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Northern Trust Perspective

Northern Trust Perspective - January 16, 2013


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December 31 has come and gone, U.S. politicians have slapped some patches on the U.S. fiscal plan, and global financial markets have been following the path of economic growth and monetary policy. Congress made permanent most of the Bush-era tax rates, while increasing rates on high-income taxpayers. As we had expected, this patchwork deal left much work still ahead — including raising the debt ceiling, dealing with mandated spending cuts (sequestration) and continuing to fund the government. The next round of discussions promises to be even more difficult, with the Republicans unlikely to approve new taxes while the Democrats may balk on entitlement reform. While we expect financial markets to handle these negotiations with an increase in market volatility, our risk case is that the markets will view the next agreement as anti-growth if it’s too reliant on revenue increases and provides insufficient long-term spending control.

We enter 2013 with a new headwind to U.S. growth, courtesy of the fiscal cliff tax increases of around $200 billion (or 1.3% of gross domestic product [GDP]). Hopefully, the momentum displayed in the global economy as we exited 2012 will provide some backstop to growth. Global manufacturing new orders rose each month of the fourth quarter, and employment and output followed suit. Emerging-market and U.S. economies showed strength, while Europe and Japan remained laggards.

Even though growth is showing some momentum, inflation remains dormant in the developed world, while picking up slightly in the developing economies. We still see this environment as one in which monetary policy will remain highly accommodative, with investors gradually beginning to question the duration of the extremely low interest-rate policy during the next year. While uncertainty around U.S. fiscal policy should remain high, we continue to favor risk taking in this environment. We see slow but steady economic growth, and low yields across investment-grade fixed income, leading investors increasingly to seek income and capital appreciation through risk assets such as stocks.



  • Equity funds have seen significant net outflows during the past five years.
  • We believe the stage is set for a rotation back into equities.

Investor concerns about volatility and fiscal policy have driven significant equity fund outflows. Despite this, the S&P 500 outperformed other asset classes with a 16% return in 2012. With earnings and market volatility subsiding with distance from the credit crisis, and as international concerns either failed to materialize or have been addressed by policy response, we believe the stage is set for a rotation back into equities after years of outflows. Equity valuations are attractive relative to history, and when low valuations are combined with record-low interest rates, the equity risk premium is at its highest level in more than 25 years. Finally, in the current low interest-rate environment, equities are also a source of yield for income-oriented investors.



  • Promises of economic reform in Japan provided a boost to equity prices.
  • Skepticism remains over the efficacy of programs given structural headwinds.

Building on second-half momentum generated by the European Central Bank’s (ECB’s) pledge to “do whatever it takes to save the euro,” Japan’s newly reappointed Prime Minister, Shinzo Abe, has pledged to do whatever it takes to reform Japanese economic policy. Policy initiatives pursued thus far include both fiscal and monetary, with Abe pushing a $116 billion stimulus package and pressuring the Bank of Japan to target a 2% inflation rate — not an easy task considering Japan’s year-over-year consumer price index (CPI) has remained mostly negative since the Great Recession. Stock markets have responded positively to Abe’s aims, but we remain skeptical — talk of economic reform emerges in Japan much more often than action, and structural headwinds in both Japan and Europe continue.


  • Emerging-market stocks spring back to life.
  • Keep an eye on developing Asia as a barometer for emerging market growth.

After lackluster performance through much of 2012, emerging-market stocks caught fire late in the year and managed to outperform world markets for the full year. We have been citing improving Asian trade data as an early sign of improvement, and Chinese export and import strength in December corroborates this trend. While Brazil, Russia, India and China receive most of the attention, the cumulative size of China, Korea and Taiwan is just as large, and emerging Asia collectively represents 60% of the index. Monetary policy across emerging markets has become more supportive during the last year as inflation has slowed, but this cycle will start to turn as growth accelerates. Recent increases in China’s wholesale food prices are likely transitory, however, and shouldn’t present a roadblock to improving Chinese growth trends in 2013.


  • The Corporate Credit Index returned nearly 10% in 2012.
  • Positive fundamentals and above-average spreads support high-grade bonds.

Despite corporations issuing a record amount of debt in 2012, their balance sheets remain in excellent condition. The uncertain political and economic environment is causing corporations to hold more cash and remain cautious investing in their businesses. Corporate credit spreads to Treasuries also remain much higher than normal, despite having tightened measurably in 2012. Investors can receive double the yield today by investing in corporate bonds vs. U.S. Treasuries. As such, we retain a positive outlook on this sector predicated on our outlook for continued slow economic growth in the United States and reaccelerating growth in emerging-market economies. Despite our positive outlook, investors should expect lower returns for this asset class in 2013 in light of the exceptionally low level of current interest rates. 


  • Despite a whiff of optimism is in the air, austerity will continue to affect economic growth.
  • Upside growth potential will require external demand drivers.

