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| Perspective - February 14, 2017

  • Investor attention likely will soon shift from the United States to the upcoming elections in Europe.
  • We don’t expect a significant upturn in risk aversion, but we are monitoring developments.
  • Inflation and populist prioritization are potential headwinds, but not likely to upend equity markets over the next year.


Last month we highlighted political engagement as a new dynamic in the U.S. economic outlook, and this month we discuss the market's reaction. So far this year, investors and traders are filtering out the political noise and focusing on the positive economic outlook. In 2016, we saw three big spikes in volatility – in the first quarter around concerns about a Chinese hard landing, in the second quarter tied to Brexit, and in the fourth quarter after the U.S. election. Most of the political focus has been on the new U.S. administration, where many campaign pledges have found their way into executive actions or communications. The markets have been relatively calm; investors expect the checks and balances inherent in the U.S. government to moderate eventual outcomes. The focus will increasingly turn to Europe, with national elections in France and Germany being front of mind. While we don't expect these elections to lead to a significant upturn in investor risk aversion, we will be closely monitoring the developments.

We expect global growth to show some acceleration in 2017, led by the United States. All the major regions started the New Year with solid levels of industrial activity, and dollar strength has contributed to improving export conditions in Europe and Asia. While there is some policy execution risk in the United States surrounding new tax policy and infrastructure spending, there is also a boost to animal spirits coming from the promise of deregulation across various industries. While we expect a positive surprise from U.S. growth, there are natural limits to how much it can accelerate. For example, current deficit levels and the advanced recovery in the labor markets will provide some cap on further improvement. We expect growth in developed Europe and Asia to also exceed expectations, supporting risk-taking globally.

We think that markets are increasingly turning their focus from monetary policy toward political engagement. The Trump administration will be able to fill at least three, and likely four, new Fed positions over the next year. We expect these appointees to take a more conservative approach to governance at the Fed, but don't expect the market to be surprised by the outcome. Investor focus will, instead, be better trained on the fundamental economic outlook along with potential legislative and regulatory changes. While our two risk cases (inflation and populist prioritization) are potential headwinds to risk taking, we judge their probabilities as low enough that they should not upend equity markets over the next year.


  • Rates have settled in after jumping in late 2016.
  • We expect a gradual return to higher yields over the next year.
  • We favor positioning portfolios neutral-to-short duration relative to their benchmarks.

After a nearly uninterrupted move upward from the U.S. election through mid-December, global yield curves have settled in over the last two months. The U.S., European and Japanese markets all have seen an increase in short-term yields as investors continue to expect gradual moves away from ultra-accommodation toward normalization. While longer-term U.S. yields have fallen since mid-December, we do not expect this trend to continue. Instead, improving U.S. growth and Fed policy action should lead to a modest boost to rates over the next year.

We do read with some amusement recent stories of non-U.S. investors "dumping" U.S. Treasuries – which would seem to indicate a resulting pressure upwards on yields. We haven't seen this happen, even though January was also the second highest corporate bond issuance month in history. Credit spreads actually tightened despite this robust supply. We think the continued appetite for yield provides some ceiling on how high rates will go, especially with the European Central Bank and Bank of Japan still actively engaged in quantitative easing.

We are tactically underweight investment grade fixed income to fund our overweight risk assets. Considering our forecast for modestly higher rates over the next six to 12 months, we are managing duration risk across portfolios to be neutral to short.


  • Credit spreads have tightened further this year as risk assets continue their upward march.
  • The best opportunities in credit markets are currently found in the lower-quality categories.
  • We remain overweight high yield fixed income supported by our constructive growth outlook.

We continue to embrace credit exposure and are overweight high yield fixed income in our global policy model. Credit spreads continue to tighten; the high yield index now has a 3.8% spread over comparable Treasuries (vs. 4.1% to start the year). Tighter spreads have combined with stable interest rates to push overall yields of 5.8% to the lowest levels in over two years. The result is a 2% year-to-date return and a 26% return over the past year.

Amid this positive price action, the opportunities in the credit markets increasingly reside at the lower end of the credit spectrum. The accompanying graph shows the differential – in basis points (bps) – between credit rating categories over the past five years. The differential between BBB-rated and BB-rated bonds (currently at 105 bps) is below the long-term mean. The same is true for the BB-B differential (currently at 104 bps). There is little opportunity here other than gaining the coupon payment. However, the differential between B and CCC is at long-term averages and still 170 bps wide of the tightest levels. These bonds have higher yields and the potential for price appreciation. Additionally, their returns are more exposed to equity markets (on which we are constructive) and less exposed to interest rates (which we expect to move to a higher channel). Those who shudder at the prospect of CCC-bond investing should keep in mind that its overall risk profile is in line with global equity markets – while the broader high yield market is actually a source of downside protection vs. other risk assets.


  • Financials have been outperforming since the U.S. election.
  • We expect further rises in rates and deregulation to support continued outperformance.
  • We remain overweight U.S. equities on strong earnings growth and manageable political risk.

Strong economic momentum has underpinned global equity markets in recent months, and this is being reflected in improving corporate earnings. U.S. earnings expectations have followed the typical pattern of experiencing reductions ahead of results, only to have the reported results outperform (by around 3.6% so far this earnings season). Earnings estimates have actually been on the rise in Europe and Japan, rising 0.5% and 1.5%, respectively, over the last month. Japan is a particular standout, with the highest ratio globally of earnings upgrades relative to downgrades.

