The influence of policy makers and politicians has moved to the forefront of investor interest this year, and the current three-month stretch might be the near-term pinnacle. With the political conventions behind us, the presidential race is now in a sprint to the finish line. Our base case scenario calls for a repeat of the current split power structure, but the races are close and we wouldnt wager much on the outcomes just yet. Federal Reserve Chairman Ben Bernanke has been lamenting the tragic state of the U.S. labor markets while defending the efficacy of the actions the Fed has taken to date. While the Fed announced further accommodation, the European Central Bank (ECB) has become the more important body as it leads the fire brigade in Europe. We continue to expect European policy makers and politicians to do the minimum required at the latest possible moment to avoid a breakup of the euro.
Media reports are increasingly reporting that high-dividend yielding stocks are overvalued and represent a crowded trade because of their strong relative performance during the last year. Based on our quality dividend focus research, the average duration of relative underperformance of a high-income portfolio during the last three decades was approximately six months. We believe that, despite recent underperformance in the current risk on environment, the highest dividend yielding stocks with fundamentally strong quality should outperform over the long term. The potential for a change in tax policy, reducing the favorable status of dividend income, is an uncertainty overhanging these stocks. However, dividends are a significant component of total equity return, and should remain in demand for investors seeking total return and income, particularly considering upcoming demographic shifts.
Proposed accommodation from the ECB has given life to European stocks, but fundamental pessimism remains strong. Eurozone PMIs remain depressed, business and consumer confidence has fallen sharply, and GDP fell in two of the last three quarters. Growth has slowed in Germany and France, while output from peripheral nations is falling. The ECB has revised downward its GDP forecasts to a range between -0.6% and -0.2% for 2012 and between -0.4% and 1.4% for 2013. At this point, the onus is on the Bank of England (BoE) to steer the United Kingdom out of its current recession. The BoE noted that the outlook remained unusually uncertain, while the Organisation for Economic Co-operation and Development (OECD) sharply lowered its outlook, anticipating GDP to drop 0.7% this year. Some signs of improving fundamentals will likely be required to sustain the equity rally.
Asia Pacific Equity
Recent cuts to Japans economic outlook reflect the PMI falling to 47.7 in August, the declining manufacturing output and a widening trade deficit. Exports to the European Union (EU) and China clearly mirror the weakness in the global economy. Japanese growth, however, is expected to trace a modest recovery path, though downside risks persist. The resilient Australian economy grew with steady momentum; close to trend with second-quarter GDP up 0.6%. Economic data persisted on the upside, with inflation lying low and labor markets stable. The future remains challenging, clouded by falling commodity prices, Chinas uncertain outlook and the global slowdown, thereby increasing the scope for moderation in growth. With time on its side, the Reserve Bank of Australia (RBA) patiently waits to assess the effect of its policy on the economy.
Emerging Markets Equity
Emerging-market stocks have lagged their developed-market peers this year, raising the question of whether this has created a valuation opportunity in these stocks. On a forward price/earnings multiple basis, the stocks have a middling valuation relative to their developed-market counterparts. On a comparison to trough valuations, emerging-market stocks are trading 37% above their trough levels since 1991, compared with Europe at just 18% and the United States at 22%. With valuations not sending a clear signal, a turn in fundamentals is the most likely market catalyst. Economic momentum in the largest emerging economies continues to slow, but is no longer presenting a negative surprise. Monetary and fiscal policy is becoming increasingly active, but has yet to provide sufficient catalyst for these shares to outperform the developed markets.
U.S. Fixed Income
Recent communications from the Fed have only served to increase market expectations about how accommodative monetary policy will become. The Federal Open Market Committee (FOMC) continues to see slow growth, subdued inflation and an unchanged Fed funds rate through 2014. In this environment, we see little value in short-term bonds as we continue to believe the Fed funds rate will remain at extremely low levels for the next few years. We see some relative value in high-quality corporate bonds maturing between five and 10 years. These bonds continue to benefit from pristine balance sheets, a steep slope to the interest-rate curve and a FOMC that will keep the Fed funds rate at an exceptionally low level for the next few years.
European Fixed Income
Early this month, the ECB proposed an unlimited sterilized bond purchase program (maturities between one and three years), while also emphasizing that eurozone-member governments must gear up initiation of the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) when financial stability is circumscribed. Peripheral bonds rallied strongly from the start of the month, when the scale and nature of the OMT program were first mooted with Spanish and Italian yields hitting three-month lows. We continue to see a long and incremental path toward repair of the European debt crisis the OMT framework is but one important proposal along this journey. Pursuing its quantitative easing program, the BoE waits while also assessing the impact of recent measures adopted. Rates, however, remained untouched. Downside risks from the eurozone crisis continue to cloud the growth horizon, providing a continuing bid to high-quality sovereign bonds.
Asia Pacific Fixed Income
Central banks are battling twin scenarios of shielding their countries economies from the softening global outlook while also monitoring inflationary trends. Leaving rates unchanged for now, the RBA acknowledged that subdued indicators from China and across the globe cloud the growth horizon. Thus they wait while assessing the economic impact of earlier easing. The government bond yield curve has shown continued improvement and is now relatively steady. The Bank of Japans (BoJs) current monetary easing plans focus on infusing money through an asset-buying program. However, the BOJ is now under further pressure because of weak economic data. On this backdrop, yields on securities maturing in 10 years or less declined. With risk-averse Japanese Government Bond (JGB) buyers contently clinging to JGBs, long-term interest rates remain well supported.
U.S. High Yield
High yield credit quality has been improving because of stronger issuers and improving corporate fundamentals. Coming out of the financial crisis, companies improved both their business profiles and balance sheets. The positive upgrade-to-downgrade ratio during this period is further evidence of the trend for high yield issuers to improve their credit profiles. Investors are maintaining discipline in choosing which companies to extend credit to. This both reduces issuance by weak credits and discourages the pursuit of aggressive transactions by issuers. These factors reduce the default rate outlook and provide fundamental support for the high yield market. Even though nominal high yield interest rates are plumbing new lows, we believe they still represent good relative value in this interest rate environment.
Central banks continue to provide accommodative monetary prescriptions to heal the global economy of its growth malaise. In response, proper portfolio management requires a clear strategy around investments in real assets (those asset classes sensitive to inflation levels). We recently published new research on this topic in a strategy piece, New TIPS on Real Assets. Natural resources both futures-based and equity-based have provided the best inflation sensitivity historically. However, inflation-linked bonds also serve a purpose as an inflation-sensitive diversifier, while global infrastructure and global real estate investment trusts provide income streams that can adjust to the inflation environment. Gold has proven to be driven less by inflation and more directly by central bank policy prompting us to reclassify the precious metal as an alternative currency.
Investors should expect some increased volatility in markets as the United States works through the election, the fiscal cliff, the European debt crisis and the current global economic soft patch. While investor sentiment remains subdued, expected volatility in the stock market (as measured by the CBOE Volatility Index [the VIX]) is low reducing the cushion for such an uptick. We see the fourth quarter of 2012 and first quarter of 2013 as having the greatest likelihood for market volatility. The negotiation process around the Bush-era tax cuts and other aspects of the fiscal cliff will be heavily influenced by the election outcome, and will likely involve some high-stakes poker. Although the European debt crisis has quieted down after the recent Outright Monetary Transactions (OMT) program announcement, were one political or legal development away from another flare-up in risk aversion.
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.