Northern Trust Perspective

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• U.S. Perspective - March 13, 2013
• Global Perspective - March 13, 2013
• Global Asset Allocation Model - March 13, 2013

Financial markets continued their upward trend during the last month, as global stock markets rallied and safe-haven assets, such as government bonds and gold, retreated. Reflecting continuing skepticism about investing in the post-financial-crisis environment, investors worry that recent gains are solely the result of central bank “money printing” and are bound to reverse. While we believe the reversal of easy monetary policy globally represents the primary intermediate-term risk to the markets, we think the market gains are justified and we remain constructive on risk taking. In recent months, we’ve seen improving U.S. economic data and solid corporate profit reports. Momentum in housing and capital spending is helping support gains in employment, which are the key to the longevity of this business cycle. These gains should also help offset some of the impact of increased taxes and reduced government spending that take effect this quarter. Even though the recent drop in the U.S. unemployment rate to 7.7% is welcome progress, we think the Federal Reserve is a long way from deciding there has been sufficient improvement to start tightening monetary policy.

Turning to the outlook for Europe: growth is stabilizing at a recessionary level, but the European Central Bank seems content for now with the progress of its programs aimed at supporting governmental bond markets. The major change in developed markets has come from Japan, where “Abenomics” is focused on trying to end a two-decade-long deflationary cycle through aggressive easing and inflation. Should Japan get this right and succeed at generating both domestic demand as well as export growth, it would be an unexpected positive for the global economy.

Emerging-market growth signals are becoming more muddled, as Chinese growth figures have shown a modest slowing in recent months. We still expect that China has avoided a hard landing, but inflationary trends need to stay subdued for policy makers to implement large fiscal stimulus. With inflation in the United States and Europe expected to remain at comfortable levels this year, and Japan seeking to boost inflation, we see little prospect for tighter global monetary policy in 2013. This should continue to support financial markets, as growth continues to generate corporate profit growth and the return of capital to shareholders.

A FOUNDATION OF PROFITS

Strong corporate profit growth underpins global stock market gains.

 U.S. EQUITY

• Four of 10 S&P 500 sectors have surpassed 2007 to 2008 peaks.
• Previously strong performing sectors rarely lead the new bull market.

With U.S. equity markets at or near new highs, we observe that not all sectors are created equal. Consumer staples, consumer discretionary, health care and technology are trading above 2007 to 2008 peaks, while the remaining six sectors are below. Performance is justified by earnings growth, with only technology and telecom showing materially different price-to-earnings ratio valuations. In the case of tech, earnings have outperformed the stocks, while the opposite is true in telecom, where earnings are significantly weaker. Financials have yet to make up half of their prior peak, but earnings suggest this is justified. While financials earnings have some room to recover, part of the gap to the prior peak is driven by permanent share dilution from large capital raises in 2009, suggesting the true recovery potential is less than it appears.

 EUROPEAN EQUITY

• Austerity is becoming more unpopular across the region.
• The United Kingdom and Europe continue to disagree on financial sector regulation.

Germany remains the strongest force in the European economic sphere. However, the German government is the quietest in the region, as Chancellor Merkel attempts to avoid any divisive decisions with elections looming. Austerity measures across Europe remain unpopular, and pressure is rising on companies and governments to ease cost-cutting measures. Slow and patchy growth, combined with rising overall unemployment, is causing concern. Unemployment in Europe is exacerbating the perceived regional differences between the relative “haves” of the North and “have-nots” of the South and East. Early March saw a 26 to 1 vote (the United Kingdom being the one “no” vote) in favor of banking sector pay limits, the first time an industry has been singled out for limits in this way during the credit crunch.

 ASIA PACIFIC EQUITY

• China’s outgoing premier gave himself a poor economic report card.
• Reserve Bank of Australia governor signaled that rate cuts are working.

In relatively stark terms, and likely to the surprise of listening delegates, outgoing Chinese Premier Wen Jiabao used his final speech to state that China’s development had been “unbalanced, poorly coordinated and unstable”. This is likely not what the new leadership wanted to hear, but it gives them scope for improvement. In Australia, pressure on the Reserve Bank of Australia (RBA) to further cut interest rates, thus undermining the Australian dollar’s relative strength, appeared to dissipate as the RBA’s governor stated that the easing seen in the past 14 months is having “significant effects.” However, Sydney’s elevation to third most expensive city in the world, including costs of US$5 for a loaf of bread, suggests that the strength of the Australian dollar is having a significant effect on costs of living at home.

 EMERGING-MARKET EQUITY

• Near-term concerns over China weigh on performance.
• Growth and valuation support a positive long-term outlook.

Emerging-market stocks performed well late in 2012, but have lost their momentum thus far in 2013. Increased competition from Japanese exports, made more competitive by Japan’s aggressive new growth policies, is contributing to the slowdown in China. Concerns over the pace of China’s economic expansion also have become more pronounced, though the economic data is still broadly constructive. A lack of transparency in growth figures and concerns about credit-fueled overexpansion will be resolved only through the passage of time. Emerging-market equities currently are trading at 12.2 times earnings, a discount to their historical median of 15.6 times, and at a 17% discount to developed world equities. Because of superior long-term growth prospects, we expect the discount to narrow during the next five years and we retain a constructive view toward emerging-market stocks.

 U.S. FIXED INCOME

• Debate is underway about “dissension” within the Fed.
• We see no change in the accommodative monetary policy on the horizon.

