April 16, 2015 OUTLOOK

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1 OUTLOOK April 16, 2015 This year financial markets have faced events of a high degree of certainty (such as European quantitative easing [QE]) and those with some degree of uncertainty (including the economic effects of QE and the health of the U.S. economic expansion). The strongest asset class impact has been focused in an area with the highest degree of certainty leading to a nearly 13% decline in the euro year-to-date, a further drop in European sovereign yields and a rally in European equities (up nearly 22% in euro terms and 9% in dollar terms). Globally, the accommodative monetary policy environment has continued to support risk taking broadly, as credit spreads have continued to tighten and even the emerging markets have seen strong stock market performance despite the persistent strength in the dollar. To some extent, the strong performance of these markets is a result of their extended underperformance in recent years. The broad U.S. equity market has delivered a total return of 3.5% year-to-date, which, on an annualized basis, would be a solid return. However, the weaker relative performance reflects not only the bounce back of the other markets, but also the soft U.S. economic data in the first quarter of this year. When comparing reported economic results to forecasts, the United States has been disappointing this year while Europe has been solidly outperforming modest expectations at the beginning of the year. We think sentiment has now likely swung too negatively against U.S. growth prospects and has become too optimistic toward Europe. The pattern of U.S. growth so far this year has followed the trajectory of 2014 economic data progressively failed to meet consensus estimates as the first quarter unfolded, culminating in the disappointing March nonfarm payroll report showing employment gains of just 129,000. Economists had been expecting 3% growth for the first quarter, but now the market wouldn t be surprised by a figure in the 1% range. Transitory factors (such as bad weather and a West Coast port slowdown) will reverse, but the impact from lower energy prices and the stronger dollar are more permanent. We expect a rebound in both job growth and overall economic momentum in the second quarter, and this should increase confidence that the Federal Reserve will begin raising interest rates later this year. In turn, this should provide further support to the dollar and pressure the euro in particular as interest rates across Europe increasingly fall into negative territory.

2 U.S. EQUITY n Economic data has been weaker than expected to start the year. n A likely rebound to trend should underpin investor confidence. Economic data so far this year has been worse than expected, as measured by the Citigroup Economic Surprise Index, because of the fall in energy prices, poor weather and the West Coast port slowdown. The past few years have had similarly gloomy starts, leading to anxiety about the state of the economy and lowered expectations. Fortunately, in those instances, the economy bounced back from relatively weak first-quarter conditions and experienced more positive surprises relative to expectations through the remainder of the year. Even though the drop in energy company earnings is leading to the potential of negative earnings growth during the near term, we expect this to be a temporary phenomenon. We expect muted earnings growth this year as a result of transitory factors to be followed by a return to mid-single-digit growth in EUROPEAN EQUITY n Deflation concerns are overblown while core inflation remains stable. n Multiple expansion is driving returns while the real economy slowly improves. Investors have long been aware of the persistent low inflation environment in Europe, but given the material decline in energy prices during the past 10 months, deflation concerns have come to the fore. However, euro depreciation and positive income effects from lower energy prices should help counterbalance the downward pressure on inflation. It s likely that these benefits will take longer to be realized, setting up for a potentially encouraging inflation path later this year. Furthermore, core inflation has been considerably more stable, pointing to steady long-term inflation. European equities have rallied handsomely year-to-date, supported by increased risk taking in response to the European Central Bank s (ECB s) QE program, reducing the valuation opportunity in European equities. We think the renewed optimism toward European growth, while somewhat justified, may have outstripped reality short of further structural improvements. ASIA-PACIFIC EQUITY n The outperformance of growth stocks vs. value stocks in the Japanese market mirrors the U.S. experience last year. n Value underperformance indicates investors are willing to pay a premium for growth. While Japanese equities have outperformed developed markets year-to-date, underlying performance has been somewhat more nuanced. Japanese growth stocks have outperformed value stocks by close to 6% to begin the year. The fact that investors are showing a preference for paying up for growth stocks could indicate that they don t expect strong economic growth and, in turn, earnings growth, from Japanese companies. We believe growth stocks will generate less of a premium, as expectations for broader growth improve. Japanese Prime Minister Shinzo Abe continues to seek corporate reforms, including more efficient capital use, which could lead to growth in the real economy. However, the upcoming annual reporting season will likely determine the sustainability of the early gains. perspective April 15, 2015 page 2

3 EMERGING-MARKET EQUITY n Emerging-market equities regain strength when the dollar weakens. n Further dollar strength is more likely than further weakness. Emerging-market equities treaded water during the first 10 weeks of the year, as the dollar continued to strengthen and investors questioned its effect on emerging-market capital flows and growth. Major emerging-market economies continue to see downgrades to their growth outlooks, and central banks are responding with easier policy rates and terms. In recent months, many Asian countries (including China, India, Indonesia and South Korea) have cut rates, as have key European countries (including Russia and Turkey). Latin America is the outlier, with Brazil raising rates last month as the real has fallen nearly 40% against the dollar during the last year. Improving growth in Europe and the United States will benefit emerging-market growth, but continued strength in the dollar presents a continuing risk to economic growth and investor risk appetite. REAL ASSETS n Global REITs have extended 2014 s gains with an impressive start to n Solid equity returns, low rates and steady credit spreads should support global REIT returns. When analyzing global real estate investment trust (REIT) returns, we find that the asset class has significant exposures to the equity markets, but also to interest rates and credit markets. These exposures (see accompanying chart) can be interpreted as the percent return for every 1% return of the individual risk factor. Global REITs significantly benefit when these risk factors move in tandem. As a case in point, since the beginning of 2014, constructive returns in both the equity and fixed income markets helped drive the 20% global REIT return during that time frame vs. 10% for global equities. Given our expectation for mid-single-digit equity returns, a constructive high yield carry trade and continued low interest rates, global REIT returns should remain supported by their underlying risk exposures. U.S. HIGH YIELD n Natural resources issuance has been elevated since n The material decline in commodity prices concentrates risk in the natural resources sector. Natural resources issuance grew from 4% of total high yield issuance in 2000 to more than 16% in 2014, including many new issuers. During the last two years, iron ore is down 67%, oil is down 50%, coal is down 33%, gold is down 33% and copper is down 27%. This has resulted in several issuers facing difficulty. These sectors could contribute to an increase in the default rate, but this should be kept in perspective. Credit quality across the broader market remains supportive. The Moody s default rate estimate for 2015 is 2.7%, well below the historical average of 4.5%. Investors need to be discerning about their credit exposures, but the overall high yield market outlook remains stable and we believe continues to look attractive in a low yield world. perspective April 15, 2015 page 3

