Perspective - PDF

December 17, 2014
The biggest surprise of 2014 in the financial markets is likely
to be the plunge in the price of oil, and it will shape market
performance through 2015 and beyond. After Brent crude
prices peaked at $115 per barrel in mid June, a combination
of high supply and some slowing in demand has led to a
decline of more than 45% to under $60 a barrel. There are
clear benefits to oil-importing countries, as energy costs to
consumers and businesses fall. However, we believe some
offsetting factors will lessen the benefit: The positive effects
to the U.S. economy from shale-related capital expenditures
and hiring will clearly fall, and the financial market pressures
on highly leveraged energy companies will dent some investors’ risk appetite. In addition, the significant fall in revenue
at some of the world’s biggest oil-exporting countries could
serve to increase an already tense geopolitical landscape.
So far, U.S. consumers seem to be enjoying the windfall
at the gas pump, as November retail sales were particularly
strong and jobs gains were robust. While Europe and Japan
will also benefit from lower energy prices, the relative
weakness in their currencies offsets some of the benefit.
Some of the largest emerging-market economies, such as
China and India, should benefit because of their energy
intensity and reliance on imports, but Middle Eastern
countries and Russia will feel particular revenue pressure.
At a global level, it’s a transfer of wealth from oil producers
to oil consumers — which should benefit the real economy.
Financial markets love predictability, and the uncertainty
around the causes of the oil price drop and its implications
have increased volatility. One result that appears clear is the
disinflationary effect that falling energy prices will have on the
global economy. With central bankers already worrying about
inflation rates running well below their targeted levels, this is
just one more factor that will extend the scope and duration of
the accommodative monetary policy cycle we currently enjoy.
In the current environment, we believe the United States
stands out among developed nations for its relatively strong
economic growth outlook, its slowly normalizing monetary
policy and the prospects for continued currency appreciation.
The declining price of crude oil introduces a near-term headwind to earnings.
Expect a boost to consumer spending and lower input costs for other sectors.
The price of a barrel of crude oil has declined more than 45% since its peak
in June, reducing earnings expectations from a range of a 20% reduction
expected for integrated majors to a 70% reduction for some exploration and
production companies. This assumes oil prices stabilize at $60 to $65 per
barrel, and this would represent an approximate 5% reduction to S&P 500
earnings. However, close to half of oil consumed in the United States is used
to produce gasoline, so consumers will benefit from lower oil prices. The
consumer sectors comprise close to 20% of S&P 500 earnings, while energy is
approximately 10%. Declining energy earnings are a headwind which should
dissipate during the next year as the benefits of lower oil prices cycle through
the economy to the consumer.
The net profit margin of European equities shows some improvement relative
to the S&P 500.
Sustained progress in profit margins is limited by the weakening growth outlook.
European profit margins remain stubbornly lower than prior cycle highs and are
still below levels experienced during the economic recovery in 2011. Encouragingly,
European net profit margins have improved from approximately 60% of the S&P
500’s at the beginning of last year to 67% at the end of the third quarter. The stronger
U.S. dollar, combined with lower input costs and exposure to faster growing regions,
likely helped overcome the less competitive economies at home. The key to further
operating leverage is stronger revenue growth, which should continue to be elusive
given limited political progress and slowing economic growth. Given this backdrop,
we expect the trend of disappointing European earnings growth to persist and equities to underperform their developed-market peers.
Japanese Prime Minister Shinzo Abe’s win raises the possibility of an expansion
of Abenomics.
Any negative surprises to real growth are likely to induce downside volatility.
Japanese equities have reacted positively to Prime Minister Abe’s ambitious
economic plan with one clear exception: Investors correctly anticipated the
negative effects of the value-added tax (VAT) hike earlier this year, which caused
a meaningful pullback in consumption and was likely a major contributor to
gross domestic product (GDP) contraction in the second and third quarters.
With Abe’s success in retaining control of the government after this month’s snap
election, the second phase of the consumption tax increase currently scheduled
for late next year will be delayed until 2017. While this deferral, combined with
a likely expansion of government spending, should prevent a repeat downturn
in the market, real economic growth needs to be restored before investors can
expect sustained gains in Japanese equities.
perspective | December 17, 2014 | page 2
Chinese equity returns go parabolic.
Chinese equity strength isn’t a signal of a broad emerging-market rebound.
Chinese equities are a global standout this year, with the Shanghai Stock
Exchange Composite Index up 43% since late July. However, the broad
emerging-market equity index is actually down 11% during this same period,
indicating that the Chinese rally is technical in nature and doesn’t reflect an
improving outlook for emerging-market growth. With limited investment
alternatives and falling housing prices, Chinese investors have jumped on
easing monetary policy signals with abandon. This has recently led regulators
to tighten collateral requirements in an effort to deflate the bubble. We continue
to have some concern over the outlook for emerging-market growth during the
next year, and see increased risk of stress from a surge in dollar-denominated
corporate debt issued in recent years. This leaves us tactically underweight in
emerging-market equities until we see signs of improved economic momentum.
The continued drop in the price of oil further pressures commodity indexes.
Dollar strength, slowing demand and increased supply represent headwinds.
The price of oil continues its downward spiral, a result of the strong dollar,
the U.S. energy renaissance, and slowing demand out of Europe and China.
This has resulted in a 12% fall in the commodities index (in dollar terms).
