Seeing Beyond the Horizon Helps Investors Make Sense of a Confusing Picture

October 2011

Every summer, about two dozen of Northern Trust's most senior investment professionals from London, Toronto and New York join their Chicago-based colleagues via telephone or in a conference room above the city's business district for a dozen or more meetings, each lasting several hours.

They are not there to simply enjoy the view of the Windy City below.

"We're there to pool our expertise and focus on the big picture," says Jim McDonald, Northern Trust's chief investment strategist.

Known as the Capital Market Assumptions Working Group, the team doesn't debate whether a certain stock or bond is a better investment than another stock or bond. Instead, the sessions establish five-year return forecasts that form the basis of Northern Trust's asset allocation strategy, or the way investment dollars are divided among the major asset classes.

Seeing beyond the near-term horizon has rarely been more important.

Correlations between individual securities and among global markets have risen sharply over the last two decades as economic shocks impacted companies and countries more or less equally. The steep sell-off in the shares of sound and profitable businesses during the recent financial crisis demonstrates the need to identify and understand the macro forces at work in the global economy.

Keeping a macro perspective also helps investors hew to a long-term plan, thus lessening the impulse to overreact to short-term volatility. And there's certainly been plenty of volatility to rattle the nerves lately, with the number of daily stock price swings of at least 3% hitting the highest level since 19621 as debt and growth worries on both sides of the Atlantic have shaken investor confidence.

"We want to give clients a road map that displays where we believe the economy and investment classes are headed," McDonald says. "If you focus on where you want to end up, you'll be better equipped to ignore the day-to-day noise that compels emotional and counterproductive decisions."

Good bottom-up security selection still can add plenty of value, of course, but the company-level view works best when done in tandem with a top-down vision that makes sense of such slow-evolving themes as fiscal and monetary policy, the regulatory, political and geopolitical environments and demographic trends.

With that goal in mind, Northern Trust's senior investment team reviews global market and economic data and formulates five-year growth and inflation outlooks for each geographic region. From those projections, total return forecasts are made for major asset classes, such as equities and fixed income.

"The group represents the best thinking of our most experienced investment professionals," McDonald says. "We put a huge amount of thought and effort into it, and the result is our asset allocation forecasts for our clients."

So, after more than 800 staff-hours analyzing data and debating over-arching trends, here's what Northern Trust's experts see for the U.S. economy and financial assets.

Slow growing
The domestic economic outlook is decidedly mixed.

On the plus side, Northern Trust thinks the economy will keep expanding through 2016. "We don't anticipate a double-dip recession or any major downturn during the next five years," McDonald says.

The not-so-good part? Economic growth in the U.S. is projected to average just 2.25% annually, about a full percentage point below its long-term average.

McDonald believes the Federal Reserve will be slower to tighten monetary policy than in previous cycles. Typically, benchmark interest rates begin rising within two years after the economy bottoms. But if the Fed adheres to its promise to keep money virtually free until at least mid-2013, the recovery will be four years old before rates even begin to creep higher.

There are good reasons for the Fed's unusual degree of caution.

"We're not in a normal recovery," McDonald says. "There is limited scope for fiscal policy to stimulate demand, regulatory reform could be another headwind, and housing probably won't recover for several more years."

Most importantly, households and governments are suffering from a severe debt hangover. "The Fed has to treat the pain," McDonald says.

But if super-low interest rates are the aspirin for an economy recovering from a throbbing debt bender, might there be unwelcome side-effects from the medication as well?

"Absolutely," says McDonald.

Among the possible consequences of the Fed's cheaper-for-longer monetary policy is higher inflation as those newly minted dollars push the U.S. currency lower. All other factors being equal, a cheaper dollar tends to boost the price of imports and of such key commodities as food and energy.

In addition, deflationary pressures from emerging economies — a force that's happily held down U.S. inflation during the past several decades — could recede as workers in fast-growing developing economies demand higher wages and benefits.

Yet inflation is not expected to get out of hand according to Northern Trust.

In fact, Northern Trust projects U.S. consumer prices to increase by only slightly above 2% per year during the forecast period. That's modestly above the Fed's comfort level, but given the chronic weakness in house prices, not by enough to compel higher benchmark interest rates.

"We don't expect the Fed to start normalizing policy rates until housing begins to recover," says McDonald, who notes that the housing industry is a major catalyst in generating jobs through the ripple effect that related purchases impart on the economy.

Fixed Income
With money likely to stay exceptionally cheap — the federal funds rate has been near zero for three years and Northern Trust doesn't expect it to reach 3.75% until 2016 — the odds of an immediate spike in longer-term bond yields figures to be low.

That should lessen fears that the plunge in 10-year Treasury yields to below 2% is setting up a bungee-like bounce in rates that would undercut bond prices.

