Brexit, threats from North Korea, political upheaval in the U.S., and other recent geopolitical events have been putting investors on edge and creating spikes in market volatility. Add elevated market valuations to the mix, and it might seem like a recipe for stock market mayhem.

But market rumblings don’t necessarily translate into a rout, says Jim McDonald, who manages the Northern Global Tactical Asset Allocation fund (BBALX) with Bob Browne and Daniel Phillips. “In the 14 years I’ve chaired the tactical asset allocation committee, I’ve learned that geopolitical events rarely have a sustained impact,” he says. “It would take a relatively extreme outcome, such as a trade war with China or actual military engagement with North Korea, to justify a change in tactical asset allocation policy.” Those views are supported by a report from Northern Trust Asset Management, which says that market declines stemming from so-called “crisis” events—such as Iraq’s invasion of Iran or the Asian currency crisis—lasted an average of eight days, and that the markets then took an average of 37 days to recover to pre-crisis levels.

McDonald, who is also the firm’s chief investment strategist, believes that the uncertainty amid such events will fade over the next year. “At the end of the day, the actors involved in the different political theaters will do what is rational,” he says. And over the longer term, more stringent financial and banking regulations implemented since the financial crisis should help us avoid another 2008-style debacle. “Some recent efforts to reduce financial constraints are warranted and can be good for growth without creating new financial risk,” he maintains.

Elevated stock market valuations, especially in the U.S., are also giving investors pause. Over the past five years, the MSCI World Index (a proxy for the developing world) has seen its price to trailing-12-month earnings rise from 13.7 to 21.5 times.

McDonald, however, says a number of factors will help keep those values holding firm—factors such as slow but steady economic growth, benign inflation and low interest rates. The higher valuations are also more justified because pricier sectors such as technology now make up a greater proportion of the indexes than they did before. The movement of assets into exchange-traded funds could further prop up values and keep retail investors in the market during times of volatility.

Nor does investor sentiment suggest that the market is in a bubble. Instead of the blind optimism that signals bubbles, anecdotal accounts suggest to McDonald that investors are in fact skeptical of the ongoing market rally.

Along with these reassurances come more modest return expectations. The firm’s latest five-year outlook calls for annualized five-year stock market returns of 5.9% in the U.S., 7.2% in Europe, 8.4% in emerging markets and 6% in Japan. Those numbers are quite a bit lower than they’ve been in the recent past. For the five years ended June 30, 2017, the average annualized returns were 14.6% for the U.S., 14% for Europe, 8% for emerging markets and 17.6% for Japan.

Unlike many money managers, who have fairly rigid allocation parameters and aren’t particularly attuned to macroeconomic events, McDonald and his team take a decisive stand on broad global trends and tailor investment strategies accordingly in the Global Tactical Asset Allocation fund. They also keep things simple by using a dozen or so ETFs, rather than hundreds of individual securities, to implement their strategies. Most of these funds are Northern Trust FlexShares products, and those that use equities have tilts toward factors such as companies’ dividend payments, value, quality or size.

McDonald says the firm uses ETFs because they’re economical and easy to trade. Because the factor tilts tend to be cyclical, since some do well while others do poorly, the aim is to reduce volatility and outperform market-cap-weighted indexes over the long term. This year, for example, the size and value factors have detracted from performance (although they have been a plus over the long term), while the quality and dividend factors have benefited international stock holdings.

Aside from its use of ETFs, the Northern Global Tactical Asset Allocation fund stands apart from other world allocation funds in other respects. Unlike many of its peers, it devotes a small portion of the portfolio to “real assets” such as real estate and natural resources. Its 0.64% expense ratio is well below the 1.05% expense ratio for the average fund in Morningstar’s world allocation group. The fund also has much lower stock turnover than its peers at about 28% per year.

With just $85 million in assets, the fund is dwarfed by much larger competitors such as the American Funds Capital Income Builder fund (CAIBX), which has $105 billion, and the BlackRock Global Allocation fund (MDLOX), which has $39 billion. Nonetheless, as David Snowball noted in a Mutual Fund Observer article earlier this year, the fund’s “returns have been higher than most [of its peers’] across the full market cycle, its downside risk has been the lowest in the group and its Sharpe ratio—a measure of risk-adjusted returns—is the second highest in the group. ... It has used its flexibility and low expenses to outperform some very distinguished competition.”

Shifting Overseas
The investment foundation for both the fund and the firm’s institutional clients is a strategic asset allocation plan that Northern Trust Asset Management’s investment committee generates each year, as well as the estimated five-year forward returns for various asset categories. During the year, the firm adjusts those allocations monthly to create a “tactical” allocation strategy that takes advantage of market opportunities and avoids potential pitfalls. Essentially, the fund is a public proxy for the asset allocation recommendations that Chicago-based Northern Trust Asset Management provides its institutional clients across most of its $1 trillion in assets under management.

The biggest recent shift has been a move from U.S. to international equities. At the end of last year, the U.S. accounted for 60% of the equity side of the portfolio, and developed international and emerging markets contributed 40%. By July 31 of this year, the international side had grown to 54%, while the U.S. share shrank to 46%.
“Investors have been rewarded handsomely by overweighting U.S. equities since the financial crisis, with a
cumulative excess return of 100% over developed ex-U.S. equities,” McDonald says. “We think this landscape is shifting, as economic momentum, political stability and currency valuations are starting to favor markets outside the U.S.”

He points out that earnings in the U.S. have fully rebounded from the global financial crisis and are near cycle highs. By contrast, the earnings across EAFE markets are still well below their highest levels. This is generally tied to the delayed economic cycle across Europe, where earnings are still roughly 40% below their prior peak. Despite the outperformance of overseas markets so far this year, fund flows into non-U.S. equity funds were weak in 2016 and only began picking up in April of this year. That trend could indicate that the shift to international securities has only recently begun, and has room to grow.

Equity valuations are also more attractive overseas, and European political risk is receding. “Client conversations around political risk have shifted noticeably over the last two years. After years of defending the European Union from the prospect of breakup, attention is now shifting to the political situation in the U.S.,” McDonald says.

U.S. bonds account for roughly 36% of his fund’s assets. Overseas, bonds offer skimpy yields and face looming currency risk, so the Northern Trust managers have avoided international exposure on the bond side of the portfolio. At 17% of total fund assets, investment grade represents the largest fixed-income sector, followed by high yield at 8%. The fund maintains an overweight position in the latter sector because default rates have been low, and low interest rates continue to help companies shore up their balance sheets.

Looking Ahead
Going forward, McDonald and his co- managers expect the aggregate of global economies to experience modest growth of 2.4% over the next five years. The constraints to global demand include high levels of government debt, especially in China, and aging populations in developed markets. Inflation will remain contained over the next five years, with most developed economies at or below central bank targets of 2%. With automation and increased efficiency keeping prices in check, the challenge ahead will be to maintain inflation, not control it.

In a slow economic recovery, the Federal Reserve might hike rates just once a year. Until other central banks can exit their monetary accommodation programs without too much disruption, the Fed will find it difficult to justify moving policy rates higher and more quickly.

In a nutshell, stocks have room to run, though expectations are that returns will be in the mid-to-upper single digits over the next five years. Economic expansion is likely to be constrained, which should help contain inflation. And given the tepid pace of economic growth, as well as the continued intervention by central banks, the threat of rising rates may not be as onerous as it seems at first glance.

Against this backdrop, McDonald says the best advice is to stay calm. He warns that investors who are planning investment moves in anticipation of the end of the economic expansion or pulling out of the stock market because of concerns about high valuations “will be missing the boat.”