The better recent tone in financial markets reflects an improving fundamental outlook. Indeed, some of the clouds shrouding the economic outlook have started to part. The debate over the Federal Reserve's second quantitative easing program (QE2) hasn't been settled, but it has improved financial conditions through higher equity prices and a lower U.S. dollar. Our economics team believes that QE2 will be effective through an expansion of outstanding credit, something that QE1 didn't accomplish. We've previously written that QE2's best chance for success was through the positive wealth effects created by a stock market rally, and we've recently enjoyed a double-digit rally in equity prices since the beginning of September.
We also think the results of the U.S. midterm elections have helped support the stock market rally and increase the odds of an improved economic outlook. We think this will come about through a more centrist deal on the extension of Bush-era tax cuts, a less activist regulatory environment and an increased focus of the Obama administration on economic growth. The path toward deficit reform is less clear - the nebulous assertions made on the campaign trail will hit the political reality of finding sufficient discretionary spending items to cut without creating significant pain.
Finally, the global economy is showing tentative signs of accelerating out of its recent soft spot. Industrial orders increased in October, after a slowing trend during the prior four months. The U.S. labor market has finally shown a faint heartbeat, with initial unemployment claims continuing to fall and private job creation now averaging 100,000 per month for the last four months. Improvement on the labor front will be a major factor to improving overall sentiment and risk taking. The combination of QE2, the election results and signs of economic improvement have increased the probability that the global economic expansion will regain its momentum.
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Equity markets posted strong gains during the last month as more aggressive monetary policy, solid third-quarter earnings and attractive valuations offset ongoing economic concerns. In addition, the markets were helped by the likely continuation of the Bush-era tax cuts in some form and a more business-friendly policy backdrop post election. Large-cap stocks outperformed small-cap, reflecting their compelling valuations and attraction of stock with high dividend-paying potential. Correlations across capitalizations - which had remained high even as volatility declined - finally began to drop as well. While certain headwinds, such as declining government spending, are likely to persist, equities remain attractive given the improving economic outlook, strength of corporate profits and stock valuation levels relative to investment-grade bonds.
EAFE and Emerging Markets
Despite the strong performance of risk assets, particularly as the second phase of quantitative easing (QE2) was priced into markets, investment-grade spreads remain well wide of precrisis valuations. This is largely because of spreads in the financial sector, which are 87 basis points (bps) wider compared to the industrial sector, which is only 12 bps wider. The industrial sector has benefited from strong, transparent balance sheets and easy access to the primary markets. We have long held the view that financial sector spread “normalization” would coincide with evidence that a self-sustaining organic economic recovery was underway. The dislocation in risk assets being fueled by QE2 is challenging this view, as investment-grade financial spread valuations look poised to improve on relative valuation alone.
Strong demand for BB-rated securities this year has resulted in spread tightening and outperformance relative to lower-rated securities. BB-rated securities are more than 39% of the high yield index, thus directly driving high yield returns and indirectly allowing lower-rated securities room to follow. The spread between the BB index and investment-grade industrials is currently 273 bps, tighter than its widest level of 388 bps in November 2008, but well above the 70bps reached in 2007. As the Fed moves to keep rates at very low levels with quantitative easing, we expect investors to continue to buy the better-quality high yield issues, further tightening spreads.
Global Real Estate
Europe and the Americas led global real estate returns with gains of 5.5% and 4.7%, respectively. Underpinning those gains are signs of improvement in commercial real estate, where property sales for the third quarter increased 22% year-over-year and transaction prices also increased. Despite an increase in sales volume, the overhang of $3.3 trillion in commercial real estate debt in the United States and anemic CMBS issuance, high unemployment and sluggish economic growth remain fundamental hurdles to a real estate recovery. The run-up of REITs in the United States in 2009 and into 2010 has them overvalued relative to other securities on nearly all valuation metrics.
Hedge funds returned 2.4% in October, as measured by the HFRI Fund Weighted Composite Index, bringing the year-to-date return to 7.1%. Risk appetite appears to have returned as UBS and Morgan Stanley have reported an increase in both gross and net leverage across most strategies. According to UBS Prime Brokerage, hedged equity managers recently have increased exposure to both long and short positions and, notably, the increased exposure has primarily been in single-stock names. This would suggest that managers are beginning to feel more comfortable with market conditions and that single-stock correlations are beginning to lessen. This environment provides the potential for further solid performance across the hedge fund universe.
We continue to believe that long term, emerging market growth will support commodity prices in a tight supply environment. Near term, significant demand for commodities has arisen through resource hoarding.With short-term U.S. real interest rates at a negative level, there’s significant interest (and low opportunity cost) in building commodity stocks. The Chinese remain one of the most savvy, and largest, buyers in the global market. They have a good track record of significant buying when prices are low, and stepping out when prices increase. China’s October oil imports were at their lowest level in 18 months, and its net imports of copper peaked when the recession ended.
The improvement in financial conditions, uptick in economic data, and likelihood of a more favorable regulatory environment in Washington have led us to reduce our tactical cash position by 3%, with the proceeds going into U.S. large cap (2%) and emerging market equities (1%). We've been describing the investing environment as uncertain because of the significant dependence on the actions of policy makers. Recent Fed developments and the U.S. midterm elections lead us to conclude that these risks are starting to diminish.
In assessing the potential destinations for the cash investment, U.S. and emerging market equities stood out for fundamental and valuation reasons. We expect the United States' economic growth during the next year, while not robust, to exceed pessimistic views. We also find the valuation of emerging market equities, at 13.7 times trailing earnings and 11.6 times forward earnings, attractive despite their strong performance during the last two years.
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 opportunities during the next 12 to 18 months where our Investment Policy Committee sees either increased opportunity or risk. The tactical recommendations are highlighted on the first page of this report.
Our asset allocation recommendations are developed through our Tactical Asset Allocation, CapitalMarkets 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.