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The blanket of low volatility covering the market has been pulled back during the last month, because of uncertainty around geopolitical risks and the economic growth outlook. Some investors might add the monetary policy outlook to this list, but we think this is inconsistent with concerns about the economic growth outlook. The volatility in reported U.S. economic statistics (e.g., GDP growth) is exaggerated when compared with the strong profit growth of corporate America (see chart below). Risk to the European growth outlook has increased because of the Russia/Ukraine conflict, and already appears to be hitting metrics such as German exports. Investor response has been as one might expect, with the increased risk aversion leading to selling pressure on risk assets from stocks to high yield bonds.
In our investment committee discussions this month, we spent considerable time debating the outlook for G-2 (United States and China) growth and the risks associated with the Russia/Ukraine conflict. We see reasonable momentum in the U.S. and Chinese economies, although we worry about the quality of Chinese growth as it appears to have reverted to dependency on infrastructure spending. Bank credit growth has continued to impress in the United States, a key differentiator from the past several years. The European Central Bank (ECB) will try to jumpstart bank credit growth with the start of its targeted longer-term refinancing operation (TLTRO) program in September, which could increase funding to European banks by up to 850 billion. This month, the ECB highlighted its commitment to using unconventional monetary policy actions should inflation forecasts continue to disappoint and communicated its concern over the risk to growth from geopolitical tensions.
The Jackson Hole conference later in August will be the next chance to take the measure of Federal Reserve policy. With a potential focus on labor markets, we expect a dovish message from Fed Chair Janet Yellen about her commitment to keeping monetary policy highly accommodative for as long as possible. We think sustained wage pressures will need to materialize before the leading voices at the Fed become less dovish, and U.S. wage growth is stubbornly stuck at 2%. Our base case remains that the Fed will move to raise interest rates later than market expectations of mid-2015. During the near term, we see a bigger risk of the ECB being too timid in implementing further accommodation to support growth and inflation across the eurozone.
With several geopolitical conflicts in the news, investors are rightly concerned about the potential for broader disruption. Prior history, however, has demonstrated the U.S. markets resiliency to world crises. The market historically has returned to pre-crisis levels within 37 days on average during bull markets and continued to advance for more than two years. Wed be more concerned with current events if the price of oil were to react and move higher. Such a move would put pressure on U.S. consumers and threaten the economic recovery currently underway. In fact, the price of oil has declined over the past month. The U.S. economy continues to expand, which supports our expectation of improvement in the corporate earnings environment and our constructive outlook toward U.S. equities.
During the past 10 years, the total revenue European companies derive from emerging markets has more than doubled. As a result, Europe has the broadest geographical exposure of all developed equity markets. Total emerging-market revenue exposure was close to 30% in 2012, while exposure to emerging markets outside Europe was almost 20% (see accompanying chart). Even though the financial sector will bear the brunt of the negative effects of enforcing sanctions, European exposure to North America and our expectation of better growth from the United States should support European earnings during the next 12 months. Europes diversification has contributed better growth than possible from the eurozone alone and should soften the overall effect of the current trade sanctions with Russia.
According to a recent International Monetary Fund report, Japanese corporate cash holdings are at 30-year highs. Given the recent material move in inflation expectations and low interest rates as a result of Abenomics (see accompanying chart), we expect continued pressure on companies to change their approach to cash management. The most direct benefit to shareholders would be increased dividend payments and share buybacks. Indeed, several large companies, including Toyota, NTT DoCoMo and Mitsubishi, have acted accordingly. Another option would be to increase capital expenditure spending, which, in aggregate, has yet to break out of its historical range. The deployment of corporate cash could help further stimulate the economy and redirect investment into more productive assets. Japanese equities have continued their recent positive momentum, supported by better-than-expected earnings results.
Economic data from the emerging markets has been improving since the second quarter, primarily due to improving conditions in Asian emerging markets. Growth trends in Europe, the Middle East and Africa (EMEA) and Latin America remain soft, as high-profile economies such as Brazil, South Africa and Russia continue to disappoint. Acceleration in China has helped improve the economic data across Asia, as the targeted stimulus Beijing has implemented has boosted spending. Chinese export growth of 14.5% in July is a sign of the strengthening global economy. However, the improved domestic growth has been accompanied by a surge in credit growth, which is heavily outpacing nominal economic growth. Even though the targeted stimulus has reduced the near-term economic risk, its delaying the structural reform and rebalancing that policy makers prescribe for a healthier long-term economy.
If a recovering economy generally leads to inflationary pressures, the markets arent buying it yet, at least not in the expectations theyre building into five-year breakeven rates (the spread between nominal and inflation protected yields). In the United States, despite ongoing and steady improvement in the labor market, inflation expectations sit at just under 2%, which is just 0.1% higher than where they started the year. A similar story is playing out in the United Kingdom, albeit from a higher starting point given higher structural levels of inflation. Meanwhile, Europe, as proxied by Germany, continues to battle the threat of deflation. This leaves our expectations for low inflation (predicated on subdued demand and excess capacity) in sync with current market consensus, and supports maintaining real asset allocations at strategic levels.
