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Stock market momentum slowed during the last month as markets paused to assess mixed economic reports. While the U.S. jobs report for March was the headline grabber, there was a more broad-based slowing in the rate of growth globally. Overall manufacturing and services output ticked up in March, but employment lagged and new orders expanded at a slower pace. U.S. growth still should approximate 3% in the first quarter because of strong momentum early in the quarter, but is likely to moderate through mid-year. This constrained growth environment continues to ease inflationary pressures, leaving U.S. consumer price inflation at a comfortable 2%.
On the other side of the Atlantic, the eurozone continues to register the weakest growth figures among developed markets, with both manufacturing and services contracting. Policy makers spent much of March working on a restructuring plan for Cyprus, which was roundly booed and then reworked. Growth trends in the emerging markets are more divergent, with growth in Asia stronger than in Latin America. Chinese growth in the first quarter was modestly disappointing, but the cooling in inflation is a welcome development. Japans oversized monetary stimulus plan has the potential to benefit emerging markets long-term from increased global growth, while hurting competing export nations, such as South Korea, in the short term.
Even though the Cyprus rescue garnered much attention, the aggressive new Bank of Japan (BOJ) policy was a more consequential development. In committing to purchase domestic assets at a pace more than double that of the Federal Reserve (relative to the size of the economy), the BOJ has taken an aggressive stance toward its 2% inflation goal. The Fed is far from removing accommodation with the current U.S. labor market conditions, while the European Central Bank (ECB) can only be described as recalcitrant. While its efforts to promote financial market stability are commendable, the lack of focus on economic recovery hinders the eurozones intermediate-term growth prospects.
The S&P 500 index ended the first quarter up 10%, and consistent with a strong rally, low-quality stocks outperformed. From a sector perspective, however, defensive sectors, including health care, consumer staples and utilities, were (atypically) the strongest performers, while cyclicals, such as information technology and materials, underperformed. Even though global central bank monetary stimulus has continued to support demand for equities, intermittent volatility driven by developments including the Cyprus banking crisis may have contributed to the more defensive positioning. In addition, higher yielding sectors, such as consumer staples and utilities benefited from a rotation out of bonds by yield-sensitive investors. A continuation of the market rally throughout the year will likely broaden participation to include the more cyclical groups.
Last summers pronouncement by the ECB that it would do whatever it takes to save the euro effectively removed the tail-risk scenario of banking system collapse and led to an equity market rally within the European Union during the second half of 2012.. However, now that stock markets have recalibrated, the outlook for Europe is once again less attractive than the slow-but-steady growth in the United States or the aggressive monetary policy experiment in Japan leading to notable underperformance year-to-date. Austerity measures have placed renewed pressures on growth, causing even Germanys purchasing managers index to return to contractionary territory. Although the ECB has pledged unlimited support to preserve the euro, the regions impaired credit transmission mechanism constrains a return to a positive growth trajectory.
ASIA PACIFIC EQUITY
Kim Jong-un pulled North Korea back into the global spotlight with a hardening in his stance toward South Korea and the countries seen as supporting its stability. In both looks and rhetoric he seems to be harking back to the Korean War era, just in time for what would have been Kim-Il Sungs 101st birthday. As usual, the rhetoric and propaganda arising from the hermit nation is close to impossible to untangle, but the prospect of action (either deliberate or accidental) is a complicating factor for governments and central banks alike. Out of ballistic missile range, Australias economy appeared to be recovering after posting the largest monthly jobs increase in more than 12 years. However, the excitement was somewhat muted as the economy subsequently gave back almost half the February increase in March.
Emerging-market stocks are more volatile than their developed-market counterparts, reflecting their higher growth and more volatile inflation history. As the accompanying chart shows, a positive relationship exists between changes in global growth rates and the relative performance of emerging-market stocks. In the second half of 2012, emerging-market stocks performed strongly as Chinas growth reaccelerated. The reverse has been the case so far in 2013, because of concerns about the cyclical Chinese recovery and the effects of yen depreciation on Japans export competitors. We will need some evidence of cyclical reacceleration to reignite the relative performance of these stocks, but an attractive valuation and the likelihood of capital flows from developed economies underpins the attractiveness of the asset class.
U.S. FIXED INCOME
We still expect the Federal Open Market Committee (FOMC) to keep rates low for an extended period, driving investors down the credit-quality spectrum to pick up incremental yield. The strong demand for investment-grade credit, and attractive funding costs for issuers, gives corporations an incentive to pursue shareholder-friendly activities with a lower penalty for ratings slippage than in the past. Issuers today are more focused on taking advantage of low funding costs and growing their business than worrying about a high investment-grade rating. This can be seen as BBB securities have grown to 39% of the Barclays Credit Index from 32% prior to the financial crisis. We also see strong support for fixed income emanating from the BOJs new QE program.