4 U.S. FIXED INCOME n The Fed remains data dependent. n We continue to believe the Fed will move at a slow and measured pace. Even though the Fed removed the word patient from its March meeting statement, Fed Chairman Janet Yellen s comments made it clear that this doesn t mean the Fed will be impatient in raising interest rates. She reiterated the importance of seeing improving employment and inflation data prior to the Fed taking action. Importantly, Fed officials lowered their projected future path of the Fed funds rate during the next few years. This narrowed the disconnect between investors and Fed members on the projected future path of the Fed funds rates in the next few years, but certainly didn t eliminate it. We derive comfort in the Fed lowering the projected future path of the Fed funds rate and feel it reinforces our view that the path to higher interest rates will be slow and measured. EUROPEAN FIXED INCOME n Greece overshadows economic progress in Europe. n Prospects for the United Kingdom are mired by political uncertainty. Despite positive surprises in economic data, sentiment in the euro area remains fragile, distracted by Greece. Although Greece has fulfilled a crucial April payment to the International Monetary Fund, creditor obligations are mounting against a backdrop of continued financial system leakage and extended reliance on emergency liquidity from the ECB. Markets are pricing in a risk of default, as the time pressure to agree to a deal intensifies. With the U.K. general election looming on May 7, markets are focused on the prospects of a hung parliament rather than the robust economic backdrop. Leading indicators underline the strong start to 2015 in the United Kingdom; however, the pound sterling has remained weak. This may also be a result of dovish comments from the Bank of England. However, with base effects of lower oil prices expected to dissipate in coming months, deflationary concerns should recede. ASIA-PACIFIC FIXED INCOME n Japan is playing the waiting game, as the Bank of Japan (BOJ) keeps policy unchanged. n The Reserve Bank of Australia is likely to cut interest rates again. Japan is making slow but steady economic progress. The widely watched Tankan surveys highlighted the tightest labor market conditions in years, which is a necessary condition for Japan to make a permanent shift from deflation. While the BOJ kept policy unchanged, acknowledging the recovery trend, the dampening effect of lower oil prices suggests it may need greater patience in achieving its inflation target. The Reserve Bank of Australia surprised markets by maintaining the target overnight rate at 2.25% at its April meeting. GDP growth is expected to slow to 2.5% in 2015, owing to the slowdown in China, while inflation is at a six-year low. We anticipate another interest rate cut during the second quarter, but the room for further stimulus is limited given weakness in the currency and the strength in the housing market. perspective April 15, 2015 page 4

5 CONCLUSION Our asset allocation discussion this month focused on the evolution of growth globally, as the divergences of 2014 strong U.S. growth and disappointing European and emerging-market growth have reversed course so far this year. As Europe s economy is showing signs of improvement and U.S. growth has disappointed so far this year, investor sentiment has shifted rapidly. Reflecting the globalization of companies and financial markets, our forecasted returns among the major equity markets aren t that divergent during the next year. We worry, however, that the continued divergence in monetary policy between the ECB, BOJ and Fed is likely to keep pressuring the dollar higher reducing the returns from Europe and Japan for dollar-based investors. We made no changes this month to our tactical asset allocation policy, continuing with our modest overweight to risk assets and favoring dollar-denominated assets. We expect the outlook for monetary policy to remain accommodative globally during the next year. The Fed will continue wrestling with incoming economic data and its desire to move away from emergency monetary policy. We expect the Fed to initiate its first rate hike this year, but expect its concerns over the fragility of the expansion to temper its aggressiveness. Financial conditions in the United States have tightened through dollar strength during the last nine months, and the Fed is conscious of the growth impact of dollar strength. The negative effect of falling energy prices, along with the stronger dollar, has led to forecasts of negative earnings growth in some developed markets. Our research indicates that as long as the United States doesn t encounter an economic recession, this earnings recession shouldn t be overly problematic to the equity markets. We updated our risk cases in this month s policy discussion, eliminating the risk case surrounding Russia and Eastern Europe. Even though there hasn t been much constructive resolution, we ve made it through poor winter weather and the level of conflict in Ukraine has tempered some. Our primary risk case remains the outlook for U.S. and Chinese growth with U.S. growth being the key, as it s the first major economy trying to exit extraordinary monetary accommodation. Chinese growth remains top of mind not only because of its consequential contribution to overall growth, but also due to the economic transition underway in the country. Our second risk case surrounds the potential for fallout from dollar strength primarily tied to capital flows and the high level of dollar-denominated debt issued by emerging-market issuers in recent years. While we expect any turmoil to be manageable, we acknowledge the risks that can surface after a long period of calm. Jim McDonald Chief Investment Strategist INVESTMENT PROCESS 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. 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