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The new year has started with a return to more typical (higher) levels of market volatility. The major asset classes have behaved according to script, with investment-grade bonds providing portfolio stability and higher-risk equities, such as emerging markets, performing the worst. U.S. high yield bonds performed reasonably well during this period and showed little sign of investor concerns over the economic cycle. Market speculation around the catalyst of the early-year sell-off focused on concerns over emerging-market risks both Chinese credit concerns and emerging-market currency pressures and weakness in U.S. economic data.
U.S. economic data has been softer than expected this year, and the January nonfarm payroll report was the second disappointing job report in a row. Were not changing our expectation of solid economic growth this year, but have created a new risk case that encompasses the possibility of slower growth. Developed markets outside of the United States have shown steadier growth, with Europe and Japan showing good momentum in confidence surveys. We continue to expect the emerging markets to disappoint on the growth front in 2014, with particular focus on Chinas credit-cycle management. Chinas substantial shadow banking system will create many headlines during the next two years, as existing trust and wealth management products either successfully mature, are rolled over into new debt or default.
It looks to us like the weakness at the start of this year qualifies as a garden-variety stock market correction. With valuations having expanded significantly in 2013, returns in stock markets in 2014 are heavily dependent on earnings growth. Earnings for the fourth quarter of 2013 are in relatively good shape, bolstering our outlook for 6% U.S. earnings growth in 2014. However, the Federal Reserve appears committed to winding down its bond buying program this year, unless growth is significantly less than expected. We anticipate this determination to lead to additional periods of market volatility this year as investors gauge whether the economy is strong enough to withstand this reduced level of accommodation.
While the steepness of the recent market decline certainly suggested a risk-off environment, underlying data doesnt support this view. Sector performance was inconsistent with a typical risk-off environment while utilities and health care were the best performers, other defensive sectors, like consumer staples and telecom, were among the worst. Additionally, lower-quality stocks actually outperformed as the market was declining, suggesting a lack of panic behind the selling. The quickness of the subsequent recovery also implies that the markets confidence was not shaken as much as first feared. Finally, high yield bonds showed resilience, implying no change in the fundamental corporate outlook. Fourth-quarter earnings are coming in modestly better than estimates, and we expect this to remain the key focus of the market this year.
One of our key investment themes has been our outlook for political volatility, with policy stability. While Italy looks set to appoint a new prime minister, financial markets have barely budged as the Italian 10-year bond has hit a new low in yield. In the United Kingdom, polls have shown a gain in momentum to 35% support for the Scottish independence parties. The area for real policy change could come from the European Central Bank (ECB), where speculation about the possibility of ending sterilization of bond purchases raises discussions about quantitative easing (QE). However, before the ECB takes the plunge into the QE world, which would face German resistance, it still has room to lower interest rates.
China and Japan remain at loggerheads over free airspace and a small archipelago in the South China Sea. This situation shows no sign of abating; neither country seems willing to back down. We think the most likely scenario remains the avoidance of serious conflict. In Japan, the seemingly unstoppable Nikkei stopped in January, as investors appeared to have concerns over regional instability and profit-taking took hold. However, Abenomics is doing what it set out to do and reinflating Japan, though investors are wondering if its running out of arrows. Springs increases in wages will be key; the government is looking to wage increases to help sustain economic momentum and partially offset the value-added tax increase.
Emerging-market equities underperformed developed-market stocks during the recent correction (falling 8.5% vs. 5.5%), but modestly lagged in the subsequent rebound. For emerging markets to outperform, investors will need to see some clarity around growth momentum and monetary policy, especially Chinas credit situation. With the typical Chinese wealth and trust investment product having a two-year maturity, well likely have many reruns of last months deadline with the Credit Equals Gold #1 product. We reduced our recommended tactical allocation to emerging-market equities this month, reallocating to global infrastructure equities, to improve the risk and return profile of the portfolio. We expect global infrastructure stocks to not only provide more downside protection than emerging-market equities, but to also provide reasonable appreciation potential in a positive market environment.
Emerging-market turbulence, combined with the Feds apparent persistence in removing itself from the QE business, prompted a shuffling of the equity exposure in our tactical asset allocation model this month. We boosted our exposure to global listed infrastructure, which boasts steady cash flows and exposure to equity markets at a lower level of volatility than emerging-market equities (which we reduced). Even though global listed infrastructure shows some exposure to interest rate volatility, it was viewed as a better alternative to the direct exposure to interest rates found in fixed income. Our historical analysis also shows that at low levels of interest rates, global infrastructure has also been less interest rate sensitive than global real estate while sporting a dividend yield of 4%.
