Wall Street's Best Minds
Expect 5 Years of Slow Growth, Tepid Returns
Northern Trust reveals its long-term investment outlook for stocks, bonds, alternatives, and commodities.
By Jim McDonald and Daniel Phillips
Updated July 31, 2015 2:25 p.m. ET
Editor’s Note: This is an excerpt of a longer piece with charts which can be found on the Northern Trust Website.
In addition to formulating five-year return expectations, the CMA exercise includes specific risks identified by our investment teams. The return and risk expectations are combined with other portfolio construction tools (standard deviation, correlation, etc.) to annually review and/or update the recommended strategic asset allocations for all Northern Trust managed portfolios.
Gravitational forces have finally started to take hold in financial markets. The approximate 5% return of global equity markets over the past 12 months is more in line with the slow global growth environment than the back-to-back 20% year-over-year returns that preceded it.
We believe the transition from cyclical to structural will occur at a modest pace over the next five years, as identified in our Cyclical Meets Structural theme. Helping to ease the transition is our expectation for Low and Slow Monetary Policy. The Federal Reserve is expected to initiate “liftoff” early in the five-year horizon, but the trajectory of rate hikes thereafter is expected to be shallow, with the Bank of England (BoE) following a similar path. Meanwhile, zero interest-rate policy is expected to persist at the European Central Bank (ECB) and the Bank of Japan (BoJ). Low productivity, as “official” numbers suggest, would challenge central bankers’ ability to maintain current monetary policy without some type of upward pricing pressures, either in the real economy (inflation) or financial markets (asset price bubbles).
We believe we are witnessing a Productivity Paradox whereby true productivity is not being appropriately captured and is merely a reflection of the low-demand environment. Given that view, we do not anticipate inflationary problems despite continued accommodative monetary policy over the forecast time horizon. We do see, however, increased risk of financial asset bubbles as investors increasingly accept the fact that we are Living in a Low-Yield World and possibly take inappropriate risks in response. Accommodative monetary policy, alongside globalization and technological advancements, has also been blamed, in part, for rising inequality. But we anticipate Inequality Inaction as redistributionist remedies fall below other priorities on the political docket — both in importance and ease of implementation. All said, we expect The Slow Burn of Low Growth to define the next five years — assigning a low risk to a typical “central banks take away the punchbowl” end to the current expansion, but subject to the “slow burn” of falling demand momentum and without much cushion against potential exogenous economic shocks.
Consistent with the past two years, we generally lowered our risk asset forecasts as valuations have caught up with — and surpassed — underlying growth fundamentals post-financial crisis. However, we still expect mid-single-digit returns for most risk assets, as we anticipate a slow transition from “cyclical to structural” will allow valuations and profit margins to remain elevated. Risk-control asset forecasts, in general, also fell alongside reduced interest rate levels year-over-year.
Five-Year Asset Class Outlooks
Fixed Income Cash return forecasts have risen ever so slightly as one year of zero interest rates on the front end is replaced with one year of below-average rates on the back end. Investment-grade fixed income forecasts remain low given their starting point and have less cushion in the market’s forward rate expectations. High yield’s energy sector-related selloff has provided an opportunity given solid fundamentals. Equities Developed market equity forecasts continue to come down as valuations march upward in the face of an expected slow-growth environment over the next five years. Although not our base case, the statistical probability of negative equity returns has risen given where valuations currently sit. Emerging market equities continue to have a modest equity premium — below long-term averages. Real Assets Natural resource/commodity return forecasts continue to face the headwinds of low global demand and transitioning emerging economies, but recent price declines have adjusted to the new environment. Global real estate and listed infrastructure benefit from their diversified risk exposures; their sensitivity to interest rates — which we expect to remain low — helps support return forecasts. Alternatives We maintained our forecasted private equity illiquidity premium over public equities; purchase prices have increased in aggregate, but financing costs will remain low and opportunities for increased efficiencies remain high. Hedge funds can benefit from nontraditional beta and alpha (in the form of manager skill), but manager selection is essential given the wide dispersion of strategy returns.
The Slow Burn of Low Growth
Various elements are contributing to greater income inequality in developed economies. Outsourcing of manufacturing and production jobs has been in play for decades, while easy monetary policies put in place after the financial crisis have disproportionately benefited financial asset owners. More recently, technology has started replacing higher-value white collar jobs. Despite these dynamics, those affected appear less in favor of redistributionist policies than they are of pro-growth initiatives that allow them to participate in the gains. Any efforts to employ redistributionist remedies and/or use the inequality issue for political purposes are not expected to bear fruit amid continued headwinds of austerity and competition.
Low and Slow Monetary Policy
Monetary policy “liftoff ” from the Fed is expected within the early part of our five-year time horizon, but its trajectory should be shallow thereafter; we expect the BoE will follow a similar path. The ECB and the BoJ will maintain rates near zero, first making their way through the quantitative easing gauntlet. All of these “low-and-slow” policies are predicated on the expectations for low inflation and modest growth. While interest rates will remain low, volatility will rise as investors attempt to understand policymakers’ comfort with large balance sheets and plans to address them.
Living in a Low-Yield World
After holding out hope for years, financial market participants are increasingly accepting the view that interest rates could remain low indefinitely — driven by slow growth, tepid inflation and lagging debt issuance relative to investor demand. This low-yield environment reduces the yield “cushion” granted investors, versus when most thought global interest rates would normalize to historical levels. It likewise creates significant challenges for financial entities (e.g., insurance companies) burdened with above-market, long-term fixed-rate liabilities.
Cyclical Meets Structural
These two issues have always been on the long-term horizon (and fairly well understood) but now are increasingly within our five-year window. After rising markedly post-financial crisis, government debt levels as a percent of gross domestic product (GDP) have slowed their increase over the past year as austerity measures have been implemented. However, deficits as a percent of GDP continue to be more or less in-line with nominal economic growth — meaning overall debt levels will continue to remain elevated. Absent stronger organic economic growth (more on that in a bit), fiscal budgets will need to be cut further in order to lower overall debt levels. It will be a difficult process — constituencies are already feeling the pain of recent reductions — made more complicated by mounting entitlement bills.
McDonald is chief investment strategist of Northern Trust and Phillips is the firm’s investment strategist. Sanford Carton, an investment analyst, also contributed to this commentary.
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