Review/outlook series: Northern Trust bullish on emerging markets, less so US Treasuries

Dec 15, 2009

In the first of a series of investment review and outlook pieces, Northern Trust's chief investment strategist says the group underestimated the rebound in global real estate in 2009, but made the right call on emerging markets.

Jim McDonald is chief investment strategist at Northern Trust in Chicago. He also chairs the tactical asset allocation committee, is a member of the investment policy and private equity investment committees and is trustee of the Northern Trust Alpha Strategies Hedge Fund.

Before joining Northern Trust in 2001, McDonald was director of research at ABN Amro in New York and Chicago (1994-2000) and equity research analyst at the same bank following the environmental services industry (1990-1994). He started his professional career in 1981 with Arthur Andersen & Co in Detroit.

In which asset class, sector or countries did you have your best investment success in 2009?

The biggest success has been our recommendation to invest in emerging markets. We moved to an overweight position on emerging markets in March, and the asset class (based on the MSCI Emerging Markets Index) was up by 72% for the year, as of November 30. Our position was based in part on our view that global fiscal stimulus would reignite risk-taking, particularly in emerging markets. We felt these markets would bounce back first economically and have the strongest financial position.

There had been speculation that the pace of emerging-market growth would slow, but China's retail sales and fixed-asset investment figures have not indicated such a deceleration. There was also concern that reduced exports from emerging markets to developed economies would hinder growth. This concern has been remedied with import data that indicates domestic growth in emerging-market economies.

Which asset class, sector or country did you see as the firm's least successful in terms of investment in 2009?

We had an underweight on real estate, which bounced back more strongly than we expected. The asset class, as measured by the Epra/Nareit Global Index (RUGL) gained 33% in the year to November 30. Those gains were primarily driven by low valuations of real estate investment trusts [Reits]. We feel the fundamentals of the real estate market remain challenging, and refinancing risks continue.

In retrospect, the valuations were so attractive, it's not surprising investors stampeded into the asset class. We have maintained a 2% underweight on real estate in our tactical asset-allocation policy, due to the fundamentals, but we are seeing evidence that the real estate market is bottoming.

Which asset classes or sectors are likely to have the most potential in 2010, and why?

Once again, we are sticking with emerging markets and the related commodities. Growth is accelerating in these markets more rapidly than anywhere on the globe, yet emerging-market stocks are still trading at a discount to the US and the rest of the world. That means emerging-market stocks generate a higher return-on-equity with a dividend yield comparable to US equities.

In the past, these stocks traded at a discount to the US because of the perception that these countries ran a higher risk -- primarily political risk. Political risk is still there, in some markets, but other risks are much reduced. For example, past concern over the stability of foreign exchange rates and fiscal conditions has solidified in the past decade. With this in mind, we expect emerging markets to continue to trade at a premium over the next five years.

Which asset classes or sectors are likely to offer the least investment potential in 2010, and why?

We have an underweight recommendation on US Treasuries, though modest at this point. The historically low interest rate has caused many to move assets out of money-market funds and into longer-dated paper. But this trend has only modestly dented the huge pool of cash holdings, and demand for all types of bonds has remained strong and steady.

The size of our underweight on Treasuries would increase if we became concerned that growth was going to surprise on the upside, which would then put pressure on interest rates to rise and bond prices to fall. On the other hand, a delayed response by the US Federal Reserve to inflation could have negative effects on a broad range of risk assets. Any perception that the Fed is reacting to the markets or raising rates to catch up with the economy could prompt a broad sell-off in equities. So we will keep a cautious eye on the Federal Reserve throughout 2010.