For now, the path of least resistance for commodity prices is down. The dollar
should continue to strengthen in 2015 given central bank divergence. Oil
supply continues to grow as OPEC maintains its production quotas, and U.S.
drillers continue to grow production to appease investors most interested
in production growth. Lower commodity prices should help the European
growth outlook and eventually stabilize energy demand. However, as seen in
the accompanying graph, the benefit to Europe (and Japan) is dramatically
less than that to the United States, given euro and yen currency weakness.
The high yield market has moved lower in tandem with the decline in the
price of oil.
The impact of falling oil prices on the broader market has been relatively minor.
The price of oil reached its 2014 high on June 20, with the high yield market peaking the next day. As oil has declined 41% over the past six months, the high yield
option-adjusted spread has widened by 80 basis points (bps), driven by the energy
and commodity sectors. In June, independent energy was 13 bps wider than the
index, while oil field services was wider by 54 bps. Since then, independent energy
has widened by 432 bps and oil field services by 524 bps. These two sectors make
up approximately 10% of the market, and smaller commodity-exposed sectors
have also suffered material declines. Although these sectors have experienced
declines, fundamentals for the rest of the market continue to be supportive.
Investors will need to refocus on idiosyncratic risk in 2015.
perspective | December 17, 2014 | page 3
Massive corporate issuance has pushed credit spreads to their widest of the year.
We continue to prefer the corporate debt asset class within investmentgrade bonds.
In the largest corporate bond deal of the year, Medtronic issued $17 billion
of new debt at the beginning of December. Like many other nonfinancial
firms, Medtronic used record-low borrowing costs to assist with its merger
and acquisition plans. Year-to-date sales of investment-grade corporate
bonds of $1.1 trillion are on pace to surpass the previous record set in 2013.
Corporations have been issuing new debt for a variety of reasons, including
funding capital projects, increasing dividends and stock buybacks, and
refinancing existing debt. The heavy corporate issuance has overwhelmed
investors in the second half of the year and pushed credit spreads wider,
which we believe has created a buying opportunity.
The European Central Bank (ECB) paves the way for quantitative easing.
The Bank of England (BOE) may have missed its window to normalize policy.
The ECB continues to feed market expectations for quantitative easing by
revealing that preliminary work for additional asset purchases is underway.
While the ECB governing council may not be unanimous in its pursuit
of balance-sheet expansion, its acknowledgment of the eligibility of
sovereign bonds, alongside lower growth and inflation forecasts through
2016, implies it’s not a matter of if but when quantitative easing begins.
The BOE policy appears increasingly tied to capacity pressures, especially
in the labor market. Even though the United Kingdom appears poised
for steady growth, the global outlook has deteriorated and U.K. GDP
growth is unlikely to be repeated at 3%. The BOE may have missed its best
chance to commence interest rate normalization, especially with a crucial
general election in sight.
The People’s Bank of China (PBoC) makes a surprise U-turn.
Japanese Prime Minister Abe puts Abenomics to the vote.
Having earlier embarked on targeted stimulus measures, the market was
surprised by the PBoC’s decision to cut interest rates for the first time in two
years, from 6.0% to 5.6%, as well as other broad-based easing announcements.
Even though the PBoC’s official bias remains “neutral,” the risk is that, with the
floodgates open and an inevitably lower annual GDP target for 2015, political
pressures may culminate in further cuts. Japanese equity markets have surged
and the currency is near a seven-year low amid upbeat investor sentiment.
Abe won the snap general election on Dec. 14 and postponed the 2015 sales
tax increase. It seemed a gamble that voters are won over by Abenomics given
the lack of economic turnaround thus far, but currency weakness may just
bring about the competitiveness Abe’s third arrow had intended.
perspective | December 17, 2014 | page 4
We have three key themes guiding our tactical asset allocation views as we approach 2015. First, we want to hold U.S. assets in
the current environment. U.S. growth is a relative standout, the Federal Reserve is actually moving toward some normalization
of policy and the United States is a safe haven geopolitically. Second, we see asynchronous growth because of uncoordinated
global policy. This may lead to increased volatility, but may also push monetary policy toward accommodation and keep interest
rates low. Finally, the low interest rate environment means there’s a high bar for taking out portfolio insurance by investing in
low-risk bonds or cash.
These themes have guided us in recent months to reduce exposure to Europe, Australasia and the Far East (EAFE) equities,
reallocating to U.S. equities and investment-grade fixed income. This month we reduced our recommended allocation to
emerging-market equities in a midrisk portfolio by 2%, with the proceeds going to U.S. investment-grade fixed income. This
move was driven by our currency outlook, preference for U.S. assets and continued concern over whether emerging-market
growth will hit consensus expectations. The result of this series of policy changes during the last three months has been a
reduction in the overall risk level in the tactical asset allocation model, as a result of bottoms-up decisions made on different
asset classes. So while we’re still overweight equities and levered to a rising stock market, we’re more defensively positioned
than we were before these changes.
What kind of market environment are we expecting in 2015? Our equity market return forecasts are driven by earnings
growth, and U.S. earnings growth of 7% drives our total return forecast of 9%. We think the recent increase in yields in U.S.
high yield bonds improves their prospective returns, and forecast a return of 7% to 8%. We believe this return outlook justifies
an overweight recommendation, especially as the return potential is above what we expect from EAFE and emerging-market
equities (which we forecast at 2% to 3% and 5%, respectively). An unexpected downturn from U.S. or Chinese growth remains
our primary risk case, along with concerns about Russian/Western relations and market volatility stemming from monetary
policy developments.
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. 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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