The Federal Open Market Committee (FOMC) remains concerned about the weakness of the U.S. economic expansion, noting the negative effects of slow growth and high unemployment. Their open-ended asset purchases of U.S. government and mortgage-backed securities are designed to put downward pressure on interest rates, support mortgage markets and make financial conditions more accommodative. Chairman Bernanke’s February speeches before Congress defended these asset purchases and made clear his view that these asset purchases will continue until he sees substantial improvement in the labor market. Even though the markets have been debating the alternative views expressed in FOMC meeting minutes, we believe the Fed is committed to accommodative monetary policy. We also don’t see a material risk of inflation over the near- to intermediate-term, which would upset the Fed’s plans.

 EUROPE FIXED INCOME

• Italy may need to hold another round of elections.
• Markets pause to assess Italy’s risk.

Italy’s election produced a hung parliament with no clear majority. The real problem is in the Senate, where there’s no obvious working coalition. Without electoral reform, it’s still possible to have the houses ruled by different parties, leading to tenuous coalitions and frequent elections. Although the outcome is unclear, the vote is significant. Italians are saying that they’re tired of politics in their current form (as evidenced by Beppe Grillo’s M5S party garnering a quarter of the vote) and of the austerity push and rush for structural reform. The country still has a debt and growth problem (of a slow burning nature), but if the people don’t want reform and they elect officials who won’t make reform, then Italy’s prospects will deteriorate.

 ASIA PACIFIC FIXED INCOME

• The new governor of the Bank of Japan pledges “whatever it takes” to reach 2% inflation.
• China’s outgoing administration implements housing reforms.

Japan’s Prime Minister Abe has nominated Haruhiko Kuroda to be the next governor of the Bank of Japan. Kuroda adopted the “whatever it takes” mantra and suggested 2% inflation could be achieved in a couple of years. If this goal is accomplished, it likely will be done without purchasing foreign government bonds. The G20 appears to have condoned central bank purchases of domestic sovereign bonds, but not foreign sovereigns. In China, outgoing Premier Wen Jiabao announced more restrictions on the property sector, including an increase in down payments on second homes and a 20% profit tax on homes held for less than five years, as part of an ongoing effort to balance China’s economy while meeting the official growth target of 7.5%.

 U.S. HIGH YIELD

• One quarter of the high yield market is composed of small issues.
• Small issues earn an illiquidity premium and can be less volatile.

Approximately 500 issues, or 25% of the high yield index, are bonds with par amounts of $250 million or less. Small issues typically provide a premium to compensate for their reduced liquidity. They can be a source of outperformance as long as the buyer’s credit underwriting is sound. Small issues can also provide some insulation from systemic volatility. The graph shows that in periods such as the high yield sell-offs of 2002 or 2008, small issues significantly outperformed large issues (par amounts greater than $500 million) as their relative spreads narrowed. The use of small issues in a high yield portfolio can improve portfolio performance, while reducing price volatility.

 REAL ASSETS

• Inflation expectations are contained, and we expect them to remain that way.
• The Fed’s actions and overt acceptance of inflation represents a risk case.

In December 2012, the Fed made explicit comments about the acceptable upper boundary on inflation expectations — 2.5% over the next one to two years (or 0.5% above its long-term goal of 2%). In response, Treasury Inflation-Protected Securities’ (TIPS) breakeven rates (a proxy of inflation expectations) have risen to just shy of that 2.5% level, while longer-term expectations range around the low-to-mid 2% level (see graph). Slightly more implicit is the Fed’s motive to err on the side of inflation. While we continue to believe inflation will be contained, our constructive near-term outlook for the economy combined with the Fed’s current approach makes us cognizant of the potential for inflation sooner than expected — thus leading to an increased tactical allocation to TIPS this month.

CONCLUSION

Besides the strength of the financial markets, the biggest surprise year-to-date may be the resilience of the U.S. economy. While the effects of higher taxes and reduced government spending remain a concern, they haven’t yet materialized in the manufacturing or services sectors. Even though improving housing and domestic energy production have helped, there also may be some impact from improving confidence, sometimes referred to as “animal spirits.” Corporate confidence has shown some gains during the last nine months, as shown by increased capital investment and return of capital to shareholders. We may also be seeing the start of an improving appetite for labor, as unemployment claims continue to make new lows and monthly hiring has been improving.

The growth picture outside the United States is less clear. We still expect emerging-market growth to be multiples of that of the developed markets’ (no great surprise here), but its near-term momentum has become somewhat more uncertain. Inflationary pressures frequently are the biggest hurdle to emerging-market growth, and we’re seeing glimmers of complications (such as China’s property actions) on this front. European growth remains disappointing, with export-oriented Germany faring the best, while other major economies are in recession. Japan’s growth is the new wildcard, and the market currently is giving Japan the benefit of the doubt that dramatically easier monetary policy will help jumpstart inflation and growth.

We made one change to our global tactical asset allocation policy this month: eliminating our tactical position in gold. We believe the benefits of holding gold as a portfolio hedge are diminishing as economic growth continues to gradually improve and investors begin to debate the eventual normalization of monetary policy. Because we didn’t want to further increase the risk profile of our tactical portfolio by increasing our exposure to risk assets, such as stocks, we moved the proceeds to TIPS. These securities offer high credit quality and protection against the (somewhat unlikely) outbreak of inflation during the next several years. Overall, we continue to be overweight in risk assets as we expect reasonable growth and easy monetary policy to support risk taking globally.