“Let my hindsight, be your foresight”
Bob Browne, CFA
Over 110 members of CFA Society Chicago gathered at the JW Marriott on December 10, 2019, to hear Robert (Bob) Browne, CFA, EVP and CIO of Northern Trust, prognosticate on his firm’s capital market assumptions including key macroeconomic themes and forecasts for the next five years. By background, Browne chairs Northern Trust’s Investment Policy Committee, which sets investment policy for all asset classes including active and passive equity, fixed income, real assets and alternatives. With over 35 years of investment experience at many of the top asset managers in the world, Browne offered listeners a wealth of knowledge from his experiences in the markets. As many investors know, experience can’t be taught from reading a textbook, but we can still gain wisdom from those with ample knowledge, per Browne’s opening line, “Let my hindsight, be your foresight.”
Northern Trust’s investment philosophy comes down, in its most simple terms, to an orientation on judgement of compensation for risk. It’s not about good risk or bad risk–it’s about getting appropriately paid for it. There will never be a time when there aren’t any risks in the market, and you must be very careful to not let the ever-present risks paralyze you as an investor. Browne reminds us: “There’s no such thing as a bad risk; only a bad risk premium”. As an example, March of 2009 felt like an immensely riskier time than the summer of 2007. However, the “risk premium” was much more in favor of investors in March of 2009 than it was in the summer of 2007.
Looking back on the last year, 2019 was a remarkable year for stocks with many asset classes up well over double digits and the US delivering 30%+ total returns. The bad news is diversification driven by rebalancing causes us to sell your winners and reallocate to the losers. This has been the biggest challenge for money managers in the asset management industry—how do you reap the benefits of a global diversified portfolio with the US continuing to outperform the rest of the world almost every year for the last 10 years? Northern Trust attempts to decode what investors should do through their publicly disclosed “Capital Market Assumptions”. The CMA is published at the beginning of each year and details Northern Trust’s 5-year return outlook for stocks, fixed income, real assets, and alternatives segregated by geographic regions across the world. A summary of the report is as follows:
Northern Trust’s 5-year Capital Market Assumptions:
Expect global growth restructuring: US GDP was +2.6% over the last five years. Northern Trust forecasts the next 5 years to be +1.7% driven by global growth restructuring with no recession in the near-to-intermediate term. That said, no return is expected to generate double digits over the next five years either. A global diversified stock and bond portfolio should return ~4.7% (including dividends) annualized over the next 5 years.
Irreconcilable differences between the US and China: The relationship between China and the US will remain strained for many years as the two largest economies in the world continue to pull apart. With volatility comes opportunity to differentiate yourself as an investor.
“Stuckflation”: Inflation will remain low due to easy money, technology and productivity. Cashiers are a top-5 job category in the US—who has been to an Amazon Go store? Low skilled jobs will have to learn new skills.
Executive Power Play: It matters who is in political power, especially if they have control of other branches of government to push policies through. Invest based on policy change, not political beliefs.
Monetary Makeover: Central banks are struggling for relevancy, taking a back seat to fiscal policy. Christine Lagarde is a big believer in fiscal expansion versus monetary expansion.
Staking out Climate Risk: ESG oriented investments will remain a key focal point for investors.
After setting the long-term structural foundation, the Tactile Asset Allocation Team meets once a month to tweak the assumptions and adjust portfolios for short-term market movements. The TAA Team asks questions such as “Where are we in the cycle?” and “Is the world accelerating or decelerating?” “What are the central banks doing to monetary policy?” Getting the tactical market calls right is instrumental for consistent outperformance from active managers. “We’re not in the business of forecasting the weather. We’re in the business of forecasting the climate.” Ask yourselves, “What business environment are we in and how should we tactically structure our portfolio?”
Northern Trust’s Current Tactical Market Views:
Growth is bottoming in the US: This is driven by the technology and services sector, not the manufacturing sector. Unemployment at 3.5% and consistent job growth will keep a floor under stocks.
Fed should keep cutting rates: It is clear the Federal Reserve backed off lowering rates three times in 2019 and central banks across the globe rushed to follow suit on concerns over slowing growth. It is Northern’s view, a likely out of consensus view that the Fed should continue to cut at least two more times in 2020.
Higher inflation not a concern: Higher inflation would have a significant impact on the markets, but there is a very low probability of occurrence in Northern’s view.
Watch Political leadership: As an investor,ask yourself “Is the executive leadership in a position to change public policy?” It’s not necessarily good or bad—split powers within government is often the best case for markets as political uncertainty is lifted. Look for when the ultimate democratic candidate is chosen this spring, the markets will pay much closer attention to the political landscape in summer and fall of 2020.
Services-based & diversity of US economy key: A services sector economy doesn’t have as big of booms and busts as a manufacturing or commodity-based economy does. Diversity and a services-based economy creates resiliency for US stocks.
Overall, Northern remains modestly overweight risk assets (+125bps): Browne’s philosophical bias is to always be fully invested. “Manage risk through diversification, don’t avoid risk.” There’s always a bull market somewhere—don’t sit in cash–find the better asset. Ask yourself, “What’s better?” as opposed to “What’s wrong?” Browne is biased toward US equity and US high yield over international and emerging markets. Global real estate and listed infrastructure should also outperform broader equity as these interest rate sensitive asset classes should benefit from “lower for longer” rates.
We wrapped up with Q&A, with the audience focused on the election, EM vs. US, and valuations:
How are you positioning for 2020 election risk? First consider if US GDP growth consideration needs to be revised down below 2%. Tactically, election uncertainty could put businesses on wait and see until the elections results are in. Hold income substitutes in the portfolio to mitigate this risk: US treasuries at 1.8% offer great yields compared to the rest of the world. Investment grade corporate bonds offer enhanced yield returns for taking on nominal increased risks. Global REITs and listed infrastructure are a very attractive hedge that would benefit if interest rates fall as a result of slowing global growth.
Why have Emerging Markets lagged so much over 10 years? Many overestimated how economic growth translates into actual earnings per share. A second key mistake is underestimating the corporate governance issues in emerging markets. Many political systems don’t favor a free market system that allow shareholders to reap rewards. As a result, Northern has increased its equity risk premium assumption for EM. Unfortunately, in many markets, it looks like it’s getting worse. As a result, Northern is no longer strategically overweight emerging markets. This is a tactical view that is often at odds with longer structural views.
Will the US market mean revert? Not necessarily so. The market was up over 30% in 2019. The last time we were up over 30% was in 2013, and the market delivered another 14% in 2014. This is not Northern’s forecast, but just because an asset goes up a lot doesn’t mean it has to come down. Be fully invested and look for a catalyst for one asset class to outperform another. Just because we’ve been growing for 10 years doesn’t mean we’re overdue for a recession.
Favor fundamentals vs. valuations. Europe is clearly cheaper than the US. However, when you consider the health of European banks compared to the US, how cheap is it really? The entire European banking sector trades below book because they don’t earn returns above their cost of capital. If they continue to have a return on equity below their cost of capital, they will continue to destroy value.