Analysts traditionally look forward at this time of year, often with a degree of confidence born from the change of the calendar. And so it is with Europe in 2013. A credible, if untested, backstop appears to be in place, and optimism abounds that the eurozone sovereign crisis is moving beyond the acute phase. This may well be, but there’s one crucial aspect of the region’s performance in 2013 that can be predicted with a fair degree of accuracy: its economic trajectory. Austerity remains the order of the day, and it will be difficult to see anything other than stabilization followed by modest improvement as we move through the year. Anything more than this will need to be generated by demand from beyond the single currency area. 


  • Chinese manufacturing and services accelerated into year end.
  • The growth rebound in China supports improved growth prospects across Asia.

In December, China’s nonmanufacturing purchasing managers’ index increased for the third consecutive month, rising to the highest level since June 2012. Both new orders and business expectations rose strongly. The manufacturing counterpart also increased, pointing to mild improvement. This, along with other recent improvements, has led to a modest re-rating of Chinese growth for 2013. We await an official target for growth, but a consensus forecast of 8.1% represents a rebound from an expected 7.7% in 2012. This suggests that the much sought after but rarely achieved soft landing is in sight. There are many challenges ahead for China, not least the demand for social liberalization accruing from the beneficiaries of the economic liberalization of the past 20 years. Nonetheless, Chinese growth above 8% in 2013 will be welcomed across the globe. 


  • Revenue and earnings growth has been slowing during the past four quarters.
  • The high yield coupon provides a cushion that’s not found in other asset classes.

Revenue and earnings growth has been decelerating, but the smaller and more domestically focused companies found in the high yield market have outperformed their larger and more globally oriented counterparts. High yield issuers have been more insulated from weakness abroad, and they also have relatively less exposure to global input costs, which have been boosted by the depreciated dollar. Given current valuations and slowing growth, the coupon earned in the high yield market provides a cushion not found in other asset classes. Future returns in high yield, however, are likely capped by the current low interest rates. We see little prospect for further spread tightening, leaving total returns captive to the coupon payments received by investors. 


  • Futures-based commodity index returns were negative in 2012.
  • Equity-based natural resources fared better given their equity risk premium exposure.

Futures-based commodities had a difficult time in 2012. Although spot prices increased 3.7% in aggregate during the course of the year, those increases (and then some) were priced into futures contracts, resulting in a negative overall return for the asset class. Some actively managed futures indexes, which take a more sophisticated approach to rolling forward futures contracts, provided positive returns for the year. Collateral yield, long a source of returns for commodity strategies, generated only 0.08% in income due to the low interest rate environment. An equity-based approach to commodity exposure generated a 9% return in 2012. The extra return is due, in part, to the equity risk premium attached to this method of commodity exposure, with the side effect being it provides less diversification than its futures-based counterparts. 


We face a global economy today still constrained by the after-effects of the financial crisis. European growth in 2013 will continue to be hindered by austerity measures, while the drag on U.S. growth from increased taxes is a direct result of efforts to address budget deficits exacerbated by the financial crisis. Japan’s policy outlook is the most interesting in years, but the promise of much easier monetary policy is too weak of a foundation to project a sustainable new growth trajectory. Emerging-market growth is showing signs of improvement; domestic demand has been relatively strong and exports are showing tentative signs of improvement. The ongoing deleveraging in the developed world, however, will cap the level of potential growth.

In this world of highly divergent economic conditions, we’re focusing on those economies in which we have the strongest growth outlook. This leads us to favor emerging-market and U.S. equities at the expense of European and Japanese stocks. Fixed income investing has become only more challenging after another year of central bank balance sheet expansion, as real yields on quality sovereign debt are negative and credit spreads have continued to shrink. So while we have trimmed our recommended overweight to U.S. high yield bonds in recent months, we remain overweight in higher yielding assets, such as real estate and high yield, at the expense of investment-grade debt.

Our outlook considers both the downside and upside risk scenarios. Our downside risk cases include a near-term concern of anti-growth policies emerging from the next round of U.S. fiscal negotiations and an intermediate-term concern over how long global monetary policy can stay so easy. On the flip side, the private sector could surprise on the upside given the relative health of corporate balance sheets and early signs of cyclical improvement. As we assess the balance of risks, we think the outlook for risk assets during the next year remains constructive and would overweight them tactically vs. investment-grade bonds.


Northern Trust’s asset allocation process develops both long-term (strategic) and shorter-term (tactical) recommendations. The strategic returns are developed using five-year risk, return and correlation projections to generate the highest expected return for a given level of risk. The objective of the tactical recommendations is to highlight investment opportunities during the next 12 months where our Investment Policy Committee sees either increased opportunity or risk.

Our asset allocation recommendations are developed through our Tactical Asset Allocation, Capital Markets Assumptions and Investment Policy Committees. The membership of these committees includes Northern Trust’s Chief Investment Officer, Chief Investment Strategist and senior representatives from our fixed income, equities and alternative asset class areas.

If you have any questions about Northern Trust’s investment process, please contact your relationship manager.

IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see https://www.northerntrust.com/circular230.

Past performance is no guarantee of future results. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.

This newsletter is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity. Any opinions expressed herein are subject to change at any time without notice. Information has been obtained from sources believed to be reliable, but its accuracy and interpretation are not guaranteed. © 2014

Northern Trust Asset Management comprises Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc. and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.