Jim McDonald
Chief Investment Strategist, Northern Trust

October 19, 2009

Evidence of the start of a global financial tightening cycle emerged earlier this month as Australia became the first G-20 central bank to raise its benchmark short rate, in this case from 3% to 3.25%. In the wake of this move, global equity markets rallied and the Australian dollar jumped 4%. Looking forward, what does the reaction of global markets to the Australian move tell us about the prospects for risk assets as we normalize policy globally? And just how important is a focus on central bank and governmental policy actions versus the more traditional focus on the outlook for growth and inflation?

Because Australia was on sound financial footing going into the global crisis, including strong banking and housing sectors, its authorities have a freer hand in removing stimulus. In the United States, over-reliance on securitization led to poor mortgage loan standards, which resulted in ballooning defaults and system-wide losses. Contrast this with the experiences in Australia and Canada, where securitization is subordinate to the bank-based credit system and default rates are less than 15% of those of the United States. This structure has led to Australia and Canada being home to seven of the 11 AA-rated banks in the world.

While Australia is clearly a developed market, the dynamics of its economy are most closely tied to emerging Asia. Due to both proximity and its natural resources, Australia has been a major beneficiary of Asian growth — and we expect this to continue. So think of Australia’s move to start raising rates as one of the signs that the developing economies likely will be the first to normalize monetary policy, which contrasts with the European Central Bank and Bank of England actions earlier this month to leave current stimulative policy measures unchanged. This sequencing of the normalization process is in sync with our expectations for continued strength out of emerging markets, followed by the developed markets.

U.S. Equity

• September concluded a strong third quarter across all capitalization ranges
• The continued positive performance was driven by increasing optimism about corporate earnings and the beginnings of an economic recovery

EAFE and Emerging Markets

• European and Japanese industrial production growth underpins the recovery
• The economies that entered the global downturn in the best financial shape likely will be the first to normalize policy

Fixed Income

• Record-low short rates continue to drive investors into bond investments
• The return of traditional investor behaviors indicates that credit markets continue to normalize

High Yield

• The stabilizing economy and improved access to capital have lowered expected default rates
• Some further narrowing of high-yield risk premiums is likely

Global Real Estate

• Real estate investment trusts (REITs) outperformed the broader equity market in September, but lag year-to-date
• Lodging was the top performing property type in the United States during September, in-line with the strong surge in cyclical areas of the market

Hedge Funds

• September was another strongly positive month for the hedge fund universe
• Distressed debt managers had their best monthly performance in 15 years

Commodities

• Commodity prices have continued to benefit from currency and reflation trades
• Inventory levels are high and would normally suggest lower prices

Conclusion
So what are the implications for the global markets and the positioning of portfolios as central banks contemplate their interest rate policies and the global economy seeks to transition from an inventory-led bounce to more sustainable growth? We think investors today need to focus more on policy actions than traditional growth and inflation metrics, as the growth and inflation picture today is unusually dependent on governmental policy.

We see the healthiest economies moving first to normalize monetary policy, as their economies are most able to handle higher interest rates. This likely will lead to continued strength in these currencies, probably at the expense of the U.S. dollar. However, our focus on the important role of government policy in this recovery means we are keeping a sharp focus on the possibility of policy errors and the resulting implications for financial markets.