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Northern Trust Perspective


January 14, 2015

Northern Trust Perspective for January 14, 2015

Click on the links to access the printable versions

The new year began with a bang as financial market volatility jumped in the first trading sessions of the year. Financial markets crave predictability, and we've seen uncertainty arise about global growth, the energy markets, currencies and Greece. Recent economic data has been improving in the United States and Europe, while reports from Japan and the emerging markets have been more muted. Financial markets continue to wrestle with the plunge in oil prices. The bearish camp believes they're a sign of a significant slowdown in global growth and discounts the bullish camp's view of the beneficial stimulus impact. Put us in the cautiously optimistic camp, as we believe the price drop will benefit the world's largest economies. However, the benefit will be reduced by energy spending cuts and the fallout from investments that are dependent on much higher oil prices.

Similar to the disruptive effect of the swing in oil prices, risks have increased surrounding the currency markets in recent months. The low interest rate environment in recent years led many emerging-market issuers to issue dollar-denominated debt, which suddenly is much more expensive. Russia is one example. Reports indicate that up to 80% of private-sector debt in Russia is dollar denominated. Attention has also returned to Greece's financial condition as it approaches its national election on January 25. The left-wing Syriza party is holding a dwindling lead in the polls, and its stated opposition to the European bailout of Greece raises concerns about how a new government will treat its existing financial obligations.

We currently don't expect the election results to lead to a new financial crisis in the eurozone, as we believe some level of eventual compromise is likely. The risks surrounding Greece have also been mitigated from the last go around, as the country is now in a primary budget surplus and roughly 80% of its debt is held in public hands. We've also not seen contagion into other European bond markets, partially because of the expectation of upcoming quantitative easing (QE) by the European Central Bank (ECB). So, while we expect solid growth from the U.S. economy, we expect Europe and Japan to continue muddling through as they experiment with new monetary and fiscal policies.


  • U.S. gasoline prices have dropped more than 40% in the last six months.
  • Savings at the pump support sentiment and spending on other goods and services.

According to the U.S. Bureau of Economic Analysis, consumers spend $12 trillion annually in the United States, with more than 3% of that amount on gasoline. Given the greater than 50% decline in the price of crude oil, and the resulting low gasoline prices, in the second half of 2014, it's not surprising that consumers feel better about the economy. The Consumer Sentiment Index has improved for five straight months and reached a new cycle high in December. The drop in gasoline prices effectively acts as a tax cut for consumers, so investors should expect to see broadly increased spending on other goods and services over the course of 2015. We continue to favor U.S. equities given stronger relative economic momentum and growth driving corporate earnings.


  • Data from Europe's largest economies suggest slowing growth.
  • The ECB's expected QE announcement is critical to investor sentiment.

The trend of weak economic growth in Europe's core countries remains firmly in place. Composite purchasing managers' indexes moved lower in Germany and Italy and sideways in France for most of 2014. As a result, earnings estimate revisions continue to move lower and remain the worst of the developed markets. While expectations already are low, investors still need to see tangible progress on fiscal or monetary policy to gain confidence that the status quo will improve. Therefore, an announcement from the ECB at the end of January to start a QE program likely will set the tone for the start the year. The size and composition of the program will determine the likelihood of the real economy benefiting and any change in our measured outlook toward European equities.


  • Japan's Prime Minister Shinzo Abe moves forward with corporate tax reform in an effort to boost wages and inflation.
  • Prior experience suggests the pass-through to wages from corporate tax cuts is limited.

Following a decisive victory in last month’s snap elections, Abe’s government announced plans to lower the corporate tax rate by approximately 2.5% in fiscal 2015 and 0.8% in 2016. The goal of the tax cut is to increase inflation via corporate savings redirected into productive uses, such as capital investments or increasing workers’ wages. However, lowering corporate tax rates historically has shown almost no influence on workers’ nominal wages, and Japanese worker wages adjusted for inflation have already been decreasing for more than a year. Japanese companies continue to hoard record levels of cash, further complicating Abe’s plan. Until investors see sustained real growth from Abenomics, a durable rebound in Japanese equities shouldn’t be expected.


  • There's a big disparity in emerging-market growth outlook.
  • Markets remain vulnerable to the U.S. dollar's strength.

The heterogeneity of emerging markets was in full display in 2014, and we expect it to continue in 2015. Asian economies look set to grow around 6%, while Latin America may grow just 1%, and emerging European, Middle Eastern and African economies may struggle to generate positive growth because of Russia's poor growth in the face of sanctions and declining oil prices. Because Asian emerging markets represent roughly two-thirds of emerging-market equity capitalization, this bodes well for overall growth. However, this asset class remains vulnerable to the risk of capital flight and currency depreciation because of the U.S. dollar's strength. A significant amount of capital was raised in these markets in recent years, and a large proportion was raised in U.S. dollar-denominated debt. Until there's better clarity around this tail risk, we expect emerging-market equities to continue to underperform.


  • As the U.S. dollar has strengthened, inflation expectations have fallen.
  • Falling inflation expectations reflect the current growth outlook.

Inflation expectations (using the difference in yields between 10-year Treasury and 10-year Treasury Inflation-Protected Securities as our gauge) fell by 0.5% in 2014. This marks four out of five years that inflation expectations have fallen, and coincides with our strategic theme of the developed-market inflation sponge — wherein slow demand and continued output gaps mitigate inflationary pressures. Commodities have borne the brunt of falling inflation, and we expect modest returns in 2015 as commodity prices — notably oil prices — settle into their new supply-demand equilibrium. Global real estate and listed infrastructure fared much better in 2014, as their exposure to interest rates and the broader equity markets resulted in double-digit returns. Even though valuations have risen, expectations for a continued low-rate environment support these cash-flow asset classes.