U.S. HIGH YIELD
The impact of the Feds reduction in asset purchases was finally reflected in the currencies of several emerging-market countries, resulting in downward pressure on financial asset valuations. Markets have since settled down, and high yield was affected by less than one percentage point. The accompanying chart shows the effect of the 1998Asian currency crisis on emerging-market and high yield debt spreads. Emerging-market spreads widened 830 basis points and the S&P 500 fell 22% during the worst two months of the above-mentioned crisis. High yield spreads widened as well, but to a much lesser extent. During 1998 and 1999, the correlation of emerging-market and high yield debt was 0.40. Crisis periods can affect all financial assets, but we believe that high yield, aided by its domestic focus, has some insulation.
U.S. FIXED INCOME
Fed Chair Janet Yellens inaugural testimony before Congress pledged to maintain the path set by former Fed Chair Ben Bernanke. She communicated plans to continue the tapering of the Feds bond purchase program in measured steps, with only a notable disruption to the outlook altering this reduction. The Fed has gone to great lengths to assure investors that while it may be tapering its bond purchase program, the benchmark Fed Funds rate will remain at record low levels. Yellens testimony once again reinforced that the rate will remain near zero well past the time the unemployment rate falls below 6.5%. While the Fed Funds futures market shows investors believe rates will move higher next year, we continue to believe the Fed will hold rates near zero into 2016.
EUROPEAN FIXED INCOME
The German Constitutional Court (GCC) has announcement that it wont pass judgment on the ECBs OMT program. Instead, it will refer the matter to the European Court of Justice. We view this as a positive in that the GCC would have likely found the OMT and the ECB to be overreaching its mandate and its bylaws and, thus, direct the German government to no longer participate in the OMT. A less engaged German government would likely have put pressures on the market. For its part, the ECB declined to take action at the February meeting and directed attention to March, when it will reveal 2016 inflation forecasts for the first time.
ASIA-PACIFIC FIXED INCOME
Emerging markets have been shaken during the past month, and events such as the stresses in the Chinese interbank market bear long-term scrutiny. The level of bad loans in Chinas economy is feared to be large, and a significant proportion of new lending may simply arise from rolling over these bad debts. The recent trust product bailout may prove to be a temporary reprieve, with investment trusts being allowed to default later this year. We believe the closed nature of the capital markets and the resources of the central government are sufficient to contain this issue. In India, the Reserve Bank of India hiked rates to 8% (the third increase in six months) and inflation slowed to 8.8% in January, marking a high in real interest rates during the past two years.
Financial markets frequently like to surprise the maximum number of investors possible, and the benign start to trading in 2014 set us up for the ensuing correction. Now that weve had the long overdue 5% correction in equities, the focus will be on the next 10% and 20% decline which are also overdue. The potential catalyst for such corrections could come from several corners: more disappointing U.S. or emerging-market economic data, problems in the Chinese shadow banking system, or even a geopolitical skirmish in Asia or the Middle East. We havent found it fruitful over the years to try to bob and weave around geopolitical risks, instead focusing on the fundamental economic and investing outlook. Even though we believe the global growth and monetary policy outlook will be supportive to risk assets in 2014, we expect continued higher volatility to persist.
In recognition of this expected pickup in volatility, we made one change in our global tactical asset allocation model this month increasing our exposure to global infrastructure stocks at the expense of emerging-market equities. This move modestly lowers the risk profile of the portfolio, with less downside risk should markets decline but allowing acceptable upside participation in a good market environment. Global infrastructure stocks provide a relatively higher yield (around 4%) with strong underlying cash flows and defensive business models. Even though the valuation of emerging-market equities look attractive, we dont see them outperforming until we see improving relative economic momentum.
We updated our risk case scenarios this month, with the primary change being the potential of disappointing U.S. growth. We think the markets are happy that the Fed is on a steady course of tapering bond purchases, but if U.S. economic growth stalls, the unwinding of this program will become a source of angst. We are also focused on the risk surrounding emerging-market growth. The current slowdown has been factored into market expectations, but meaningful deterioration hasnt. Finally, the policy risks in Europe and Japan seem to be focused on Japan during the next six months. Well want to see continued momentum in the Japanese economy to evidence the progress of Abenomics. Count on higher volatility over the next year, but if our fundamental views come to pass, this will occur alongside higher stock prices.
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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