Northern Trust Perspective


August 19, 2015

Northern Trust Perspective for August 19, 2015

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Last month, markets worried about Greece; this month the focus is China. What could possibly be the common link between financial difficulties in Europe's most-challenged economy and market turmoil in the world's greatest growth story over the last 50 years? One common thread is the challenge of generating sufficient economic growth after the global financial crisis. It's not only Greece that has accumulated too much debt and finds itself struggling to re-engineer its growth model. As the manufacturing hub for the world (allowing for some literary hyperbole), Chinese exports have suffered lately, as the country's end-market growth has slowed and its currency has appreciated during the last decade by nearly 40% on a trade-weighted basis.

This loss of export-competitiveness, along with a desire to impress the International Monetary Fund (IMF) on market pricing, likely led to this month's decision to devalue the renminbi by 3%. While we can't be sure of the Chinese government's intentions around further weakening, a concern over capital flight probably puts some ceiling on how much depreciation it really wants to engineer. The softer growth among China's key trading partners can be highlighted by Europe's modestly disappointing second-quarter gross domestic product (GDP) report (1.2% annualized vs. 1.6% estimated) and the report that Japanese growth turned negative in the second quarter. The softer growth picture, along with continued U.S. dollar strength, has put significant pressure on commodity prices this year. We don't expect a sustained recovery in commodity prices until we see some reacceleration in emerging-market growth or the passage of time eats into excess supply.

Weakness in global economic growth, all other things being equal, would argue for the Federal Reserve to exercise greater patience in commencing "liftoff" (initiating the first rate hike). However, U.S. growth may just be strong enough to give the Fed cover to make its first rate hike in September. Despite its avowed "data dependency," we think the Fed has tired of zero interest rates and is biased to move unless there's real risk to the growth outlook. The markets are rarely shaken by an event that has been studied to death, and we expect the Fed's tempered pace to avoid significantly ruffling risk appetites. As shown in the graph below, U.S. equities have outperformed European and emerging markets since the renminbi devaluation. Should the Fed's move lead to further dollar strength, this will serve to tighten financial conditions and reduce the Fed's ability to execute further rate hikes without endangering the economic expansion.


  • Energy is having a material negative impact on sales and earnings growth.
  • Growth stocks are handily beating value stocks as growth has become scarce.

The second-quarter earnings season is coming to a close, and earnings per share (EPS) are down 1% from last year — beating the consensus expectation of a 5% decrease. Excluding the energy sector, EPS grew 5% in the second quarter. As seen in the accompanying graph, even though reported EPS growth has deteriorated significantly since the third quarter of last year, removing the energy sector shows more stability. What's less comforting is the slowdown in sales growth, even excluding energy. As growth in the market has become scarce, investors have moved toward growth stocks, which have outperformed value stocks by 7% year-to-date. While the overhang on sales and earnings from the energy sector is likely to subside as year-over-year comparisons become easier in first quarter of 2016, mitigating the headline pressure on growth, the nonenergy slowdown in sales likely will need to turn before reversing the trend of growth vs. value.


  • The strength of German factory orders indicates stimulus from the weaker euro.
  • Market expectations are still relatively low in Europe compared to the United States.

Europe's stock market has delivered low double-digit gains this year. However, this advance was nearly offset by the euro's decline as investors anticipate incrementally tighter policy in the United States. Economically, France's weak second-quarter industrial production report was mixed in with strong factory orders in Germany, as well as positive capital goods orders in Spain. Importantly, German factory orders jumped 2% in June, driven by a 4.8% increase in foreign orders. Even though Europe is still slowly recovering while suffering from the challenges of structural reform, there's a longer-term valuation case to be made. Despite the market's rise this year, expectations are still relatively low when looking at its 10-year cyclically-adjusted price/earnings (CAPE) ratio relative to the United States.


  • Second-quarter earnings in Japan are off to good start.
  • Weak foreign machine tool orders are a yellow flag on growth.

The Nikkei 225 Index moved higher in the low single-digit range the last four weeks, offset marginally by yen depreciation. Second-quarter earnings have gone well thus far, with 70% of Nikkei companies beating their earnings estimates. In addition, the Japanese labor market continues to improve with the help of rising minimum and union wages that should help put upward pressure on wage inflation. On the flipside, the slowing growth in China is a concern for Japan, because the third highest percentage of its exports (approximately 21%) go to China. An early warning indicator could be foreign machine tool orders, which are now down 26% from their peak in November 2014. A drop of this magnitude has historically corresponded with declines of at least 10% in real exports, which could hamper the otherwise strong earnings outlook.


  • China has begun weakening the renminbi to reflect slower growth.
  • Policy makers are playing catch-up with other emerging-market currencies.

Financial markets have been consumed by developments out of China in recent months, starting with the end of China's massive equity bull market to the current issue of its currency devaluation. We think the decision by Chinese authorities to adjust the trading band for the renminbi is driven short-term by economic weakness, and longer-term by a desire to become an official reserve currency (a designation controlled by the IMF). The recent applause from the IMF on the new trading bands surely heartened policy makers in Beijing, but the economic benefits from the devalued currency will be longer in the making. With 18% of Chinese A-shares still halted from trading, the markets remain artificial. We expect continued stimulus efforts to put a floor under Chinese growth, but think the markets will remain skeptical until concrete signs of reacceleration appear.


  • Natural resources are facing tactical headwinds.
  • Longer-term fundamentals still support an allocation in strategic portfolios.