A slower-than-average normalization of official interest rates also should allow for a so-called flattening of the Treasury yield curve, in which the differential between short- and long-term rates would narrow from around 350 basis points (3.5 percentage points) this summer to potentially just 75 basis points by 2016.2

Credit spreads — the difference between yields in corporate bonds versus similar-maturity Treasuries — are also expected to tighten, especially in the financial sector as regulatory reform makes the group appear "safer." Tighter spreads are good for existing bondholders, since they could cause bond prices to rise. However, credit spreads aren't likely to contract to the unrealistically optimistic levels that prevailed before the 2008 financial crisis.

From current levels, Northern Trust believes that corporate bonds look to be the most attractive investment grade fixed-income sector — more so than Treasuries, Treasury Inflation Protected Securities and mortgage-backed paper  — over the five-year period.

McDonald says the tax-exempt sector could be impacted by several issues in coming years. Besides changes to interest rates, municipals will face ongoing questions about credit worthiness and a possible tweaking of its tax-advantaged status.

Though credit quality probably won't improve appreciably given the sluggish economy, it isn't expected to deteriorate meaningfully either.

"Municipal bonds are an area where we believe a conservative, credit-oriented approach can make a big difference," says McDonald, "and relentless attention to credit quality always has been Northern Trust's calling card."

The tax-exempt status of the municipal sector could be part of any deficit reduction negotiations. "We think the most likely scenario is that no changes will be made," says McDonald. However, Northern Trust also believes that if there is a partial reduction in the tax-exempt treatment of municipal bond income it probably would not be grandfathered, but a complete elimination of the exemption might be grandfathered.

The bottom line: The easy money in most sectors of the fixed-income market already has been made, but the asset class could remain attractive to investors given its potential for more generous yields than cash, sluggish growth, modest inflation, and the scant likelihood of a new monetary tightening cycle any time soon. In addition, Treasury bonds should retain their safe-haven status, especially with the eurozone far from solving its underlying structural deficiencies and the U.S. dollar likely to retain its role as the world's reserve currency.

Northern Trust foresees a subdued but benign environment for domestic stocks.

Though sub-par economic growth is not an ideal backdrop for equities, an uninterrupted recovery might significantly reduce the likelihood of a bear market. Still, investors should expect periodic bouts of volatility as governments and households pay down debt, the global financial system is reformed, and new economic relationships evolve between rich and developing countries.

Total returns could still be attractive, though, especially if inflation remains around 2%, as expected.

"We anticipate reasonably attractive performance for equities on an inflation-adjusted basis," says McDonald.

Within the U.S. equities market, Northern Trust views small-cap stocks more favorably than large-cap stocks over the five-year time horizon. Smaller companies stand to benefit from improved access to credit and increased global trade. Revenues from foreign operations among small companies have more than doubled since 1998, and at more than 20% of sales are only about 8 percentage points below that of large-cap companies.3

Given that economic growth is expected to remain strong in emerging markets, a more globally diversified revenue stream could bode well for the small-cap sector, which often is erroneously seen as unhealthily tied to domestic demand.

Emerging market equities look particularly attractive over the same period, with Northern Trust viewing small-cap emerging market stocks even more favorably than large-cap emerging market stocks.

"Developing countries have been growing faster and have less debt than developed nations, yet still trade at lower price-to-earnings ratios," says McDonald, who attributes the emerging markets valuation discount to higher inflation rates and occasionally murky corporate finances. But Brazil and China, which together currently comprise more than a quarter of the market capitalization of the MSCI Emerging Market Index, have strong incentives to maintain price stability and create better transparency.

"We expect significant progress in those areas over the next few years," says McDonald, "which should allow the emerging markets asset class to gain valuation parity with its rich-world counterparts."

On a clear day ...
Overall, the view from Northern Trust's conference room is much better than it is at street level.

"It's noisy down there and your vision is limited," says McDonald. "We believe successful investors make money by seeing the big picture and understanding what it means. From where we sit, there are still attractive opportunities as we look into the future."

Or more specifically, as dozens of eyes from around the world look into the future. 

This material is provided for informational purposes only. Information is not intended as investment advice since it does not take into account an investor's own circumstances. Past performance is no guarantee of future performance. There are risks involved with investing, including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met.

This informational report may be deemed to include forward-looking statements. Forward-looking statements are Northern Trust's current estimates or expectations of future events or future results. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties.

1 "Market Swings Are Becoming New Standard." Louise Story and Graham
   Bowley. The New York Times. September 12, 2011.
2 Northern Trust; Five Year Outlook: 2011 Edition p.8
3 Northern Trust; Five Year Outlook: 2011 Edition p.12

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