Northern Trust Perspective

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• U.S. Perspective - December 19, 2012
• Global Perspective - December 19, 2012
• Global Asset Allocation Model - December 2012

Global financial markets are approaching year end with positive momentum, as economic data has been improving and concerns over the potential fallout from the U.S. “fiscal cliff” have been receding. Stock market returns this year have positively surprised many observers, as global growth decelerated from 3% in 2011 to around 2.5% in 2012. Easy monetary policy has been a key support. While Federal Reserve balance sheet expansion has been supportive to financial markets, the real game changer was the European Central Bank’s (ECB’s) pledge to “do whatever it takes” to save the euro. The Fed’s continued accommodation is meant to buy time for economic repair, while the ECB’s objective is to keep financial markets in order while politicians negotiate the nettlesome details of greater fiscal union.

Growth in the United States, which we estimate will average around 2% this year and next, is slow but durable. Job creation has averaged 145,000 per month this year, the unemployment rate has fallen to 7.7% and the housing market is healing. Peripheral country bond yields in Europe have dropped because of the aggressive actions of the ECB. This has yet to work its way into an improved economic outlook, however, and we expect austerity programs will continue to crimp growth in 2013. Economic momentum in the emerging markets is improving into year end, and evidence is building that China may be avoiding a feared hard landing.

Financial market returns in 2012 were significantly boosted by a reduction in risk premiums, as investor concerns surrounding the European fiscal crisis and the health of the global economy were mollified. While we believe this reduces event risk in the markets in 2013, it also means potential returns are unlikely to match those of 2012. We think the return potential in fixed income is capped by the current low level of yields, but feel that risk assets — such as equities — will generate solid returns as economic growth trudges along and accommodative monetary policy continues to lubricate the financial markets.

U.S. EQUITY

• U.S.-exposed firms have significantly outperformed more globally exposed firms this year.
• Relative valuations of globally exposed firms are at 12-year lows.

We wrote in July about the relative outperformance of stocks with higher U.S. exposure, because the market was penalizing companies with greater reliance on non-U.S. revenue sources. We now recommend increasing the allocation to companies with international exposure; these companies are attractively valued and well-positioned for this phase of the cycle. Equities with non-U.S. exposure have outperformed following each of the last three mid-cycle slowdowns. Further, we believe countries outside the United States will be greater drivers of global growth in 2013, with growth from China expected to increase and some stability (at low levels) for eurozone countries. With growth stabilizing and valuation attractive, we view international equity exposure as increasingly compelling at this point in the economic cycle.

EUROPEAN EQUITY

• Despite the maelstrom hitting the real economy, there are no signs of resolution to the eurozone crisis
• European equities are poised to outpace their development-market counterparts in 2012.

Even though its banks finally capitulated and asked for aid, the Spanish government continues to resist asking for a bailout that would open the door to the ECB’s potential unlimited bond purchases program. Moody’s downgraded France’s rating to AA1, the country’s second downgrade of the year, despite President Hollande’s pledge to reduce the public deficit to 3% by 2013. The European Commission set a timeline for eurozone integration, including plans for a separate eurozone budget and joint issuance of debt. However, divisions prevail amongst European Union members over the seven-year budget, with Germany firmly opposing the joint debt issuance. We see these developments as signposts that there is still considerable work before Europe’s move toward a fiscal union becomes a reality.

ASIA PACIFIC EQUITY

• Australia’s economy is showing signs of pressure from materials slowdown.
• China’s Politburo handover went smoothly; Japan is up next.

In Australia, with third-quarter GDP coming in at 0.5%, it’s becoming obvious that growth is faltering on the back of reduced materials exports, which provides the policy makers with scope for additional rate cuts. The Reserve Bank of Australia’s board voted to hold the interest rate at 3.25%, while leaving flexibility to adjust the monetary policy stance as required. Japan’s GDP contracted at 0.9% quarter-over-quarter, the first decrease in three quarters, as the spill-over effect of the eurozone crisis and worsening political ties with China continued to hit home. Japan’s exports fell for a fifth straight month, with net exports dipping 6.5%, highlighted by exports to China and the EU being down 11.6% and 20%, respectively.

EMERGING MARKET EQUITY

• Emerging-market inflationary pressures differ from developed markets’ pressures.
• Stabilized Chinese housing prices create breathing room.

Developed-market central banks have been trying to reinflate their economies during the last two years while emerging-market economies have been seeking to contain price inflation. Because of tighter monetary policy during 2011, inflation is now at or below central bank targets in key economies like Brazil, China, Indonesia, Korea and Taiwan, while it remains above targets in India and Mexico. The broad moderation of price pressures has allowed a new round of interest rate cuts, which are beginning to support improved economic growth as evidenced by improving Asian trade data and several months of better Chinese growth statistics. With emerging-market stocks only recently having started to outperform their developed-market peers, we see good relative upside potential and further increased our tactical overweight this month.

U.S. FIXED INCOME

• The 10-year Treasury has remained locked in a range between 1.55% and 1.85% in recent months.
• Yields will remain low as the Fed continues to expand its balance sheet.

