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Northern Trust Perspective

Northern Trust Perspective - July 16, 2013


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Investors have faced a torrent of central bank actions and communications during the last month, and markets continue to differentiate amongst economies and companies — a welcome maturation from the markets’ prior regime of “risk on/risk off.” We believe the Federal Reserve has moved from an easing bias to one of tightening — but at an elongated pace that will remain data dependent. Joining in this parsimony are some key emerging-market central banks, including the People’s Bank of China, which is working to control credit risk in the Chinese economy. A more expansive approach is emanating from Europe and its equivocal partner, the United Kingdom. Both the European Central Bank (ECB) and the Bank of England (BoE) have communicated a willingness for monetary policy to support economic growth. Aggressive action by the Bank of Japan is stimulating the Japanese economy, along with expectations of further benefits from Prime Minister Abe’s new growth policies. Japan’s Upper House elections later this month look set to strengthen Mister Abe’s hand in furthering his economic reform agenda.

Current growth in the United States is unimpressive, as the effects of fiscal drag, weak export markets and lower inventories mean second-quarter growth could be below 2%. We continue to expect slow, but durable, growth in the United States, supported by the continuing recovery in housing. As the accompanying chart indicates, however, mortgage rates have risen quickly in the wake of the changing monetary policy outlook, and this may slow the pace of housing growth. Emerging-market growth also slowed as the quarter progressed, and is now facing the additional headwind of somewhat tighter monetary policy. European growth is slowly rebounding and looks set to be aided by central bank policy.

Financial markets have been digesting the changing policy outlook, and seem to be gaining some confidence about the likely path forward. Equity markets have performed reasonably well over the last month, continuing the pattern of U.S. strength and lagging emerging markets. Negative returns have been realized across broad bond market indexes, but yield-oriented plays like global real estate have bounced back this past month. We expect this volatility to continue in the bond market, as investors assess incoming data on labor markets and inflation to handicap further monetary policy action.


  • Rising interest rates have spurred concerns about the impact on valuations.
  • Our research suggests that further P/E multiple expansion is justifiable.

As interest rates have begun to rise, reflecting the expectation of a reduction in the pace of Fed purchases of U.S. Treasury and mortgage-backed securities, concerns about the impact of higher rates on price-to-earnings (P/E) multiples have moved to the fore. We believe real interest rates and P/E multiples should be positively correlated —assuming growth and interest rates are moving together — while inflation, instead of improving growth prospects, typically is negative for multiples. Our research suggests that multiples and rates are positively correlated until real interest rates exceed approximately 4%, well above today’s level of under 2%. As a result — and with inflation data remaining relatively benign — we believe that further P/E expansion is justifiable at this point in the cycle.


  • Europe’s growth slowdown has likely bottomed.
  • European finance ministers are deadlocked in how to regulate the region’s financial sector.

The consensus view is that Europe is stuck in the economic doldrums. Thus, we believe any positive spark could provide a surprise to the markets. This could come from German Chancellor Merkel retaining power after the fall election, allowing for progress on a host of eurozone-specific issues and for further monetary accommodation. Regulation remains a contentious issue throughout Europe, and the BoE’s appointment of a foreign ex-Goldman Sachs banker has, again, singled out the United Kingdom from the rest of the EU. EU finance ministers continue to discuss increased control over the eurozone financial sector. How much influence the new BoE governor will have remains to be seen. At a 19% discount to U.S. stocks (on a sector-neutral basis), European shares look attractive.


  • China remains in the spotlight with a surprise fall in exports.
  • Japan’s Prime Minister Abe moves on to his “third arrow for growth.”

In scenes reminiscent of a Robin Hood tale, Prime Minister Abe has launched the final “arrow” to overcome deflation and revive the economy. Accompanying previously announced fiscal and monetary measures, the key points in this “arrow” include improving productivity in the private sector, opening up the country and its markets to the world, and encouraging investment by reforming tax systems and free-trade agreements. As with the early days for Robin Hood, the long-term effect is yet to be confirmed, but the first two arrows appear to have hit their targets. China’s surprise announcement of shrinking exports has raised concerns in the region that the world’s second-largest economy is slowing further, at a time the central bank is also talking of tighter monetary policy.


  • Credit and inflation concerns are leading to tighter emerging-market monetary policy.
  • Tighter monetary policy hinders an already softer growth outlook.

Financial markets have been focused on the rate of slowing in the Chinese economy, but are now also grappling with the unexpected prospect of tighter monetary policy across the emerging markets. While reported economic data doesn’t indicate an economy facing a hard landing, Chinese economic officials surprised the markets with a signal of tighter monetary policy during the last month in their efforts to slow credit growth. This added to investor concerns over the negative impact of higher U.S. interest rates on emerging-market assets. In addition, we’ve seen inflationary concerns lead to higher policy rates in recent weeks in Brazil, Indonesia and India, broadening the concerns over tighter monetary policy. In the wake of these developments, we reduced our recommended weighting to emerging-market equities this month.


  • Corporate credit spreads jumped after talk of Fed tapering took hold.
  • With fundamentals remaining strong, we expect spreads to narrow going forward.

