VIEWPOINTS November 2017

A JUSTIFIABLE

While sentiment has been improving, many remain 2014 and 2015, and has led the rebound since. Most skeptical about the current market rally and the resulting recently, September import and export data showed outlook. We have analyzed returns across the major equity meaningful acceleration from last month, and surveys of markets this year, and earnings growth has been the companies doing business in China are setting new highs. biggest contributor by far. Earnings growth has contributed European growth, including in the important industrial 53% of the gains in emerging market , 81% of the sector, has been remarkably durable, shaking off political gains in U.S. equities, and virtually all of the gains in difficulties and euro currency strength. Finally, U.S. growth developed markets outside the United States. Currency has shown little evidence of wide-spread disruption from moves have been a big issue this year, significantly the hurricane season. boosting returns in non-U.S. developed markets (adding Inflation is one of the great variables in the outlook; central 9% to total return), but they have only been a minor bankers and have been waiting for its re- contributor to emerging market gains. Finally, emerging emergence for years (while our Stuckflation theme has markets also have benefitted from increasing valuations predicted continued torpor). We formally learned of the U.S. this year, while falling valuations in developed markets Federal Reserve’s plan to begin shrinking its balance sheet outside the United States have been a headwind to their in September, but we expect the pace to be slow and the returns. U.S. valuations have increased modestly this year, overall impact to be manageable. This will help pave the contributing just 1% of the 14% total return. way for tapering of the European Central Bank’s (ECB’s) While earnings growth over the next year is likely to purchases, but actual increases in rates by either the ECB decelerate, in the global economy is supportive or Bank of Japan are likely far in the distance. Inertia in the of continued solid growth. Global economic growth looks inflation metrics across most developed economies has set to accelerate a full 0.5% in 2017 over 2016, a central bankers questioning their models, which we think meaningful move upward. Importantly, corporate spending will lead them to choose deliberation over action when it has finally picked up and tracked at an annualized 7.5% comes to hard choices in monetary policy. rate last quarter. China led the downturn in global growth in

EARNINGS HAVE DRIVEN RETURNS Only emerging markets have seen a real boost to returns from valuations. 32

24

16

8

Percent (%) 0

-8

-16 U.S. Developed ex-U.S. Emerging markets Earnings Currency Valuations Total return

Source: Northern Trust Investment Strategy, Bloomberg.

111 N. Washington Street • Green Bay, WI 54305-3900 • 800.369.0226 • www.nicoletbank.com INTEREST RATES FINDING A NEW LEVEL The Fed has formally announced the start of its balance sheet The Fed’s balance sheet reduction has its limits. reduction plan. It plans to reduce holdings slowly and mechanically, 4.5 initially allowing $10 billion worth of bonds to mature each month, with an eventual upper limit of $50 billion per month. We believe the 4.0 Fed prefers to slowly tighten policy despite recent data showing continued modest growth and limited inflation. As a result, we 3.5 believe interest rates will slowly rise across the curve and we look to 3.0 portfolios neutral relative to their benchmark duration. Euro- ($) Trillions area economic conditions remain solid and appear supportive for 2.5 the ECB to announce the start of policy renormalization later this month. However, ECB rhetoric has remained cautious, and political 2.0 2010 2013 2016 2019 2022 2025 developments are once again dominating the headlines. Elections Balance sheet assets Forecasted across Europe have shown that voters remain fragmented, and the Source: Northern Trust Fixed Income; Federal Reserve Bank renewed push from Catalonian separatists provides an unwelcome of New York. distraction at a time when German elections have weakened the x Fed balance sheet reduction to finally commence. hand of pro-European policy makers. European bond markets have been fairly well behaved, and a flight to quality bid has not x We expect the pace of normalization to be very materialized in the wake of political headlines. Even the Bank of gradual. England appears ready to deliver a rate hike in spite of Brexit x We are neutral U.S. duration, underweight uncertainties. We maintain an underweight bias to -dated European short-dated government bonds. European government bonds because they look most vulnerable as they remain below official policy rates.

