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Northern Trust Perspective


November 20, 2014

Northern Trust Perspective for November 20, 2014

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Diverging prospects among the world’s major economies have become more acute. The goal of the world’s central banks in the post-financial-crisis environment has been to provide sufficient accommodation to allow the political and real economies time to address the structural deficits highlighted by the financial crisis. The passage of time has shown that the most responsive economies (the United States and the United Kingdom) have significantly reduced unemployment and generated reasonable growth, leading their central banks to be first in line to start normalizing monetary policy. Less competitive economies (such as those in Europe and Japan) have struggled to generate sufficient growth, leaving their central banks to continue experimentation with monetary policy support as the political class struggles to develop, articulate and implement comprehensive reform policies.

The recent mid-term elections in the United States provide a modicum of hope that voters’ dissatisfaction with lack of political progress might turn the tide toward an improving regulatory environment. The current duel on immigration policy threatens to stunt the potential of legislative compromise, but the environment in D.C. looks downright placid when contrasted with European and Japanese politics. While German Chancellor Angela Merkel’s position remains strong, poor growth has compromised other leaders, such as French President Francois Hollande. Approval ratings for the Japanese leadership have also sunk, which will only be exacerbated by the recent news that Japan’s economy has now shrunk for the second quarter in a row. Japanese Prime Minister Shinzo Abe has called for a snap election, figuring that his strong majority in the lower house will support re-election.

Slowing economic growth, teamed with continued disinflation and increasingly aggressive monetary policy, has served to weaken the yen and euro by 9% and 11%, respectively vs. the dollar this year. While this should aid Japanese and European growth in coming years, it’s also disinflationary because the rising dollar has a direct negative effect on commodity prices, with Brent crude falling nearly 30% year-to-date. This should help oil-importing countries like the United States, which remains a net importer of oil (6.2 million barrels per day (b/d) in 2013, down from 12.5 million b/d in 2005). For the global economy, the fall in oil prices is a short-term stimulus, and will also buy more time for central banks as it puts further downward pressure on inflation.


  • The U.S. dollar continues to strengthen against most major currencies.
  • Sustained dollar strength shouldn’t affect corporate margins.

Since the end of the second quarter, the dollar has appreciated approximately 10% against most major world currencies as measured by the U.S. Dollar Index. In fact, the index has reached levels not seen in more than four years. Investors remain vigilant about risks that could derail the robust corporate margin environment, but should consider prior periods of dollar strength. Since 2003, there’s been little impact on S&P 500 operating margins from dollar strength. Prior periods of strength likely reflect faster growth in the economy, which supports corporate revenues and margins. We don’t expect this trend to change and remain favorable of U.S. equities, driven by earnings growth of approximately 8% during the next year.


  • Economic data indicate European economies remained weak in the third quarter.
  • Despite negative real rates, Germany remains focused on its fiscal deficit.

While European Central Bank (ECB) policy has improved financial conditions, there’s been limited transmission of benefits to the real economy. Meanwhile, despite the subpar growth environment, there’s been no political agreement on fiscal policy. The differences in fiscal spending are readily apparent, as Germany spends just over half as much as the United States or France on public investment. It’s possible that Germany actually isn’t making any net investment in the economy after accounting for current depreciation. Germany’s recent announcement to slightly increase public investment could lead to a more constructive stance in the future, but there’s a long way to go. We continue to expect that disappointing earnings growth during the next year will limit the relative performance of European equities.


  • The Bank of Japan’s (BOJ’s) Quantitative and Qualitative Easing (QQE) expansion should offset the end of the Federal Reserve’s quantitative easing (QE).
  • A surprise Japanese recession mid-year raises risks to Abenomics.

The BOJ’s recent announcement surprised with a plan to expand the monetary base at an annual pace of 80 trillion yen of assets per year, up from between 60 trillion to 70 trillion yen, and to triple the allocation to Japanese exchange-traded funds and real estate investment trusts as part of its ongoing QQE program. This large expansion of the program should help offset the end of the Fed’s QE program, supporting overall global liquidity. The Japanese market historically has responded positively to the BOJ’s growing balance sheet, but this time it has to combat deteriorating economic data. The surprise 1.6% third-quarter real economic contraction, after a revised 7.3% contraction in the second quarter, likely thwarts the government’s plan for the second phase of its value-added tax (VAT) increase. Investors likely will want proof that Prime Minister Abe’s and BOJ governor Haruhiko Kuroda’s efforts are restoring real growth before a sustained rebound in Japanese equities can be expected.


  • Emerging-market currencies have fared better than some developed-market competitors.
  • Differentiation in currency moves suggest country specific risk is outweighing systemic concerns.

Many investors have been concerned about the effects that normalizing U.S. interest rate policy may have on emerging-market asset prices. However, realized currency moves this year have been driven by country specific developments. The Russian ruble has been a victim of Western-led sanctions and the effects of declining oil prices on the Russian economy, while Brazil has suffered through investor disappointment in the lack of political change. Asian currencies, meanwhile, have been relative islands of stability, reflecting both solid economic performance and managed trading bands (the Chinese renminbi). Emerging-market equities have been a middling performer this year, outperforming European and Japanese markets in dollar terms, but significantly underperforming U.S. equities. An improvement in relative economic momentum is likely required in order for emerging-market equities to begin outperforming on a tactical basis.


  • A strong dollar and modest global economic growth have weighed on oil prices.
  • Current oil prices are at unsustainable levels longer term.

