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While financial markets have been consolidating during the last month, the global economy is showing some evidence of improving momentum. The U.S. economy continues to generate steady growth, shrugging off the effects of higher taxes and reduced government spending. In Europe, signs of the emergence from recession continue to build, something we think investors continue to underappreciate somewhat. The Japanese economic recovery also continues apace, giving the government the confidence to consider raising taxes and begin addressing the countrys high level of government debt. In the emerging-market economies, an increasingly anachronistic designation, growth trends are highly divergent. Chinese growth has improved during the last month, while growth estimates for large economies, such as Brazil, India, South Korea and Taiwan, are falling.
Among the many inputs investors weigh, monetary policy is currently at the forefront of market drivers. Markets are microscopically focused on the pace of change in Federal Reserve bond purchases, and whether it happens in September, October or December. We think the recent increase in interest rates reflects this eventuality, and that the incoming Fed chairman will continue an accommodating monetary policy. Both the European Central Bank (ECB) and the Bank of England (BoE) continue to reiterate very easy forward guidance, with mixed results in the bond markets which may only increase their resolve. With Japanese monetary policy the easiest among the developed economies, the focus has turned to fiscal policy, which needs to address massive debt levels without reversing the hard-fought economic momentum. Across the developing economies, monetary policy is broadly tightening because of concerns about currencies and credit growth.
While we think monetary policy is the largest driver of current market volatility, geopolitics remain a concern of the markets. The possibility of a negotiated settlement in Syria has recently improved risk appetite, as the risk premium in the energy markets has begun receding. These challenges have, however, taken the eyes of U.S. politicians off the upcoming debt ceiling deadline, which could lead to another short-term extension. The recent withdrawal of Larry Summers from consideration for the Fed chairmanship may simplify the eventual decision and confirmation process, but a deterioration of the recent gains in the Middle East could prove a further delay. We continue to think the debates over monetary policy will be much more consequential to markets than the political volatility from events like the U.S. debt ceiling or the German Federal elections.
From April 2012 to mid-to-late July 2013, value stocks outperformed growth stocks by roughly 10%. As demonstrated by the relative strength of the Russell 1000 Growth Index vs. the Russell 1000 Value Index, the second-quarter earnings season marked an inflection point for growth stocks. Since late July, growth stocks have outperformed value stocks by nearly 4%. Technology stocks, which had materially underperformed in prior periods, increased following second-quarter earnings as results exceeded subdued expectations, while financial stocks have underperformed. With Fed tapering and higher yields pointing to a more sustained economic recovery, we foresee the intermediate-term prospects for growth stocks as positive.
Could it be that austerity is working? The United Kingdom has seemingly broken out of the semi-paralysis of scything public sector cuts to report positive purchasing manager indexes and growth figures. The eurozone also limped into positive territory in the second quarter. Though there have been some improvements in France, the eurozone is still being supported by the German economy Whats been more of a surprise has been the strength of the numbers emanating from the United Kingdom. Strong purchasing manager indexes and the International Monetary Funds upgraded growth forecasts are most unlike the United Kingdom of the last couple of years. It remains to be seen whether these figures are an aberration, but equity flows seem to support the fact that theres more belief in Europe as a region.
A new prime minister is arriving in Australia, faced with a stalling economy and inflation thats increasing the cost of living to among the highest in the developed world. Theres plenty of work to do to protect the growth story in Australia and prevent it from becoming too dependent on the materials sector, which continues to dominate the economy and is the main wealth contributor. Recent growth numbers seem to suggest that China is back on track, which will help the new Australian government by stabilizing the materials sector while the Liberal government begins to unwind six years of the Australian Labour Partys (ALPs) policies. Equity markets have thus far approved, with Australian equities hitting highs and recovering from a heavy fall in June.
Emerging-market equities have perked up alongside Chinese growth during the last month, increasing 4% as compared to developed markets, which are up approximately 2%. Looking at the largest emerging markets, growth has continued to moderate while monetary policy has broadly been tightening. With our view that these inputs are key drivers of near-term stock performance, we dont see sustained outperformance from the group. On the monetary policy front, countries with large current account deficits (such as India) are seeing significant currency pressures, leading to defensive increases in interest rates. Until this stabilizes, investors will question the risk to economic growth from higher rates. The poor relative performance of emerging markets in recent years has, however, improved its relative valuation and sets them up for attractive long-term returns.
U.S. FIXED INCOME
Fed Chairman Ben Bernanke announced in May that the central bank might begin to taper its bond purchases later this year if the economic expansion were to gather strength. Despite frequent pledges to keep the Fed funds rate at exceptionally low levels for the foreseeable future, investors have been pulling forward when they anticipate interest rate hikes. Despite the move in the markets, we continue to believe the Fed will maintain its current zero-to-25 basis point range on the Fed funds rate for the next few years as we foresee modest economic growth and very low inflation. While a continued zero-interest-rate policy would keep interest rates anchored, current uncertainty in the markets around the Feds plans will keep interest rate volatility high.
