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Northern Trust Perspective


December 17, 2014

Northern Trust Perspective for December 17, 2014

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The biggest surprise of 2014 in the financial markets is likely to be the plunge in the price of oil, and it will shape market performance through 2015 and beyond. After Brent crude prices peaked at $115 per barrel in mid June, a combination of high supply and some slowing in demand has led to a decline of more than 45% to under $60 a barrel. There are clear benefits to oil-importing countries, as energy costs to consumers and businesses fall. However, we believe some offsetting factors will lessen the benefit: The positive effects to the U.S. economy from shale-related capital expenditures and hiring will clearly fall, and the financial market pressures on highly leveraged energy companies will dent some investors' risk appetite. In addition, the significant fall in revenue at some of the world's biggest oil-exporting countries could serve to increase an already tense geopolitical landscape.

So far, U.S. consumers seem to be enjoying the windfall at the gas pump, as November retail sales were particularly strong and jobs gains were robust. While Europe and Japan will also benefit from lower energy prices, the relative weakness in their currencies offsets some of the benefit. Some of the largest emerging-market economies, such as China and India, should benefit because of their energy intensity and reliance on imports, but Middle Eastern countries and Russia will feel particular revenue pressure. At a global level, it's a transfer of wealth from oil producers to oil consumers — which should benefit the real economy.

Financial markets love predictability, and the uncertainty around the causes of the oil price drop and its implications have increased volatility. One result that appears clear is the disinflationary effect that falling energy prices will have on the global economy. With central bankers already worrying about inflation rates running well below their targeted levels, this is just one more factor that will extend the scope and duration of the accommodative monetary policy cycle we currently enjoy. In the current environment, we believe the United States stands out among developed nations for its relatively strong economic growth outlook, its slowly normalizing monetary policy and the prospects for continued currency appreciation.


  • The declining price of crude oil introduces a near-term headwind to earnings.
  • Expect a boost to consumer spending and lower input costs for other sectors.

The price of a barrel of crude oil has declined more than 45% since its peak in June, reducing earnings expectations from a range of a 20% reduction expected for integrated majors to a 70% reduction for some exploration and production companies. This assumes oil prices stabilize at $60 to $65 per barrel, and this would represent an approximate 5% reduction to S&P 500 earnings. However, close to half of oil consumed in the United States is used to produce gasoline, so consumers will benefit from lower oil prices. The consumer sectors comprise close to 20% of S&P 500 earnings, while energy is approximately 10%. Declining energy earnings are a headwind which should dissipate during the next year as the benefits of lower oil prices cycle through the economy to the consumer.


  • The net profit margin of European equities shows some improvement relative to the S&P 500.
  • Sustained progress in profit margins is limited by the weakening growth outlook.

European profit margins remain stubbornly lower than prior cycle highs and are still below levels experienced during the economic recovery in 2011. Encouragingly, European net profit margins have improved from approximately 60% of the S&P 500's at the beginning of last year to 67% at the end of the third quarter. The stronger U.S. dollar, combined with lower input costs and exposure to faster growing regions, likely helped overcome the less competitive economies at home. The key to further operating leverage is stronger revenue growth, which should continue to be elusive given limited political progress and slowing economic growth. Given this backdrop, we expect the trend of disappointing European earnings growth to persist and equities to underperform their developed-market peers.


  • Japanese Prime Minister Shinzo Abe's win raises the possibility of an expansion of Abenomics.
  • Any negative surprises to real growth are likely to induce downside volatility.

Japanese equities have reacted positively to Prime Minister Abe's ambitious economic plan with one clear exception: Investors correctly anticipated the negative effects of the value-added tax (VAT) hike earlier this year, which caused a meaningful pullback in consumption and was likely a major contributor to gross domestic product (GDP) contraction in the second and third quarters. With Abe's success in retaining control of the government after this month's snap election, the second phase of the consumption tax increase currently scheduled for late next year will be delayed until 2017. While this deferral, combined with a likely expansion of government spending, should prevent a repeat downturn in the market, real economic growth needs to be restored before investors can expect sustained gains in Japanese equities.


  • Chinese equity returns go parabolic.
  • Chinese equity strength isn't a signal of a broad emerging-market rebound.

Chinese equities are a global standout this year, with the Shanghai Stock Exchange Composite Index up 43% since late July. However, the broad emerging-market equity index is actually down 11% during this same period, indicating that the Chinese rally is technical in nature and doesn't reflect an improving outlook for emerging-market growth. With limited investment alternatives and falling housing prices, Chinese investors have jumped on easing monetary policy signals with abandon. This has recently led regulators to tighten collateral requirements in an effort to deflate the bubble. We continue to have some concern over the outlook for emerging-market growth during the next year, and see increased risk of stress from a surge in dollar-denominated corporate debt issued in recent years. This leaves us tactically underweight in emerging-market equities until we see signs of improved economic momentum.


  • The continued drop in the price of oil further pressures commodity indexes.
  • Dollar strength, slowing demand and increased supply represent headwinds.

