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Northern Trust Perspective

Northern Trust Perspective - November 19, 2013


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It’s been “risk on” in global equity markets during the last month, as a short-term resolution to the U.S. fiscal situation set a supportive backdrop for risk taking. While U.S. growth indicators have been mixed of late (employment a little better, housing a little softer) the global metrics continue to show some acceleration into 2014. The European Central Bank (ECB) has added some stimulus to the system through a recent interest rate cut, and Federal Reserve Chair nominee Janet Yellen smoothly navigated her confirmation hearing while reiterating support for continued easy monetary policy. What may be most interesting about her reception on Capitol Hill was the noticeable lack of animus from Republican senators, which may be a reflection of evolving political strategy.

Double-digit gains in developed countries’ stock markets are pretty much the rule this year, leading investors to focus on the fundamental outlook to support these gains and the resulting valuation picture. With growth expected to improve, margins looking relatively stable and disinflationary trends providing cover for continued central bank easing, the outlook still appears constructive. In the chart below, we show that the recent advance has only brought the U.S. stock market back to median valuation levels experienced since the early 1950s. Our research indicates that while valuations have a strong effect on returns over subsequent five-year periods, they have little predictive value for returns during the next year.

Markets have risen in recent years in the face of great skepticism, and rising prices have started chipping away at some of those worries. For the first time in years, we’ve seen significant inflows into equity mutual funds and exchange-traded funds, and the IPO market has been successfully floating companies that aren’t yet profitable. This change in sentiment has caught our attention, but doesn’t yet appear to have caused material mispricing in risk markets. The most likely catalyst for a change in this constructive investing environment is an unexpected change in Fed policy, but Vice Chair Yellen’s testimony about the low cost of quantitative easing helps mitigate that concern for now.


  • Earnings growth is set to accelerate from recent sluggish performance.
  • Financials have driven recent growth, but are expected to shift to a drag.

S&P 500 earnings growth has been lackluster during the past year, with positive readings largely driven by growth in the financial sector. Third-quarter earnings are showing modestly better growth overall, and appreciably better growth excluding financials. Looking forward, while we believe the consensus expectations are typically optimistic, we agree that earnings growth is set to accelerate in upcoming quarters. Financial sector earnings are expected to become a modest drag on S&P earnings, implying an inflection in growth in the “real economy.” It’s our view that future market appreciation will be driven increasingly by growth in earnings rather than valuation, and if that earnings growth is coming from nonfinancial sectors, the market will increasingly be willing to take note.


  • Eurozone growth slowed to 0.4% in the third quarter.
  • The United Kingdom is showing good economic momentum.

Eurozone growth softened in the third quarter as Germany fell to a 1.2% growth rate (down from 2.8%) and France slipped into negative territory (-0.4%). Meanwhile, Italy printed its ninth consecutive quarter of negative readings. Many European commentators blame the situation on austerity measures. However, the country which held to austerity longer than most — the United Kingdom — seems to be recovering at the strongest pace. U.K. purchasing managers are reporting strong activity (see chart), and the country’s gross domestic product forecasts average 2.7% for the next three years. While Europe struggles through its debt consolidation process, the United Kingdom may be a sign of things to come. In the meantime, an actively engaged ECB and low expectations make European equities attractive.


  • Australia is confronting the possibility of a government shutdown.
  • The slowdown in the Australian economy is bringing debt matters to the forefront.

Australia, with a newly acquired prime minister, is battling an economic slowdown and a budgetary situation with similarities to the United States’. The Reserve Bank of Australia is forecasting below-trend growth and rising unemployment in 2014, with resource investment dropping and the currency strengthening. While likely to avert a “U.S.-style” government shutdown before the Dec. 12 deadline, the dispute highlights the government’s increasingly burdensome budgetary position. Much of Australia’s recent strength, and avoidance of the biggest pitfalls of the crash, has been based around China’s decade-long thirst for raw materials. The third plenary session in China ended with the authorities claiming to have introduced policies to open the internal market to “competition” and redistribute income and land rights. Australia waits hopefully to see the effects.


Emerging market represents the market-cap weighted average of China, South Korea, Brazil, South Africa and India.

  • Economic momentum has increased during the last quarter.
  • Monetary pressures have increased benchmark interest rates.

Emerging-market equities have regained some momentum since mid-year, but have still lagged the developed markets during this broad market upswing. Relative economic momentum has been favoring the developed markets, as these economies have accelerated most rapidly during the last three months. Monetary policy can also be a strong catalyst for equity performance, and tighter monetary policy across the emerging markets has joined with concerns about Federal Reserve tapering to restrain investor sentiment. China has recently completed its all-hands Communist Party meeting and has communicated policy goals to increase market influence and relax the one-child policy, among other proposals. While these initiatives appear to be moves in the right direction, their potential positive contribution to Chinese growth may be years away.


  • Yields across the U.S. Treasury curve have been falling since the beginning of September.
  • We continue to believe the economy is in a slow-growth, low-inflation environment.