EUROPEAN FIXED INCOME
Judged by the standards of the necessarily piecemeal rescues, interventions and policy making conducted by the eurozone in recent years, the first iteration of a Cypriot bailout was a study in confusion. With the passage of time, and the realization that the imposition of losses on depositors was necessary, markets have stabilized. However, the genie is edging out of the bottle with the imposition of capital controls. The ECBs Outright Monetary Transaction program is the stopper, and for the moment it seems to be holding. The political course appears to be unwavering, so once again all eyes turn to the central bank, with a growing expectation that the ECB will be forced to adopt new forms of easing to support growth in the single currency area.
ASIA-PACIFIC FIXED INCOME
In his first meeting as BOJ governor, Haruhiko Kuroda delivered a significant program of quantitative easing (QE) asset purchases in excess of elevated expectations. A combination of increased Japanese government bonds, exchange traded funds and real estate investment trust purchases is targeted to double the yen monetary base in the next two years and deliver 2% inflation in that time. The effect on markets has been significant as the yen extended losses and government bonds rallied. Repercussions are being felt across the market as participants position for a domestic rotation out of Japanese government bonds and into treasuries, bunds and gilts. Even though the program was targeted domestically, it looks likely to amount to a cross-border QE program, which should drive significant asset flows from Japan to international bond and stock markets.
U.S. HIGH YIELD
High yield new issuance has been a strong $89 billion in the first quarter of 2013. Although there are selective aggressive deals, the market as a whole has remained disciplined on credit quality. Seventy percent of new issuance has been to refinance existing debt rather than dividends, M&A activity and leveraged buyouts. In the last five calendar years, approximately 65% of issuance has been for refinancing. It was less than 45% in the preceding five years. The accompanying graph shows that leverage on non-refinancing new issues has actually moved materially lower following the financial crisis. We believe issuer conservatism and market discipline will help keep the default rate low over the intermediate term, providing support for current tight valuations.
Developed markets have staged an impressive start to the year, but emerging-market and natural-resource stocks didnt keep pace. This atypical relationship extended beyond natural resources, as most higher beta sectors, such as technology and industrials, have also underperformed. One potential explanation is that central bank policy has been effective in pushing new investors out the risk spectrum but only enough to dip their toes in the water of the least risky risk assets. Recent mixed data out of China has also raised questions about global growth a key component of the outlook for commodities. However, we believe unprecedented central bank accommodation with Japan now entering the fray will ultimately prove positive for global growth and, by extension, the commodity complex.
The standout performers this year have been the two economies with the most aggressive central banks: Japan and the United States. We believe Japans monetary policy has the real potential to bolster inflation and growth. The BOJ is likely to push domestic savers to seek out yield in foreign markets, supporting the value of those foreign assets. Capital flows out of Japan are another technical support to world bond markets, helping to drive down yields from European sovereign debt to U.S. high yield debt. The United States looks to be a relative safe haven, with relatively stable economic growth and an investing climate that looks attractive to overseas investors.
We entered 2013 with a positive view toward risk taking, as we saw steady economic growth joining easy monetary policy to gradually entice greater allocations to equities. We made no changes to our global tactical asset allocation model this month, as we continue to view the outlook for equities favorably with growth in the United States, Japan and emerging markets to be supportive of risk taking. Even though shrinking credit spreads have reduced the return potential from corporate credit, we continue to favor high yield as a source of yield in a yield-starved market. We remain tactically underweight investment-grade bonds, as a way to fund our overweights and also to recognize the asymmetric risk in the bond market today.
Our primary risk case is the potential for cracks in the monetary policy foundation a scenario where the very low interest rate environment suddenly changes due to forced central bank action. This could be the result of a positive growth surprise (potentially less problematic) or an unacceptable inflation pickup (potentially difficult). The lessons of the last two big rate hike cycles in the United States are that slow and steady rate hikes (circa 2004) are manageable, while unexpected jumps in rates (circa 1994) can lead to losses in both the bond and stock markets. Our expectation is that a 2004 scenario is more likely, but not until several years from now.
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.
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Northern Trust Global Investments comprises Northern Trust Investments, N.A., Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K., the investment advisor division of The Northern Trust Company and Northern Trust Global Advisors, Inc., and its subsidiaries.