The price of oil continues its downward spiral, a result of the strong dollar, the U.S. energy renaissance, and slowing demand out of Europe and China. This has resulted in a 12% fall in the commodities index (in dollar terms). For now, the path of least resistance for commodity prices is down. The dollar should continue to strengthen in 2015 given central bank divergence. Oil supply continues to grow as OPEC maintains its production quotas, and U.S. drillers continue to grow production to appease investors most interested in production growth. Lower commodity prices should help the European growth outlook and eventually stabilize energy demand. However, as seen in the accompanying graph, the benefit to Europe (and Japan) is dramatically less than that to the United States, given euro and yen currency weakness.


  • The high yield market has moved lower in tandem with the decline in the price of oil.
  • The impact of falling oil prices on the broader market has been relatively minor.

The price of oil reached its 2014 high on June 20, with the high yield market peaking the next day. As oil has declined 41% over the past six months the high yield option-adjusted spread has widened by 80 basis points (bps), driven by the energy and commodity sectors. In June, independent energy was 13 bps wider than the index, while oil field services was wider by 54 bps. Since then, independent energy has widened by 432 bps and oil field services by 524 bps. These two sectors make up approximately 10% of the market, and smaller commodity-exposed sectors have also suffered material declines. Although these sectors have experienced declines, fundamentals for the rest of the market continue to be supportive. Investors will need to refocus on idiosyncratic risk in 2015.


  • Massive corporate issuance has pushed credit spreads to their widest of the year.
  • We continue to prefer the corporate debt asset class within investment-grade bonds.

In the largest corporate bond deal of the year, Medtronic issued $17 billion of new debt at the beginning of December. Like many other nonfinancial firms, Medtronic used record-low borrowing costs to assist with its merger and acquisition plans. Year-to-date sales of investment-grade corporate bonds of $1.1 trillion are on pace to surpass the previous record set in 2013. Corporations have been issuing new debt for a variety of reasons, including funding capital projects, increasing dividends and stock buybacks, and refinancing existing debt. The heavy corporate issuance has overwhelmed investors in the second half of the year and pushed credit spreads wider, which we believe has created a buying opportunity.


  • The European Central Bank (ECB) paves the way for quantitative easing.
  • The Bank of England (BOE) may have missed its window to normalize policy.

The ECB continues to feed market expectations for quantitative easing by revealing that preliminary work for additional asset purchases is underway. While the ECB governing council may not be unanimous in its pursuit of balance-sheet expansion, its acknowledgement of the eligibility of sovereign bonds, alongside lower growth and inflation forecasts through 2016, implies it's not a matter of if but when quantitative easing begins. The BOE policy appears increasingly tied to capacity pressures, especially in the labor market. Even though the United Kingdom appears poised for steady growth, the global outlook has deteriorated and U.K. GDP growth is unlikely to be repeated at 3%. The BOE may have missed its best chance to commence interest rate normalization, especially with a crucial general election in sight.


  • The People's Bank of China (PBoC) makes a surprise u-turn.
  • Japanese Prime Minister Abe puts Abenomics to the vote.

Having earlier embarked on targeted stimulus measures, the market was surprised by the PBoC's decision to cut interest rates for the first time in two years, from 6.0% to 5.6%, as well as other broad-based easing announcements. Even though the PBoC's official bias remains "neutral," the risk is that with the floodgates open and an inevitably lower annual GDP target for 2015, political pressures may culminate in further cuts. Japanese equity markets have surged and the currency is near a seven-year low amid upbeat investor sentiment. Abe won the snap general election on Dec. 14 and postponed the 2015 sales tax increase. It seemed a gamble that voters are won over by Abenomics given the lack of economic turnaround thus far, but currency weakness may just bring about the competitiveness Abe's third arrow had intended.


We have three key themes guiding our tactical asset allocation views as we approach 2015. First, we want to hold U.S. assets in the current environment. U.S. growth is a relative standout, the Federal Reserve is actually moving toward some normalization of policy and the United States is a safe haven geopolitically. Second, we see asynchronous growth because of uncoordinated global policy. This may lead to increased volatility, but may also push monetary policy toward accommodation and keep interest rates low. Finally, the low interest rate environment means there's a high bar for taking out portfolio insurance by investing in low-risk bonds or cash.

These themes have guided us in recent months to reduce exposure to Europe, Australasia and the Far East (EAFE) equities, reallocating to U.S. equities and investment-grade fixed income. This month we reduced our recommended allocation to emerging-market equities in a mid-risk portfolio by 2%, with the proceeds going to U.S. investment-grade fixed income. This move was driven by our currency outlook, preference for U.S. assets and continued concern over whether emerging-market growth will hit consensus expectations. The result of this series of policy changes during the last three months has been a reduction in the overall risk level in the tactical asset allocation model, as a result of bottoms-up decisions made on different asset classes. So while we're still overweight equities and levered to a rising stock market, we're more defensively positioned than we were before these changes.

What kind of market environment are we expecting in 2015? Our equity market return forecasts are driven by earnings growth, and U.S. earnings growth of 7% drives our total return forecast of 9%. We think the recent increase in yields in U.S. high yield bonds improves their prospective returns, and forecast a return of 7% to 8%. We believe this return outlook justifies an overweight recommendation, especially as the return potential is above what we expect from EAFE and emerging-market equities (which we forecast at 2% to 3% and 5%, respectively). An unexpected downturn from U.S. or Chinese growth remains our primary risk case, along with concerns about Russian/Western relations and market volatility stemming from monetary policy developments.



The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.