U.S. HIGH YIELD
The accompanying chart shows how June 2013 outflows compare to the recent round of withdrawals, which are similar in size but couldnt be more different in terms of the catalyst. The selling in high yield was broad in nature, resulting in a 1.05% increase in yields off the recent low (4.82% to 5.87%). Whereas previous large outflows have been accompanied by changing commentary surrounding default scenarios, rate risks or economic growth, this round lacked a true fundamental catalyst. The macro-environment is favorable as second-quarter earnings surprised to the upside, and U.S. economic data has been steadily improving throughout the summer. As a result, we believe the backup in yields has improved valuations and created a buying opportunity.
U.S. FIXED INCOME
At the height of the financial crisis in late 2008 and early 2009, S&P and Moodys quickly downgraded corporations as revenue and earnings fell sharply, affecting balance sheet metrics. Corporations quickly responded by cutting costs, increasing cash balances and reducing debt, which resulted in improved credit metrics that peaked in early 2012. Since then, these metrics have begun to slowly deteriorate. Leverage is on the rise as corporations issue debt to repurchase equity, increase dividends, and engage in merger and acquisition activity. This increase in leverage to a near-decade-high surprisingly coincides with a recent uptick in rating upgrades. As upgrades have broken away from fundamentals, were closely watching the actions of corporate management teams to ensure continuing solid credit quality.
EUROPEAN FIXED INCOME
Data in the eurozone remains challenging, as weve seen a new low in inflation, a negative economic growth data point in Italy and some disappointing German industrial production numbers. There are some positives on the ledger, as broad surveys continue to point toward growth, and area-wide bank lending has shown some improvement. From the other side of the fence, the ECB continues to hope that actions beyond those announced in June will be unnecessary. For the moment, we expect no action with the centerpiece of Junes package, the TLTRO, starting operation in September. Nevertheless, post-meeting press conferences are likely to be uncomfortable for ECB President Mario Draghi for some time to come, as pressure builds for further action. This is precisely why the ECB is moving to a less-frequent meeting schedule starting in 2015.
ASIA-PACIFIC FIXED INCOME
Much has been written about the quality of Chinas economic growth, and we agree that a rebalance is necessary for sustainable economic growth. A big part of the challenge is overcoming the vested interests that have become rich on the back of the vast infrastructure spending of the past three decades, but there should be little doubt of the leaderships resolve to transition. Combined with growing public distrust of the monied elite, President Xi Jinping is pursuing an aggressive anticorruption agenda. Any uncertainty regarding the scope of his campaign has received an emphatic answer with the investigation of a former member of the Politburos standing committee. Meanwhile, Japans Prime Minister Shinzo Abe has had success through monetary and fiscal policy, but the market awaits progress on greater structural reform.
While recent economic data has been noisy, we think the global economic expansion underway will continue to advance. We see the U.S. economy as having the most predictable growth outlook of the major economies, as steady improvement in the labor markets is joined by strong bank credit growth. While expectations for European growth have deteriorated in recent months, we think growth will be sufficient to exceed these lowered expectations. Emerging-market growth is more uneven; China has pulled up Asian growth while the other emerging regions are lagging behind. Because we expect inflation to continue to be quiescent, we believe developed-market central bankers should continue their easy policy leanings.
The markets reaction to bumpy economic data and heightened geopolitical risk has been textbook in some cases, but counterintuitive in others. Safe-haven assets like U.S. Treasuries and the dollar have rallied, while gold has declined. The S&P 500 indexs decline of 3.3% during the last month was better than the decline of 4.7% in the other developed markets, but actually lagged the 1% decline in emerging-market equities. Demonstrating its higher correlation to equities than interest rates, U.S. high yield spreads widened from 3.29% to just over 4% during the last month. We view this widening of spreads as a simple reflection of increased risk aversion, as opposed to a signal of deteriorating credit quality or impending economic slowdown, and we believe it has created a buying opportunity.
We made no changes this month to our global tactical asset allocation recommendations, which remain significantly overweight stocks at the expense of investment-grade bonds. Market weakness during the last month has led to a rapid deterioration in investor sentiment (a positive for future returns), as measures like the Chicago Board Options Exchange put/call ratio moved into extreme bearish territory. Despite the noisy economic data and the resulting market uncertainties, we expect the global economic expansion to continue and easy monetary policy to support risk-taking over the next 12 months. Our primary risk cases start with G-2 economic growth, the strength of which can help offset our other two risk cases. First, the confrontation between Russia and the West over Ukraine has the potential to become an economic headwind, particularly for Europe. Second, we expect the ECB to provide additional accommodation should the languid pace of the European recovery continue, however, theyve disappointed us in the past.
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.