We forecast the strongest earnings growth in 2017 in the United States (at 9.0%), even before the potential of any jump in buybacks tied to repatriation of overseas profits. We see growth in the developed markets outside the United States at 7%, and emerging market earnings growth of 4% due to higher share dilution.

The U.S. financial sector remains a favorite, underpinned by our expectations of gradually rising interest rates. As shown in the nearby graph, financial stock performance has been strongly tied to moves in interest rates. We also expect improving economic growth, along with some progress on deregulation, to support further gains. Valuations in the United States remain above historical norms, but we don't find this to be a valuable timing indicator on performance and continue to favor U.S. equities.


  • Increasing global economic demand momentum has pushed commodity prices higher.
  • Other constructive dynamics in the natural resource space support the positive market sentiment.
  • We remain fully invested in real assets with an emphasis on natural resources.

Real assets have been strong out of the gate in 2017. Global real estate and listed infrastructure are both up 3% year-to-date, while natural resources are up more than 5% (now up 50% over the past year). Since the U.S. election, industrial metal commodities (most prominent being copper and aluminum) are up more than 10% in aggregate, while energy commodities (primarily oil and natural gas) have appreciated by nearly 20%.

We remain fully invested in real assets with an overweight in natural resources. The upward price momentum of the underlying commodities has provided a foundation for the asset class. But there are other factors also driving the improving market sentiment. Thus far, OPEC has (mostly) honored its commitment to reduce oil production. Many were skeptical that production cuts would actually be achieved given the historical precedent of cheating on such agreements; but the January numbers showed a 90% compliance rate. OPEC's loss (in output) is the U.S. fracker's gain – and we have seen the number of deployed rigs (which drill the wells for oil extraction) increase as the price of oil has stabilized and moved higher (see chart). This dynamic is increasing business activity for upstream energy companies. Meanwhile, the recent advancement of the Keystone XL and Dakota Access pipeline approval process – along with the removal of the oil export ban back in 2015 – means the additional supply from new activity will eventually be able to more easily meet accelerating demand – both in the U.S. and abroad.


We upgraded our outlook for developed markets outside the United States last month, with a particular focus on the improving growth environment in Europe. This led to a concurrent increased allocation to developed ex-U.S. equities, funded by a reduction in investment grade bonds. With this change leading us to the top end of our recommended risk budget, and with no meaningful changes in our fundamental inputs last month, we made no asset allocation recommendation changes this month. We continue to expect the pro-growth policy outlook in the United States to push the U.S. growth channel higher, while having a positive spill-over into other economies.

While the political world generates lots of heat and distraction, the profit picture among public companies has been gradually improving. We expect the strongest growth in 2017 in the United States, followed by Europe and Japan, with emerging markets growth the slowest due to high levels of dilution. While we have some cushion in our return expectations for the potential of higher rates pressuring valuations, interest rates at current levels are clearly supportive. We judge a further rise in interest rates to be likely driven by both improving growth increasing inflation expectations. Provided inflation expectations remain constrained longer-term (our base case scenario), this should not prove detrimental to share prices.

The risk of anti-growth populist policies in the United States has risen, and joins an unexpected inflation spike as our key risk cases. While we think the overall economic risks tied to the new U.S. administration are relatively low, we do consider the negative economic impact that certain policy initiatives could generate. For example, new immigration policy could hurt growth, depending on its design, while the threats of tariffs to maintain U.S. manufacturing could impair corporate profitability. However, the risks of inflation and populist prioritization are just risk cases at this time.

We think investors need to focus particularly on tuning out the political noise over the next year, and stay overweight risk assets (U.S. equities, high yield bonds and natural resources). We would fund those overweights through an underweight to investment-grade bonds – not because we are overly negative on fixed income, but due to the low relative return opportunity. We actually see a small, but positive, total return potential for U.S. investment-grade bonds over the next year. In this environment, the benefits of the bond portfolio are even more concentrated than before in liquidity management and diversification, as opposed to total return potential.

-Jim McDonald, Chief Investment Strategist


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. Committee membership includes Northern Trust’s Chief Investment Officer, Chief Investment Strategist and senior representatives from our fixed income, equities and alternative asset class areas.

Indexes used: Bloomberg Barclays (BBC) 1-3 Month UST (Cash); BBC Municipal (Muni); BBC Aggregate (Inv. Grade); BBC TIPS (TIPS); BBC High Yield 2% Capped (High Yield); JP Morgan GBI-EM Global Diversified (Em. Markets Fixed Income); MSCI U.S. Equities IMI (U.S. Equities); MSCI World ex-U.S. IMI (Dev. ex-U.S. Equities); MSCI Emerging Market Equities (Em. Markets Equities); Morningstar Upstream Natural Resources (Natural Res.); FTSE EPRA/NAREIT Global (Global Real Estate); S&P Global Infrastructure (Global Listed Infra.)

If you have any questions about Northern Trust’s investment process, please contact your relationship manager.

© 2017 Northern Trust Corporation.

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. 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.

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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.