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2018 Five-Year Investing Trends

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Although we had a year of strong risk asset returns and some increase in global interest rates, we believe many of the factors supporting the financial markets remain unchanged from last year. We expect continued economic growth, controlled inflation and accommodative monetary policy to result in good-but-not- great risk asset returns and low-but-mostly-positive fixed income returns.

Against this backdrop, we believe six key themes have emerged. Many of these themes are a continuation from last year's, updated to capture the shifting, subtle nuances that took place in the past year:

Risk asset is a term broadly used to describe any financial security or instrument that is not a risk-free asset - that is, a high quality government bond. Risk assets would therefore include equities, commodities, property and all areas of fixed income apart from high quality sovereign bonds, such as Treasuries.

1. MILD GROWTH MYOPIA Subdued economic cycles and stronger financial systems will likely push out the next recession and limit its severity.

Many lament that the global economy seems stuck on a slow growth trajectory. They are short-sighted. The same forces keeping a lid on growth have also buffered downturns and extended the cycle itself. The service economy's steady expansion smooths out cycle peaks and valleys the same way that gradually removing monetary stimulus balances fiscal policy limitations. Nearly 10 years into the U.S. expansion, the cycle has matured and recession odds have risen — but the onset of a slowdown will likely be later and less threatening than suggested by the standard playbook.

2. STUCKFLATION Low and durable structural inflation has altered both monetary policymaking and investor behaviors.

Most major central banks have fallen well short of their 2% annual targets over the past decade — and many of the supply-side forces behind the shortfall are only gaining traction. This is reflected in low interest rates and flattening yield curves. Technological innovations combined with vast troves of data are enhancing price discovery and optimization techniques globally. Monetary policy adjustments and trade frictions will produce uncertainties and pockets of inflation, but companies and consumers will continue to find ways to alleviate such pricing pressures.

3. PASS/FAIL MONETARISM Without a template for policy normalization, central banks' efforts cannot be graded — other than that we feel they must not fail.

Stuckflation and a boisterous political backdrop argue for under-the-radar monetary policymaking, but operating with uber-large financial market footprints makes this challenging. This is new territory, where only two grades exist: Pass or Fail. Monetary experts know recent business cycles ended because of financial instability — not high inflation. With stricter regulations this time around, a more cautious monetary path will be taken. Increasing interest rates too fast, only to increase the odds that interest rates will need to be taken lower, is self-defeating.

4. TECHNOLOGY SLOWZONE Technology has been pulled into the orbit of government meddling but will remain a constructive economic force. After being allowed to flourish without governmental interference in its business models and data collection endeavors, technology now finds itself in the political cross hairs. Social media data mining for political purposes has sparked deep angst over the integrity of democratic elections just as it is increasingly leveraged by politicians on a global level. A period of political maneuvering is now underway but technology's benefits are too great to be throttled for long. Tech will regain its swagger by adhering to revamped rules of the road.

5. GLOBAL (RE) POSITIONING SYSTEM The irreversible fade of legacy multi-lateral institutions is creating as many investment opportunities as risks.

Those left behind by globalism and information technology question whether western-style democracy can right the ship; they also have weak attachment to the post World War II institutional frameworks led by the United States. Global engagement will continue, but based on transactions-oriented instead of ideological frameworks. Investors appreciate that these new approaches will likely favor tech savvy and globally integrated corporate structures. Over time, the tug of war between free markets and managed capitalism will be resolved somewhere in the middle.

6. EXECUTIVE POWER DRIVE Investors are accepting leaders who challenge political norms in order to favorably tilt the economic landscape.

Mainstream, rules-compliant politicians are in retreat everywhere as tech-enabled populists push strong leaders and new agendas onto the political stage. One truism embraced by all sides is that control of executive political power and technology are the most important levers for shaping the future economic landscape. Populism has often been described as a road to economic dysfunction. But for now, asset owners have accepted the movement and been rewarded with strong returns. Investors will likely stay supportive until populism runs its course.