Fear of higher interest rates caused investors to withdraw funds from fixed income in June, and corporate credit spreads widened as a result. This is partially attributable to the continued sparse liquidity in the fixed income markets, where broker-dealer risk appetites remain highly constrained. The widening in spreads occurred despite corporate balance sheets remaining in excellent condition. The uncertain political, regulatory and economic environment continues to cause corporations to be reluctant to invest in their businesses. This is occurring despite historically low interest rates that allow companies to forecast a low cost of capital when evaluating new projects. We retain a positive outlook on corporate credit, as continued moderate economic growth in the United States should support strong credit fundamentals.


  • Interest rate uncertainty has resulted in reallocations between asset classes.
  • The revaluation of the high yield market was driven primarily by cash flows out of the market.

Uncertainty about the Fed’s monetary policy outlook has resulted in the reallocation of assets away from fixed-income markets. When the market consensus was for indefinite Fed support, there was little impact of interest rates on fund flows. However, as rates rose in early May, because of the Fed’s comments about changing the amount of asset purchases, fund flows became significantly negative. In an illiquid market, these flows were the primary driver of the revaluation of the market, as nothing has changed in the fundamental picture. Credit quality hasn’t deteriorated, and the outlook for the default rate hasn’t increased. With a current yield of around 6.5%, we continue to find U.S. high yield attractive.


  • Governor Mark Carney wasted no time in his new role at the BoE.
  • The ECB responded to Fed tapering talk.

In response to a rise in interest rates, the BoE issued an unprecedented statement prior to its most recent MPC meeting. The statement, indicating that the market was incorrectly reflecting the MPC’s view on the future of the U.K.’s interest rate path, was fully accepted as the market has since corrected. The BoE subsequently held fast its policy interest rate and the size of its asset purchase program. Almost simultaneously, the ECB seemed to backtrack on its “the ECB does not pre-commit” mantra by highlighting that “the Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.” What can be gleaned from this is that we now have greater insight into the rate environment and policies at the ECB than at the Fed.


  • The new PM in Australia doesn’t alter the country’s economic outlook.
  • Challenges are mounting as China reassesses its economic policy.

Kevin Rudd has returned to the position of prime minister in Australia after defeating Julia Gillard in the recent leadership challenge. Rudd will now lead the Labour Party into a general election expected in September. However, any change in leadership or government is unlikely to materially alter the economic outlook as all political parties are committed to budget surplus, abundant natural resources and a well-funded pension system. Any potential volatility in Australia’s economic performance will therefore be more from external factors. A more cautious growth outlook in China is concerning the Reserve Bank of Australia, who kept the cash rate at 2.75% in July. It has, however, maintained an easing bias and would welcome a further depreciation in the exchange rate.


  • Emerging-market weakness creates a headwind for industrial metals.
  • Other sectors of the natural resources complex are driven by unique factors.

Alongside our tempered outlook for emerging-market equities, we also reduced our recommended allocation to natural resources in our global tactical asset allocation policy. As China’s infrastructure exploded during the last decade, emerging-market and natural-resource equities moved together (exhibiting a correlation of 0.86). However, recent government pronouncements have indicated concern over the quality of past investment and a reticence to engage in significant stimulus spending, especially as concerns over credit expansion have grown. Industrial metals prices likely will languish in this environment, while agricultural prices may moderate during the next year after weather-related price spikes. Meanwhile, energy prices are being driven by unrest in the Middle East. We think the lowered emerging-market growth outlook will serve to constrain natural resource price appreciation during the next year.


We made changes to several inputs to our investment outlook this month, keying off the outlook for monetary policy. While we moved both the United States and emerging markets from an easing bias to a tightening bias, we have seen further evidence that the major developed markets outside the United States (Europe, the United Kingdom and Japan) remain fully committed to easy monetary policy. So while we downgraded our growth outlook for emerging markets based on slowing momentum and tighter policy, we upgraded our outlook for the European Union (EU) and Japan. We also boosted our assessment of the political leadership for the EU and Japan, with a view that the post-electoral leadership will be able to be more aggressive in tackling their respective regional challenges.

These assessments resulted in some changes to our recommended global tactical asset allocation policy. With our downgraded growth and monetary policy outlook in the emerging markets, we reduced both emerging market and natural resources to equal weights and moved the proceeds into developed ex-U.S. equities. With economic expectations for the EU still muted, we see the potential for modest improvement to be well-received by the markets, especially in the wake of easy monetary policy. With these changes, we remain overweight risk assets at the expense of investment-grade bonds. We expect reasonable performance from credit-related fixed income as credit quality remains high, and continue to favor an overweight to U.S. high yield bonds.

Our risk cases have evolved, as concern about a change in the outlook for low interest rates has come into view during the last two months. First, we see risk in the Fed’s ability to deftly manage the normalization of its balance sheet and management of investor expectations over interest rates during the next year. The road during the last two months hasn’t been smooth, and we face the likely nomination and confirmation of Chairman Bernanke’s successor over the next six months. Our other primary concern centers around political stability in Germany and Japan, where we see the potential for solidified leadership engendering solid policy progress which underpins our more favorable view toward the European and Japanese markets. Should Chancellor Merkel or Prime Minister Abe not secure the political gains we expect, our expectations for political progress stand to be disappointed.


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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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.