CREDIT MARKETS ENERGY BOOST The high market posted a 2.0% return in the third quarter and Energy sectors showed third quarter outperformance. is now up 7.0% on the year. While its return pales in comparison to 10 the 18% return from global equities, we remain attracted to the lower risk profile of high yield vs. the higher risk profile of other 8 asset classes (e.g., global equities) found in the risk asset portfolio. 6 Digging deeper into high yield’s third-quarter returns, we find they were boosted by strong returns in the energy sector. Oil prices rose 4 Return (%) over 12% to close the quarter at $52 per barrel – and drove the 2 8.4% return in the refining sector, a 6.5% return in the oil field 2.0 8.4 6.5 5.0 services sector and a 5.0% return from exploration and production 0 companies. These three sectors comprise only 10% of the high HY index Refining Oil field E&P yield market, but they accounted for more than 25% of the market’s services Source: Northern Trust Investment Strategy, Bloomberg return for the quarter.

Now that oil prices appear to have more stability (at around $50) x Third-quarter high yield returns were boosted by the energy sector as oil prices stabilized. and the energy sectors have become more fairly valued, outlying sectors are less likely to drive returns. High yield portfolio managers x Looking ahead, returns likely will be more likely will look to exploit issuer-level opportunities for dependent on individual contributions vs. sector outperformance for the remainder of the year. Because of our performance. constructive outlook for global economic growth, we expect those x We remain overweight high yield, with a focus on portfolio managers to also receive a tailwind from steady returns in corporate issuers (over emerging market debt). aggregate. We retained our 3% overweight to high yield in our global policy model, with our 5% overweight to high yield corporate issuers offsetting our continued 2% underweight to emerging market debt, a region where we prefer to get our exposure through equities.

2 VIEWPOINTS EQUITIES As equities have marched steadily higher in 2017, markets have MOVING TO THEIR OWN BEAT Correlations between stocks are falling. departed from recent history by exhibiting low levels of and 1.0 lower correlations. As the chart shows, correlations between stocks rose dramatically during the financial crisis sell-off, which is to be 0.8 expected as stocks are more indiscriminately sold during periods of significant weakness. But correlations remained relatively elevated 0.6 for several years post-crisis. Most attribute the higher post-crisis 0.4 correlation to the “macro-driven market,” where central bank policy Correlation was viewed to be the driver of equity returns. With central banks on 0.2 the path toward normalization, particularly in the United States, 0.0 while global growth expectations have firmed, markets have shifted 1987 1993 1999 2005 2011 2017 their focus to company-level fundamentals. Low volatility is Avg. correlation coefficient between stock returns generally supportive of equity returns, and lower correlations Source: Northern Trust Investment Strategy, Bloomberg. Data from 12/31/1986 through 9/30/2017. provide opportunities to capture more than when the market is macro-driven. While there’s a tendency to equate low volatility to x Stocks have started trading more on their own complacency, given the economic backdrop and gradual central fundamentals. bank movement, we are less concerned that the muted volatility x This could improve the opportunity for stock conditions spell trouble for equities over the intermediate-term. A pickers. small correction is inevitable, but we could have said the same thing x We remain constructive on equities globally. at the beginning of the year and missed a gain 15% trying to avoid a 5% pullback.