  • The lowest-rated high yield bonds underperformed in the fourth quarter.
  • The energy and commodity sectors distorted the performance of the rating categories.

The lowest-rated high yield bonds (CCC and below) represent 16% of the market, and they underperformed higher-rated credits in the fourth quarter. The two largest components of the CCC rating category are energy at 22.7% and materials at 14.3%. The decline in the price of oil has resulted in return declines of up to 16% in some energy sectors in the fourth quarter. We believe these sectors' substantial underperformance presents a distorted picture of the broader group of CCC securities. However, rating categories don't provide a true picture of the performance of individual securities. There are stable credits and attractive securities in the CCC category, and we think this illustrates how high yield investment returns in 2015 will be driven primarily by security selection rather than market beta.


  • 10-year U.S. Treasuries finished 2014 0.87% lower than they started.
  • The global search for yield should keep yields lower than many believe.

Market expectations heading into 2014 were for long-term interest rates to rise, so, of course, they did the opposite — with the 10-year Treasury falling 0.87%. We kick off 2015 with the U.S. economy in better shape than last year and the consensus once again expecting higher yields. However, we believe low yields across developed economies will play a role in keeping U.S. rates lower than many believe. The search for yield is a global one, and U.S. Treasuries offer higher yields than those of other high-quality, liquid, developed economies. With the continued struggles in the global economy, we believe foreign investors may continue to pour money into the United States in 2015 and that this will help keep yields on long-term U.S. Treasuries lower than consensus expectations.


  • The ECB is likely to kick start 2015 with quantitative easing (QE).
  • Worries of a Greek exit (or "Grexit") from the European Union (EU) have returned.

With the return of headline deflation, it seems likely that the ECB will announce additional asset purchase plans at its January meeting. As the monetary transmission mechanism remains broken, it's not clear how much QE will help the real economy. However, it should continue to support risk assets, with German bund yields firmly in negative territory. The risk of Greece exiting the EU (Grexit) has re-emerged with the possibility that the anti-austerity Syriza party may be a winner in the January 25 elections. The Greek yield curve has become sharply inverted, with three-year bonds rising more than 750 basis points (to higher than 14%) in the last month. It's more likely that, should the Syriza party come to power, there'll be hard negotiations with the Troika regarding Greece's debt burden and Greece's continued membership in the EU, but in the meantime this may bring unwelcome volatility in Europe.


  • India is set for another good year.
  • After an electoral victory, Japanense Prime Minister Abe refocuses on employing "Abenomics."

After a historic election win for the pro-development BJP Party in 2014, the outlook for India continues to improve. Leading growth indicators have risen to a two-year high while inflationary pressures have eased. With policy reforms and fiscal consolidation, India should be better sheltered from broad emerging-market concerns tied to U.S. interest rate normalization. Japanese Prime Minister Abe's strategy for Japan remains in play following the resounding election victory. The third arrow likely will include long overdue labor market reforms. However, with a delay in the sales tax hike, fiscal conservatism may constrain spending plans to avoid further credit rating downgrades. Therefore, pressure will remain on the Bank of Japan to do more, but asset purchases may be challenging with bond yields close to or below zero. A lowering of the inflation target might be more palatable amid falling oil prices and weaker global growth.


Even though the increased volatility experienced so far this year is unlikely to continue at the current pace, we expect higher volatility this year than witnessed in 2014. While the U.S. growth picture looks sound, lack of conviction toward other major economies such as Europe, Japan and China increases investor uncertainty. The plunge in oil prices represents a modest tailwind to growth in the developed world, and the strong disinflationary/deflationary trends globally give central bankers more leeway to keep policy accommodative. The returns from additional monetary policy easing are clearly diminished today, as interest rates are already rock bottom and the transmission mechanism from central bank balance sheet expansion to credit creation is leaky.

We entered 2015 with a tactical asset allocation policy that encompassed a lower-risk position than at the start of 2014, primarily because of reduced growth expectations outside the United States. After making recommendation changes at each of the last three meetings in 2014, we stood pat at our January meeting. We continue to favor U.S. dollar-related assets in this environment because of the relative growth outlook in the United States alongside the potential for continued U.S. dollar appreciation in 2015. We see the increasingly divergent growth trajectories further extending the timeframe for easy monetary policy because central bankers will be increasingly concerned about the sustainability of global growth. Even though the Federal Reserve believes the U.S. outlook can withstand the slower global growth environment, it's clearly concerned that further deterioration is a risk to the U.S. outlook.

While we update our risk cases each month, we continue to view the outlook for G-2 (United States and China) growth as our top risk case. Should U.S. growth falter, investors will question whether monetary policy can be effective in this post-crisis environment. A material slowdown in Chinese growth, which officials seem dedicated to avoiding, would have a disproportionately negative effect on global growth. Fallout from U.S. dollar strength was added as a new risk, as emerging-market companies and economies adjust to weakening local currencies and, in many cases, U.S. dollar-denominated debt. Finally, we continue to monitor geopolitical events, especially in Eastern Europe. While the fall in oil prices might be a catalyst for reducing tensions, it could also provide a reason to ratchet up adventurism.



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.