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Northern Trust Perspective


February 19, 2015

Northern Trust Perspective for February 19, 2015

Click on the links to access the printable versions

World stock markets have regained some momentum since the end of January, as constructive economic data have helped offset worries over Greece and fighting in Ukraine. Markets have been concerned about the diverging growth between the United States and other major developed economies. European gross domestic product (GDP) for the fourth quarter was a better-than-expected 1.2%, supported by the weaker euro. Japan emerged from its 2014 recession, but growth of 2.2% in the fourth quarter was disappointing compared with forecasts of 3.7%. Even though the United States reported robust job growth in January, other data indicate economic growth is more modest in the first quarter. In summary, the global economy looks set to report improved growth in 2015, but the pace will be muted compared to before the financial crisis.

When analyzing Greece, it's difficult to be optimistic save for the fact that an agreement was never likely until just before the current bailout expires on February 28. With the European Central Bank (ECB) as the primary liquidity provider to Greek banks, it holds considerable leverage. However, the ultimate plans of the Syriza party are hard to forecast, and the risks of a Greek exit from the European Union have risen. So far, market contagion (as shown in the chart below) has been isolated, but an actual exit would surely increase volatility. Negotiations around de-escalation in Ukraine also continue with mixed success, as the recent cease fire doesn't appear to be fully working. The potential for further deterioration, with a negative follow-on effect to European growth and security, remains a risk case in our investment outlook.

Global monetary policy has become even more accommodative in recent months thanks to emerging markets. In the last three months, 14 emerging-market countries have seen their 2015 growth forecasts trimmed, while just three countries have seen expectations increased. The softening growth environment, along with falling interest rates and inflation globally, has led 12 of these central banks to easier policy, while five are tighter. On the margin, easier global monetary policy pushes out the timeframe for an eventual hike in the U.S. Federal Funds rate. The market has been vacillating between a June and September timeframe for the first hike, but more important is the pace of subsequent hikes. We expect the Federal Reserve to be patient, lest it risk being too far ahead of market expectations.


  • Lower oil prices and the stronger U.S. dollar detract from our 2015 earnings estimate.
  • We expect multiple expansion to support the market outlook.

The effect of the plunge in oil prices and the strength of the U.S. dollar in the second half of last year has led us to cut our 2015 S&P 500 earnings expectations. Because the price of crude oil and the U.S. dollar are notoriously difficult to accurately predict, we've assumed current levels when forecasting earnings. The decline of energy sector earnings is the largest detractor, but we expect that redirected consumer spending and lower energy input costs for companies will offset some of the decline. We now forecast earnings growth of 3% in 2015, but expect valuation expansion, because the low interest rate environment supports higher valuations. We continue to favor U.S. equities given better relative economic momentum and the potential of continued U.S. dollar strength.


  • Recent credit and money supply figures show promising improvement.
  • We're still awaiting the transmission of benefits to the real economy and earnings.

While Greece dominates the headlines and fixates investors, eurozone credit indicators and money supply have recently shown signs of life. According to the ECB's January survey, financing demand from companies for fixed investment turned meaningfully positive for the first time in almost four years, driven primarily by France, Germany and Spain. The banks surveyed also anticipate an increase in net credit demand from both companies and consumers in the first quarter of 2015. Broader monetary data also show clear improvement, typically a sign of stronger future growth. Even though these are hopeful developments, the outlook for European equities will continue to be constrained by currency weakness and risks from Ukraine to Greece.


  • Despite an uncertain economic path, corporate earnings are stronger than expected.
  • Revisions to estimated earnings are the best of major developed and emerging regions.

Japan's economic data remains mixed following the country's dip into recession last year. Encouragingly, the corporate earnings environment provides a better outlook. Of the 83% of TOPIX companies that have reported their fiscal third-quarter results, more than half have beat earnings expectations. Estimated fiscal third-quarter year-over-year growth has improved from -4.8% at the beginning of the announcement cycle to 2.8% currently. Excluding the energy sector, growth further improves to 10.1%. Although revisions to earnings estimates declined slightly in January, Japan is the only global region with more positive than negative earnings revisions during the last three months. However, given the size and scope of Abenomics, equity investors are likely to continue to wait for signs of durable real growth before becoming more constructive.


  • Economic momentum in the emerging markets remains lackluster.
  • Central banks are responding to the weakness.

While emerging markets are collectively expected to grow more rapidly than developed markets in 2015, the gap has been closing as emerging-market growth expectations have been shaved lower. In the last three months, 2015 forecasts for 14 emerging-market economies have been reduced, while only three have been increased. This hasn't gone unnoticed by policymakers; 12 countries have now eased monetary policy while only five have tightened in recent months. The easier monetary policy backdrop has provided some support for equities, which have now kept pace with global equities year-to-date. Current valuations support the group's long-term return potential, but we need to see improved economic momentum to support tactical outperformance. We expect increasing U.S. interest rates, and the potential for a continued rise in the dollar, to provide additional performance headwinds.


  • Falling interest rates have benefited both global real estate (GRE) and global listed infrastructure (GLI).
  • Valuations have risen but low interest rates continue to support both GRE and GLI.