The Citigroup Economic Surprise Index has steadily declined since the beginning of September, showing that economic data has disappointed investor expectations during the past two months. While the data has disappointed, we continue to believe the U.S. economy remains in a slow-growth, low-inflation environment. The weaker data, in part, has led investors to purchase U.S. Treasury securities — taking advantage of the highest yields observed in the past couple years. The bond rally has occurred across the interest rate curve, but has been led by the five-year maturities, which are benefitting from the Fed reiterating its pledge to keep interest rates at exceptionally low levels for the next few years. We believe this means the current zero interest rate policy will continue into 2016.


  • Eurozone inflation has hit a four-year low.
  • The ECB responded to deflation concerns with a cut in the main refinancing rate.

In a surprise move, the ECB lowered its refinancing rate at its November meeting. Despite a recent uptick in eurozone data, a low reading in headline (and core) inflation in late October saw markets refocus away from growth. Justifying the change, ECB President Draghi suggested that the eurozone was set for a sustained period of disinflation, but not outright deflation. Judged in the context of a trifecta of government, private and business (primarily financial) deleveraging, this shouldn’t really surprise commentators. However, the specter of Japan looms large, and the ECB appears eager to burnish its “low for longer” credentials. As usual, currency effects were taboo for policymakers, but a three-point fall in the euro will be more than welcomed in European capital cities.


  • After decades of falling prices, inflation in Japan leads the developed world.
  • Japan’s inflation reading of 1.1% is driven by weak currency and renewed optimism.

A common theme last month has been renewed disinflation in developed economies. A eurozone headline rate of 0.7% year-over-year was sufficient for the ECB to cut interest rates. In the United States, 1.1% is bordering on uncomfortable for the Fed. Even the inflation-prone United Kingdom has seen a sustained decline from a near four year period of out-of-range price rises. Among developed nations, only Japan has seen recent inflation increases. The most recent available data has national inflation at 1.1% on an annualized basis, up from -0.9% as recently as March. A weaker currency and a genuine sense of optimism are culprits. Japanese inflation-protected bond holders have been handsomely rewarded, returning 3.6% year-to-date vs. a world index at -4.1%.


  • Economic uncertainty has resulted in companies remaining risk averse.
  • Credit profiles have remained stable, as companies focus on cost control and balance sheet stability.

Economic uncertainty has restrained risk taking by management teams. There hasn’t been a great deal of activity that increases default risk, such as merger and acquisition activity, leveraged buyouts (LBOs) or leveraging transactions. Rather, a majority of new issues have been for refinancing existing debt, which lowers default expectations by extending maturities. Through the third quarter, 57% of new issues have been for refinancing (vs. 33% in 2007) and 18% have been for acquisitions and LBOs (vs. 47% in 2007). Furthermore, companies continue to focus on cost control, as evidenced by earnings growth consistently outpacing revenue growth. There are always individual exceptions, but credit quality has remained stable for the market as a whole. This provides a supportive environment for high yield investments.


  • Commodity prices have been trending lower on both lower demand and higher supply.
  • Equity-based investments are benefitting from commodity underperformance.

Commodity prices have started to show some softening trends. Important commodities, such as copper and wheat, have started to sell off while other notable commodities, such as oil and corn, are down 15% since the beginning of September. During this same time frame, the broader commodity complex is down 4%. The issues stem from both reduced demand (as emerging markets settle into a moderate growth profile) and increased supplies (a notable driver of corn’s price action). While not doing any favors for a futures-based commodity allocation, equities are benefitting. Developed-market equities are up 4% since our September start date, as falling commodity prices are keeping inflation levels lower and wallets heavier heading into the holiday season.


Barring a significant reversal in markets during the remaining six weeks of the year, 2013 will go into the books as a year of excellent equity returns. Does this tell us anything about the future? Our research indicates that valuations aren’t a good predictor of one-year equity returns, and the history of the U.S. stock market during the last 85 years shows a pattern of strong years being followed by another positive year. Specifically, we have had 31 years of greater than 20% stock market gains in this period, and in 22 of those instances, the following year showed another positive return from equities. On a longer-term basis, our research demonstrates a relationship between valuations and subsequent five-year returns, which we incorporate into our strategic asset allocation outlook.

We made no changes to our tactical asset allocation policy recommendations this month, retaining our significant overweight to risk assets and underweight to investment-grade bonds. We’re becoming more concerned that the market consensus now seems to embrace an outlook for steady growth and low inflation, a change from the “wall of worry” the market has climbed in recent years. However, as we review our fundamental inputs (such as growth, inflation, monetary and fiscal policy) we don’t foresee a significant disruption during the next year. So we hang in with a constructive view and keep monitoring developments and the fundamental outlook for the economy and risk taking.

The risk that most concerns us during the next 12 months is an unexpected change in the interest rate markets, which would most likely emanate from the Fed. This prospect has seemingly been reduced by Vice Chair Yellen’s relatively dovish confirmation testimony, where she gave no indication of a bias toward normalization of policy ahead of economic progress. We believe normalization alongside economic recovery can be handled by the risk markets (as happened from May to September of this year). We also continue to believe that the risks of fiscal problems in Washington D.C., and uncertain policy progress in Japan and Europe, remain manageable and don’t warrant a change to our asset allocation views.


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.