Commodity prices continued to be pressured by the slowing global economy and dollar strength (see accompanying graph). Decelerating growth in China has led to a shortfall in commodity demand while, in the oil space, OPEC has kept its pumps running full speed in an apparent attempt to slow U.S. fracking. The resulting poor return of commodity-related investments has caused some investors to question both the short-term and long-term merits of natural resources investments. We have a tactical underweight recommendation (12-month time horizon) for commodities, due to the soft demand outlook and expectations for continued dollar strength. However, we also believe the attractive valuations resulting from price weakness increasingly provide an opportunity for strategic investors, given the need for more investment to continue to meet even subdued global demand.


  • The recent decline in valuations has been driven by the lowest-quality commodity sectors.
  • Actively managing sector exposures can enhance performance.

The high yield market has returned 1.2% through August 7, down from a high of 4.1%, driven primarily by commodity sectors. Overall, 37 of 44 sectors in high yield have positive returns year-to-date. However, the metals and mining sector has declined 9.7% and the independent energy sector is down 8.9% year-to-date. There's further differentiation by credit quality within these sectors. The accompanying graph shows the year-to-date returns of the energy sector by credit quality. There's a 21.7 percentage point differential between the returns of BB energy bonds and CCC energy bonds. The index takes the full impact of the underperformance and default experience of the weakest credits. However, actively managing credit risk can reduce price volatility and preserve capital by avoiding areas of the market with negative credit fundamentals.


  • New issuance of corporate bonds is running more than 20% higher than last year's record pace.
  • After new issuance begins to slow, we believe credit spreads will start to narrow.

Largely due to an uptick in merger and acquisition (M&A) activity, new investment-grade issuance is running more than 20% ahead of 2014's record levels. July alone saw $123 billion in total supply, nearly 45% higher than the previous July record and 115% higher than the five-year July average of $57 billion. Investors in corporate debt have been overwhelmed by issuance and M&A activity and have been demanding issuers pay them more to buy their debt. Option-adjusted spreads have steadily widened during the past 12 months and are now at their widest in two years. After the supply of new issuance slows, we expect the widening the market has seen to reverse and credit spreads to tighten.


  • The Bank of England is in no rush to raise interest rates.
  • Greece narrowly avoids an exit from Europe as third international bailout nears approval.

Markets anticipated greater clarity from the Bank of England's (BOE's) August meeting. However, soft near-term inflation courtesy of low oil prices and the lone dissent of David Miles indicate no rush to commence rate hikes. That said, with domestic conditions showing continued improvement and inflation projected to be above 2% in 2017, a rate hike early next year looks likely. Greece has surprised to the upside both with its second-quarter GDP growth at 0.8% as well as closing in on a rescue package in time for repayments to the European Central Bank on August 20. However, with Prime Minister Alexis Tsipras losing support within SYRIZA, political stability may be compromised. Longer term, markets still reserve judgment on debt sustainability, and this issue is creating friction between the key creditors to Greece.


  • China continues to take the markets by surprise.
  • The Reserve Bank of Australia kept rates on hold in spite of global currency market pressures.

Markets have focused on renminbi devaluation after the considerable stock market decline and weak trade data as a protectionist measure to boost the Chinese export industry. However, the devaluation is small in absolute terms and could be a strategic adjustment toward market-determined exchange rates while the dollar remains strong. As such it may not trigger widespread panic and competitive devaluations in the region. The Reserve Bank of Australia maintained its 2% policy rate in August, while the quarterly Statement of Monetary Policy signaled a neutral stance by tempering higher inflation projections with lower growth forecasts. Past depreciation is partly behind the adjustment to inflation, but to this end, developments in China should be closely monitored especially as the commodity sector remains challenged.


Two market indicators used to gauge the outlook for growth and risk taking are the commodities and credit markets, and at first glance both are concerning. The precipitous decline in the broad commodity indexes during the last year is certainly a reflection of a slowdown in growth globally, but is also a reflection of oversupply in the oil markets and dollar strength (which results in a commensurate decline in commodity prices). So while we would consider some of the decline in commodities prices a signal of slowing growth, this is hardly a news flash to investors. We think the recent increase in credit spreads (U.S. investment-grade spreads have increased 59 basis points from their lows, while comparable European spreads have risen 37 basis points) is closely tied to surging new debt issuance from heightened M&A activity. We expect these spreads to tighten, boosting investment-grade fixed income returns and assuaging concerns that the credit markets are predicting a significant deterioration in the economic and profit outlook.

We made no changes to our global tactical asset allocation model this month, after reducing risk in the prior two months. Our current risk positioning is close to long-term strategic levels, reflecting our view that the markets are more likely to run in place during the next six-to-12 months than make a major break in either direction. Economic growth is too languid to lead to much upside in earnings estimates, and central bank policy looks increasingly unlikely to provide much boost to animal spirits and, therefore, valuations. The move by China to devalue its currency will only steal growth from its competitors, without changing the overall level of global growth.

The biggest risk to our outlook is the prospect for G-2 (United States and China) growth, and it could surprise in either direction. Even though we're conditioned to think of risk as a downside event, it may be more fruitful to define risk as events turning out differently than what was planned. Should Chinese policy makers succeed with their stimulus efforts to support growth, market fundamentals would be positively affected. Likewise, acceleration in the U.S. housing market represents the biggest swing factor toward U.S. growth over the next year. It's important to keep an eye on investor sentiment, as it can prove a useful contrary indicator. Various measures of investor risk appetite (AAII Sentiment Survey, CBOE Equity Put/Call Ratio, hedge fund net exposure) point to cautious positioning. This relative caution helps support the case for a normal risk allocation in portfolios, as the current cautious positioning helps offset some of the risk of further economic and financial market disappointment.



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.

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. © 2015

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.