Coming out of the financial crisis, both GRE and GLI have been valuable components of a well-diversified portfolio. GRE has provided an 11.7% annualized return (vs. global equity's 9.4%), while GLI's 8.8% annualized return is impressive on a risk-adjusted basis. Both asset classes have been a nice source of yield in a low-rate environment — and have played off one another nicely. For instance, when GRE showed weakness in 2013 and 2014, GLI provided stability (see chart). But are these asset classes now overbought? While dividend yields have trended down to the mid-3% level, our expectation of continued low rates continues to support a strategic allocation to these cash-flow assets.


  • The revaluation of the high yield energy sector reduced overall risk tolerance.
  • Valuations may now favor the sectors that lagged behind.

The decline in the price of oil and subsequent revaluation of the high yield energy sector resulted in an overall reduction in investor risk tolerance. After the market hit its recent low on Dec. 16, 2014, higher-quality issuers led the recovery. The chart shows how the spread differentials between rating categories have widened since mid-2014. Since Dec. 16, 2014, the BB index has tightened by 88 basis points and currently yields 4.65%. Given that the BB index is approaching its lowest yield of the past six months, investors may be forced to look at a broader universe. An indication of this may be returns of more than 4% in the high yield energy sector in the first five days of February. Current valuations may result in the compression of the spread differentials between rating categories.  


  • Investment-grade debt was less affected by falling oil prices than high yield.
  • The investment-grade energy sector is relatively small at just 2%.

The negative effect of falling oil prices has been much publicized in the high yield market. And while investment-grade debt hasn't been immune to the decline, we don't believe that depressed prices will cause a major disruption in the high-grade market. It's worth noting that the energy sector is currently only 2% of the Barclays Aggregate Bond Index, relative to 13% for the Barclays Corporate High Yield Index. Even though contagion fears may persist as long as oil prices stay at lower levels, improving fundamentals across the broader U.S. economy will help to isolate the impact that lower oil prices have on the investment-grade market.


  • The ECB embarked on sovereign quantitative easing, but markets are awaiting finer details.
  • The Swiss National Bank sent currency markets into a frenzy.

The ECB added sovereign quantitative easing to its tool kit in January, announcing €60 billion in monthly asset purchases beginning in March, and adding European government and agency bonds to its existing purchase programs. While markets reacted positively, much of the finer details around eligibility remain absent. In the lead-up to the ECB decision, the Swiss National Bank surprised markets by ending its currency cap vs. the euro and significantly cutting its LIBOR target rate to -0.75%. The consequential effect on the currency markets, together with interest rate cuts in the region, notably in Denmark, suggest that European yields will remain in negative territory for some time — while the ongoing negotiations with Greece over its bailout package will keep volatility heightened.


  • The Peoples Bank of China is unlikely to sit on the sidelines.
  • The Reserve Bank of Australia joins the wave of central bank accommodation.

With evidence of a slowing economy, the Peoples Bank of China succumbed to pressure and announced a reduction in the bank's reserve requirement ratio by 0.50%. Leading indicators have continued to disappoint, causing the central bank to abandon its earlier rebalancing efforts. Further policy measures are likely for the exporter as the global growth outlook remains modest. The Reserve Bank of Australia (RBA) joined the long list of global central banks in easing mode, cutting its policy rate to a record low of 2.25%. The timing was a surprise, but Australian growth and inflation forecasts have been declining alongside Chinese growth and commodity price weakness. With an undeclared global currency devaluation war underway as central banks embark on monetary easing, the RBA could act again.


We've been of the view that the diverging growth between the United States and other major developed economies (primarily Europe) wouldn't persist throughout 2015, and the most likely case was for some improvement in European and Japanese growth. Europe has started off the new year in that vein, while Japan has been modestly disappointing. The financial markets have quickly picked up on this improvement, rewarding investments in Europe in particular. The MSCI European Index has returned 10% year-to-date in euros, but euro depreciation has cut that return to just 4% for U.S. dollar-based investors. Similarly, the MSCI Japan Index has also delivered a U.S. dollar return of around 4% year-to-date, besting the U.S. total stock market return of 2.3%. As a result, a global portfolio has performed well this year and demonstrated the benefits of global diversification.

We made no changes to our tactical asset allocation recommendations this month, continuing with our overweighting of stocks over bonds, and favoring U.S. equities and high yield bonds. While developed markets outside the United States have outperformed U.S. stocks so far this year, our overweighting of risk assets in aggregate has overcome this headwind. The only change to our fundamental view this month was our decision to categorize emerging-market monetary policy as accommodative, as there's been a decisive shift toward easier monetary policy in these markets in response to slowing growth. We'll want to have confidence in improving economic momentum before considering upgrading our view on emerging-market equities.

Our recommended tactical underweightings to international developed- and emerging-market equities are driven by both our economic outlook and the risk horizon. Even though we don't expect major disappointments, we anticipate both regions to fall short of investor expectations. In addition, the risks from Greece and the conflict in Ukraine would both hit Europe disproportionally. Our caution toward emerging-market equities and debt reflects both our measured economic outlook and the potential upset from increasing U.S. interest rates and dollar strength. Having said this, we're modestly overweight risk overall because of a substantial overweight to U.S. equities and high yield. Should the major developed economies continue to "converge" toward more solid economic growth, our overweighting to risk assets should pay off.



The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.