REAL ASSETS ONLY A PROBLEM WHEN IT’S A PROBLEM Investors worldwide have been anticipating a “global reflation trade” Wage growth has more impact when above 4%. – global growth acceleration that would push inflation higher, 15 bringing interest rates along with it. Recently investors have been teased with higher commodity prices, upward-trending Chinese 12 inflation and increased central banker rhetoric about the need to 9 unwind accommodative monetary policy. Then the September U.S. jobs report hit, showing that unemployment had fallen to 4.2% and 6 wage growth continued to strengthen, now at 2.9% year-over-year. 3 Core inflation(y/y%) However, the wait for the global reflation trade is likely to continue. 0 While wage growth is correlated to inflationary pressures overall, 0246810 low levels of wage growth show a much weaker relationship. As the Wage growth chart shows, wage growth above 4% has a 0.7 correlation with core Wage growth <= 4% Wage growth > 4% inflation but wage growth at 4% or less has a correlation of only 0.3. Source: Northern Trust Investment Strategy, Bloomberg. Data from 12/31/1966 through 8/31/2017. Important to understanding whether higher wages lead to higher inflation is determining the productivity associated with any x Recent anticipation for a “global reflation trade” increase. Wage gains tied to higher productivity need not be has been stalled by lower than expected inflation inflationary and can actually support continued economic growth data. expansion – a key tenet of our Stuckflation theme. More recently, x U.S. wage gains (2.9% year-over-year) are not the global reflation trade has diminished as U.S. and Chinese likely to push inflation higher at this point. inflation reports have come in softer than expected. In the United x We remain strategically allocated to inflation- States, expectations for inflation have rolled over from recent highs linked bonds as investor expectations for future and investors look for inflation to be below 2% over the next 10 inflation remain low. years. We think this cost of insurance for inflation protection is about right and remain strategically allocated to inflation-linked bonds.

VIEWPOINTS 3 CONCLUSION

This month’s investment strategy discussions included our the U.S. dollar-based returns realized during the last 10 normal review of the growth and inflation outlook (good months. Notably, developed markets outside the United and good, respectively) along with an extended discussion States and emerging markets have a greater valuation and of the political outlook in the wake of the Catalonia dividend cushion than U.S. markets. Fixed income markets succession vote in Spain. The question up for debate was have surprised the bears this year, with broad measures of whether this most recent sign of populist upheaval could U.S. investment grade bonds up 3%, intermediate municipal be a trigger for further dissension within the European bonds up 5%, and non-U.S. investment grade bonds up 9% Union, straining the Union at a time when the financial in U.S. dollar terms (unhedged). It’s been very expensive to markets are looking for greater integration. The Catalonia be underinvested in this market, as a simple 60/40 portfolio vote also was discussed in the context of other recent of global equities and U.S. investment grade bonds is up political convulsions that garnered investor attention. We double digits this year. believe the current environment is one where most political problems are chronic, but aren’t rising to the level Our top two candidates to upset the positive risk of crisis. (We are indebted to Ian Bremmer of Eurasia environment are central bank policy and politics. Risk Group for this characterization). So while we will continue assets globally are dependent on low interest rates, raising to assess political developments as they arise, they will the cost of a monetary policy mistake as central bankers likely take a back seat to the outlook for economic data start the slow path to normalizing policy. We also have the and investor risk appetite. unique risk of a new Federal Reserve Chairperson, raising the chances of policy uncertainty. Our other concern is in Early in this report we decomposed the returns achieved in the political world, where risks range from North Korean major equity markets so far this year. It’s a good news/less military concerns to European populism. While both risk good news story. While returns have been heavily cases currently look manageable, they are top of mind as supported by earnings growth this year, growth is certain to we regularly debate our positive outlook on risk taking. slow and equity returns likely will follow suit. While we still expect positive returns, markets will be challenged to match

INVESTMENT PROCESS The asset allocation process develops both -term (strategic) and shorter-term (tactical) recommendations. The strategic returns are developed using fi ve-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 the Investment Policy Committee sees either increased opportunity or risk. The asset allocation recommendations are developed through the Tactical Asset Allocation, Capital Markets Assumptions and Investment Policy Committees. Past performance is no guarantee of future results. Returns of the indexes also do not typically refl ect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved. This newsletter is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity. Any opinions expressed herein are subject to change at any time without notice. Information has been obtained from sources believed to be reliable, but its accuracy and interpretation are not guaranteed. Northern Trust Asset Management comprises Northern Trust Investments, Inc., Northern Trust Global Powered by Investments Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc. and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company. ViewPoints refl ects data as of 10/17/17. ©2017. All Rights Reserved.