The fall in oil prices can be attributed mostly to the strong dollar and the modest economic growth picture. Supply has also risen, as new technology has aided in impressive U.S. production gains. However, for both economic and social reasons, oil prices cannot remain at current levels indefinitely. Unconventional oil supplies (fracking) are seeing stretched economics at current price levels. For now, the drilling will continue, with investors prioritizing oil production growth rates over profits. A more immediate effect on oil prices could come from social unrest in less-developed oil producing countries, for example, those needing oil at $100 per barrel to keep the peace (through welfare subsidies, etc.). Should Venezuela’s 2.5 million b/d go offline, for instance, oil prices would spike. This is a risk case in an otherwise subdued outlook for oil prices.


  • Nontraditional buyers have introduced more-volatile fund flows.
  • Investors should remain focused on fundamentals.

During the past two years nontraditional buyers have made substantial asset allocations to high yield, and these buyers tend to move in tandem. The accompanying graph shows large fund flows during single weeks. In the June 2013 interest rate move, nontraditional accounts took money from the market and returned as buyers shortly thereafter. The largest outflow in the market’s history occurred in early August 2014, primarily in a single day. These outflows have now begun to reverse, with an inflow of close to $2 billion on a recent day. These flows result in increased price volatility. The market will adjust to this technical factor, but it’ll be driven over the longer term by fundamentals. We see an extended business cycle, continued low interest rates and strong credit fundamentals still supporting the outlook for high yield.


  • The Fed successfully wound down its bond purchases in October.
  • The futures market shows that investors believe the Fed is too optimistic on future rate hikes.

Fed communications show it would like to begin to normalize interest rates next year, as recent data shows that the U.S. economy continues to grow. At the end of the Fed’s September meeting, Fed members released their thoughts on where the Fed funds rate will be at the conclusion of 2015 and 2016. The now well-known “dot plot” shows an average of 1.27% and 2.68%, respectively. With that said, the Fed funds futures market reflects how investors believe the Fed is too optimistic regarding how fast rates will rise in the next few years. We continue to believe the Fed will be patient, and that the path to higher interest rates will be slow and measured.


  • The ECB wants to expand its balance sheet.
  • BOE Governor Mark Carney reverses tone; speaking dovishly.

The ECB is doing a good job of reassuring the market that it is committed to providing additional stimulus if required, which seems increasingly probable as economic data trails expectations. Although the hurdle for sovereign bond buying is undoubtedly high, activity in the corporate bond market may be feasible if the ECB’s indicated goal of expanding the balance sheet to its March 2012 level is real. After reminding the markets a few weeks back that the point of interest rate renormalization is nearing, Bank of England (BOE) Governor Mark Carney delivered a dovish message in the November BOE inflation report that has earned him the “unreliable boyfriend” label. Expectations of a rate hike have consequently moved back to late 2015, with inflation projected to fall further. However, Carney is unlikely to ignore any future strong data. This could lead him to again assert that the next move for rates is higher, possibly causing further volatility in Gilts.


  • The BOJ surprised markets with new stimulus measures.
  • The Reserve Bank of Australia (RBA) keeps interest rates on hold.

The BOJ surprised markets in October with an announcement to expand the monetary base at a faster pace of 80 trillion yen per year, as well as implement a number of portfolio adjustments in Japanese government bonds (JGBs) and risk assets. Although the vote was close, the BOJ reaffirmed its commitment to the 2% inflation target. Given recessionary pressure in Japan, there’s good reason for a delay in the planned VAT increase. Prime Minister Abe has called for a snap election and will dissolve parliament in a popularity vote hoping to consolidate power. While unlikely, this move could leave the BOJ in the driver’s seat if Abe loses. The RBA held the key official cash rate steady at 2.5% in November, but voiced concerns that the Australian dollar remains fundamentally high. The outlook for growth remains moderate, but the race to the bottom in the currency markets is dependent on a rise in U.S. interest rates. As such, the RBA is expected to maintain an accommodative monetary policy stance.


Changes in our fundamental outlook during the next year led us to make another change to our recommended tactical asset allocation model this month. Last month, we downgraded our outlook for growth in the developed markets outside the United States because of concerns in both Europe and Japan. This month we also downgraded our view on the political leadership in these regions, as weak growth isn’t being met by a resolute policy response. We also upgraded our outlook for regulatory reform in the United States, believing that we’ll see some progress beyond the limited expectations of the markets. In a mid-risk allocation, these changes led us to recommend a 4% reduction to developed equities outside the United States (Europe, Australasia and the Far East [EAFE]), with 2% of the proceeds flowing to U.S. equities and the remaining 2% to U.S. investment-grade fixed income.

The positioning of our global tactical asset allocation model continues to favor risk assets such as equities and high yield bonds, at the expense of investment-grade fixed income. This remains primarily a judgment regarding total return potential as opposed to bearishness toward interest rates (which we expect to remain well-behaved during the next year). Within the risk asset category, we favor U.S. equities over EAFE and emerging markets because of a better growth outlook, clearer policy picture and the potential for continuing appreciation of the U.S. dollar. As we’ve moved some proceeds into U.S. investment-grade bonds during the last two months, this has reduced the overall risk level of the portfolio, but we remain levered to rising equity prices through our overall portfolio positioning.

Our key risk scenarios evolved during the last month, with the risk of market disruption from unexpected monetary policy changes being added to the list. We continue to cite the risk to G-2 (United States and China) growth as our primary risk case, as the United States needs to prove that monetary policy can improve longer-term growth prospects and China needs to demonstrate that it can manage its credit cycle without cratering growth. Finally, we continue to be concerned about the fighting in Eastern Ukraine and the unclear path toward de-escalation. Not only is there risk around the potential of increased military skirmishes, but increased economic fallout to Europe from rising sanctions remains a concern as well.



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.