The Fed has further upped the ante in its effort to support the repair of the U.S. economy. With its announcement this month that it will convert the expiring Operation Twist into an outright purchase program of $45 billion per month in U.S. Treasuries, the Fed’s balance sheet is projected to increase by around $85 billion per month. Short-term rates are expected to stay near zero at least as long as the unemployment rate remains above 6.5%, inflation is projected to be no more than 2.5% and longer-term inflation expectations continue to be well anchored. The Fed believes this new guidance is consistent with its prior expectation of a potential mid-2015 tightening, and we don’t expect much consternation over this in 2013.

EUROPEAN FIXED INCOME

• Italy’s 10-year rates spike after Silvio Berlusconi re-enters the political picture.
• Despite announcing his resignation, Italy’s Prime Minister Mario Monti may soon return to office.

Italy’s Prime Minister, Mario Monti, recently announced his intention to resign following the passage of his government’s 2013 budget. Installed just over a year ago, the unelected technocrat has restored credibility to Italian politics at a time when the county’s ability to get its fiscal house in order was once again in doubt. The catalyst behind Monti’s resignation was Silvio Berlusconi, an actor many had assumed had left the stage. Act one has seen an unsurprising bond market reaction with nervous investors marking down the price of Italian debt. However, we don’t believe Berlusconi has a strong hand, and he may well succeed in creating an opportunity for Monti to return to the prime minister’s office with a popular mandate from the voters.

ASIA PACIFIC FIXED INCOME

• Japan’s new prime minister called for aggressive action to depreciate the yen.
• Obstacles exist to achieving significant currency debasement.

Japan elected its eighth leader of this century in Shinzo Abe. Foreign exchange markets have been volatile as Abe has been calling for the Bank of Japan (BOJ) to take aggressive action to halt the rise in the yen. However, there are three reasons this plan may be difficult. First, the BOJ is a politically independent body and while the government is able to nominate a new governor (and deputies) in April, central bankers are fiercely protective of their independence. Second, a 20-year trend is, to say the least, an entrenched view. Finally, and most important, an active and clearly articulated policy of currency debasement by the world’s third-largest economy is unlikely to pass without comment in Washington, Beijing or Frankfurt.

U.S. HIGH YIELD

• U.S. tax and budget uncertainty has increased the range of potential 2013 gross domestic product (GDP) outcomes.
• Absent materially negative GDP, the high yield market typically performs acceptably.

The U.S. tax and budget negotiations underway at the close of 2012 have occupied the attention of financial markets. The range of outcomes from the negotiations, from automatic tax increases and sequestration budget cuts to a scenario approaching the status quo, could have a variety of effects on the GDP — from recession to continuing the current growth pace. The high yield market historically has posted adequate performance absent materially negative GDP. The graph shows quarterly high yield performance for various levels of the following quarter’s GDP. High yield has posted flat to positive returns when the next quarter’s GDP is greater than -0.5%. We believe this demonstrates the cushion the coupon on high yield bonds provides against economic volatility.

REAL ASSETS

• Real assets are benefiting from factors other than inflationary concerns.
• Growth and technical factors support an overweight to natural resources.

We come into 2013 with a positive view toward real assets despite our fairly sanguine views on near-term inflation. In addition to our modest overweight to global real estate, this month we also moved to a tactical overweight toward natural resources. This decision was less dependent on near-term increases in inflation and more tied to a combination of our macro growth views, where we have a generally constructive outlook, and technical factors. While we believe the commodity “super-cycle” may have run its course given China’s changing strategic priorities (becoming less commodity intensive), a more traditional cycle may be underway. Given this view, we believe a “commodity restock” of inventories may unfold, providing support for those commodity prices and the companies that supply them.

CONCLUSION

We enter 2013 with the global economy still growing below potential, but with some flickers of life in emerging-market and U.S. economies. Slow growth, high unemployment and tame commodity prices mean that inflationary pressures are muted — helping the valuation of equities and supporting monetary policy accommodation. Even though the Fed has moved to policy goals based on unemployment and inflation, we don’t expect either measure to spur tighter policy in 2013. The ECB is likely to continue to provide liquidity programs sufficient to prevent chaos without taking the heat off politicians. With the political leadership transitions completed in the United States and China, and another underway in Japan, we believe the financial markets will be able to analyze and price the contours of future political leadership.

As the U.S. economy continues its healing process, and the ECB has bought time for politicians to advance their union, we see lowered risk levels in the financial markets in 2013. With that lower risk profile, however, comes the potential for lower returns. We start the year with negative real yields across much of the developed sovereign bond world, and with equities having already benefitted from an upward rerating in valuations in 2012. We further increased the risk profile of our tactical asset allocation recommendations this month, as we increased exposure to emerging-market equities (at the expense of investment-grade bonds) and natural resources (in place of gold). This recommendation was underpinned by our view that emerging-market growth is in the process of accelerating, which should benefit both equities and natural resources.

Our two primary risk cases going into the New Year surround the level of global monetary policy accommodation and the U.S. fiscal cliff. With the Fed now moving to specific economic objectives to guide their policy, investors’ focus will start changing and questions about the longevity of current policy will only increase. This raises the risk of investment-grade bonds, which have little yield cushion to soften the blow of policy changes. As we go to press, negotiations on the U.S. fiscal cliff are continuing with a hope of agreement before year end. Even if this fails, we expect sufficient progress over the near-term such that this is unlikely to be an issue in the financial markets at this time next year.