2018 ASSET CLASS OUTLOOK

We believe this year's trends help identify the potential impact we see affecting the markets and economy over the next five years - and they also underlie our asset class outlooks.

Our expectations for equities are based, in part, on the modest growth outlook articulated in our Mild Growth Myopia theme. And our structural expectation for Stuckflation reflects our belief that profit margins will remain elevated in developed markets. In fixed income, our Mild Growth Myopia, Stuckflation and Pass/Fail Monetarism themes reflect our belief that short-term interest rates will move only modestly higher over our five-year horizon.

EQUITIES

We believe that overall equity returns will be below long-term historical averages, but higher than what current valuations such as price-earnings (P/E) ratio or forward price-earnings ratio would predict.

P/E ratio is the average share price of the firms in an index divided by their average earnings per share for the preceding 12 months. Forward P/E is similar except that the index's current average price is divided by the average earnings expected from all the companies within the index for the next 12 months.

We believe that developed market equities will provide investors with mild gains over the next five years. Valuations, while still elevated, retreated this past year as per share earnings grew faster than equity prices. We don't expect a tailwind from valuations during the next five years, but we don't expect a material headwind either. Ongoing but slower economic growth, per our Mild Growth Myopia theme, will provide modest support to revenues while share repurchases and Stuckflation will continue to support earnings.

Emerging market equities' valuations are below historical levels and continue to represent a longer-term buying opportunity. Higher growth, which we believe will persist, and lower valuations may allow for a return premium over developed market equities.

FIXED INCOME

The end of the 30-year-plus bull market does not mean the start of the next bear market. We believe Interest rates will remain low.

Interest Rates
Over the next five years we anticipate interest rates will remain below investor expectations, driven by the continued Stuckflation trend. With long-term interest rates anchored, the current Federal Reserve rate hike cycle will end earlier and at a lower level than is priced into the markets. Also controlling short-term U.S. rates is the ongoing accommodation from other major central banks in response to low inflation. The expected result will be a nearly flat U.S. yield curve and a very small shift upward in other yield curves around the world.

The Forward Rate Curve can be defined as the way the market is feeling about the future movements of interest rates. Bloomberg calculates a forward rate curve at any given time by extrapolating from the risk-free theoretical spot rate. Forward rates are also known as implied forward rates.

Credit Markets
Both investment grade and high yield — will settle in at slightly higher levels than the lows seen during the past 24 months from July 31, 2016 – July 31, 2018. The ongoing economic expansion and still-low debt servicing costs continue to provide a foundation. We anticipate slightly higher fixed income returns due to higher starting point yields, continued central bank accommodation and steady credit spreads.*

* Credit spread is the difference in yield between one debt security and another debt security with the same maturity but of lesser quality.

REAL ASSETS

We expect real asset returns will be mostly in line with equities, providing potential diversification through different "flavors" of market risk.

According to Bloomberg, natural resource returns, as measured by the S&P Global Natural Resources Index, outpaced the broader global equity universe, as measured by the MSCI ACWI (All Country World Index), from Jan 02, 2018 – July 31, 2018, but continue to trail significantly those same indexes performance over the past 10 years from Jan 2, 2008 to Jan 2, 2018. Ongoing global economic growth and better calibration between supply and demand will likely allow recent outperformance to persist.

Exposure to interest rate and credit risk will support global real estate. But negative investor sentiment remains as the real estate market is forced to respond to the more digitally based economy.

Global listed infrastructure can serve as a lower-risk (but also slightly lower-return) alternative to global real estate for income generation. The public-to-private transfer of infrastructure projects has opened up a new set of opportunities.


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IMPORTANT INFORMATION

The opinions expressed herein are those of the author and do not necessarily represent the views of Northern Trust. Northern Trust does not warrant the accuracy or completeness of information contained herein. Such information is subject to change and is not intended to influence your investment decisions.

Past performance is no guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by FlexShares. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index.