EUROPEAN FIXED INCOME
The BoE, under its new governor, has embraced forward guidance on interest rates as a policy tool, following the ECB in July, the Bank of Japan in April and the Fed back in 2012. Indeed, the success of the Feds commitment to keep rates on hold until certain economic thresholds were reached was doubtlessly on European policy makers minds in recent months. Early indications, however, suggest that mere words arent enough and that financial market correlations will hold unless definitive, tangible action is taken (for example the Swiss National Banks currency interventions). Across Europe, leaders have been enjoying a peaceful August, the first since 2006, as economic data improved and troublesome politics failed to implode. Challenges remain, not least in the new cross-border institutions, but the European Union looks in better shape with a classic summer break behind it.
ASIA-PACIFIC FIXED INCOME (GLOBAL VERSION)
Australian voters firmly rejected a continuation of the last six years of ALP rule and elected Tony Abbott and the Liberal National coalition to head the government. The electorate acted on frustrations at the ALPs continuous infighting but also on concerns that the government wasnt doing enough to address increasing unemployment and the economic slowdown. The incoming coalition will need to retain its pro-business agenda but ground its policies in the reality that the country will need to rebalance its economy away from capital expenditures to preserve growth throughout the cycle, and continue to build on its relationship with Asia. In Japan, there now can be no doubting the effect of Abenomics as data continues to impress. A sustained impact will only come about via real structural trade and labor market changes. We continue to await Abes third arrow of structural reform.
U.S. HIGH YIELD
The summer slowdown, investors vacation schedules, an inactive new issue market and macroeconomic uncertainty have resulted in less liquidity during the past month. High yield funds saw $3.6 billion in outflows during a six-week period. To respond to these flows, high yield managers and exchange-traded funds focused on the most liquid issues to manage cash needs. As a result, the liquid issues suffered a greater price impact. The outperformance of these less-liquid issues has been particularly acute during the summer The less-liquid issues generally have a yield advantage to compensate for liquidity and smaller average issuer size. They also often benefit from positive trading dynamics. Exposure to these issues can be part of an effective high yield strategy.
As we highlighted in our annual five-year capital market assumptions work this summer, global real estate has a statistically significant exposure to interest rate movements. This relationship has been especially acute since May as the 10-year Treasury rose from 1.6% to its current level approaching 3%. Given the potentially bumpy road ahead for interest rates as the Fed begins to implement its tapering strategy, we reduced our recommended allocation to global real estate this month as a way to fund our increased exposure to European and Japanese equities. To be clear, we still believe interest rates will remain relatively anchored during the next six to 12 months. However, we have greater conviction about the increasingly constructive environment for developed market equities, which have lower interest rate sensitivity than real estate securities.
Shifting monetary policy globally is a key driver of asset-class performance and our tactical asset allocation outlook. Economic progress is relatively steady in the developed markets, while the picture is much more variable across emerging-market countries. We believe the Fed has reached a turning point in its monetary policy, with the uncertainty centered around the pace of policy normalization. In this environment, we see reduced attractiveness of those asset classes that are most dependent on low interest rates. Monetary policy is starting to normalize in an environment without inflationary pressures, which we think is constructive for the performance of equities.
In this months investment policy deliberations, we increased our recommended exposure to Europe, Australasia and the Far East (EAFE) equities to reflect the improving economic momentum and constructive monetary policy outlook. To fund this move, we reduced our recommended tactical exposure to global real estate, a direct beneficiary of low interest rates. We also reduced our tactical weighting in Treasury Inflation Protected Securities (TIPS), because we dont see a high likelihood of increasing inflation expectations during the next year. These moves had the net effect of modestly increasing the risk level in our global tactical asset allocation model, where it now sits at the top end of our targeted risk level. This leaves us strongly overweight in developed market equities. While higher yields in fixed income increase bonds potential return, volatility remains high, and they arent currently fulfilling their role in stabilizing portfolio values.
Depending on the progress of competing political developments, such as a Syrian deal on chemical weapons, we expect a decision on the nomination of the new Fed chairman in the next month or so. While the withdrawal of Larry Summers candidacy leaves Janet Yellen as the current favorite, we wouldnt expect any nominees to rapidly taper bond purchases or contemplate raising short-term interest rates. How the new Fed chairman manages communication will affect market volatility and asset-class performance. A repeat of the 2004 interest rate cycle, where steady and predictable interest rate hikes were well received by the market, is our base case scenario. A more unpredictable policy, such as the rapid rate hikes in 1994, would portend a much more volatile ride for financial markets.
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. 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.
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Northern Trust Global Investments comprises Northern Trust Investments, N.A., Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K., the investment advisor division of The Northern Trust Company and Northern Trust Global Advisors, Inc., and its subsidiaries.