an erosion of profit margins,” said Paul Eitelman, investment strategist. “We maintain our underweight preference to the U.S. equity market in global portfolios at Russell Investments because despite the recent market selloff, U.S. equities remain quite expensive.”

Managed slowdown in China

The Chinese economy is decelerating but not collapsing, notes the report. Real GDP growth in China in the first half of 2015 was the slowest since the end of the 2008 financial crisis, which stirred investor fears that Chinese weakness may undermine global growth.

Read: China fears continue to rattle markets

The strategists say, most likely, the Chinese economy will continue to decelerate. But policy instruments will forestall major financial distress and prevent a threat to global growth.

“A formidable array of policy instruments is being activated in China, and we believe the Chinese economy continues to be an engine for world growth, expanding at a rate in excess of 6% per annum,” says Pease.