Principal Global Investors

Economic Insights:
Will ghosts scare off the recovery?
October 2019
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist, andRobin Anderson , Ph.D., senior global economist

We don’t think so, but ghosts of recessions
past are haunting business leaders. The
world economy is still at a “trick or treat”
crossroads. One road to further slowdown,
the other to recovery.
Slivers of good news suggest an upturnis coming, even though there haven’t
been clear-cut signs of it. Our conviction
is growing for a pickup in world growth
into mid-2020. That bump could provide amodest but erratic upside for stock markets.

A waiting game
Like Vladimir and Estragon waiting for Godot, we’ve been
waiting for evidence to validate our optimism about U.S.
and world growth. For months, signs have stayed mixed:
good news was always balanced by proof of furtherdeterioration.
Lately, though, geopolitical risks dogging businessleaders have lessened, and lagged positive impacts ofeasy central bank policies have become more apparent.
The U.S. economy remains resilient. There are grounds
to believe Europe may be enjoying a tentative economictrough. Chinese activity is in a modest uptrend. Betterindustrial output reports in Korea and Japan hint that themanufacturing recession has started to fade.
The turn could be at hand.
The U.S. economy is doing just fine, thank you. The labormarket is robust. The payroll report for October wasway above expectations: a decent level of new jobs, plus
a huge upward revision the prior two months. The GM
strike took off about 40,000 and a quirk in census jobs
dropped another 20,000. Excluding drags, payrolls would

have advanced 270,000 jobs…fabulous. New entrants are
swarming into the labor force; disability rolls are falling aslabor force participation of disabled adults rises. Hourly
wages are up over 3%. Wage gains haven’t accelerated
lately, but, gains should speed up shortly. Business surveys
have improved even though CEO confidence remains
at recession levels. Housing activity is accelerating as
household formation swells. Consumer confidence stays
high. Regional Fed manufacturing surveys have improvedon average. Bank loans and the money supply are
expanding nicely.
U.S. economic growth did decelerate a bit in the thirdquarter. Investment contracted for a second quarter withbroad-based weakness likely from trade uncertainty.
Consumers are keeping things humming with strong
spending on durable goods. Solid income growth meansthat purchases don’t erode household savings.
The dichotomy between business and consumers may
carry through the next few months. Flagging profit growth
could keep capital spending and business confidence on
the weak side. If layoffs stay low and the labor market
healthy, consumers will keep the economy percolating.
We look for U.S. growth at 2% -2.5% through mid-2020
with mild deceleration in the second half. Falling profit
margins pose a risk into 2021. The surge in corporate debt
may bring stress to credit markets. The coming economic
upturn may not be strong nor long.
Economic momentum may be on the uptick in China, too.
Retail sales, industrial production and fixed investment
all improved in September. The official survey of Chinese
manufacturers was very weak, staying below the 50
breakeven level at 49.3, the lowest since February. But, aprivate barometer from Caixin Global was vastly betterat 51.7, the best since early 2017. Output, plus new andexport orders, were all the strongest since 2018 or before.
Vehicle sales have improved markedly since spring. Several
monthly series, like exports, electricity production, andcement output have been trending higher sequentially.

Expressions of opinions and predictions are accurate as of the date of this communication and are subject to change without notice.
There is no assurance that such events or prospections will occur and actual condition may be significantly different than that shown here.

Loan and credit growth are better. Bloomberg’s measureof China’s credit impulse, which monitors incremental
gains in lending versus gross domestic product (GDP),
has rebounded this year. The issuance of special local
government bonds has accelerated since June. The
boost in credit and fiscal stimulus from the central
government should keep economic growth around the6% target. Secular forces—demographics, declining
competitiveness, and high debt levels—are big long-termheadwinds for growth.
The Eurozone has been muddling through the world
slowdown. It still is, but we hear whispers of betterthings. Third quarter growth in real GDP wasn’t as bad
as expected, up 0.75%, seasonally adjusted annual rate.
Household demand was decent as auto sales rebounded;
capital spending was unexpectedly good. The composite
business survey for October showed a marginal uptick.
Bank loans and the money supply are growing, whichbodes well for modest growth. The labor market is in good
shape with the jobless rate at 7.5%, the lowest in over adecade. Overall employment growth is steady.
The main weakness in Euro area growth has been exports
outside the region. With business surveys and industrial
production improving in emerging Asia, those export
troubles may have bottomed. It’s likely the Eurozone
downturn was at its worst in October. Stabilization is more
likely than recession, but, progress out of the trough may
be tough. Even with super-slow growth, though, inflation
is edging higher; the consumer price index ex food andenergy is up 1.1% over the prior year. Central bankers
should feel better.
We don’t see Europe falling into recession but, it’s hard
to see much upside near term. Business sentiment isabysmal. The weakness in manufacturing looks to bespreading to services. A Brexit extension may provide
mild relief. Any turnaround in world growth may lift
manufacturing. Region-wide, growth should be 1% thefirst part of 2020.
Japan is a different story. The two-percentage point risein the value-added tax on October 1 pulled consumer
spending forward, so retail sales will be weak for a while
and GDP may contract. There are some bright spots.
Industrial production was robust in September. Machine
tool orders and business surveys seem to be stabilizing.
The jobless rate rose two tenths in September, but, at
2.4%, it’s incredibly low. The labor market is great; theratio of job openings to applicants is 1.59, near record
highs. Total employment is growing around 1% even as
the population is falling. We expect economic activity totrough the fourth quarter. A mild pickup in world growthwould be a nice tailwind for Japan.

Looking ahead
The global downturn of the last 20 months has been thethird since the financial crisis. The biggest risk to this third
upturn is flat profits and falling margins, which suggest
it may be neither lengthy nor dynamic. High corporate
debt levels combined with falling profits could bring credit
market stress and a potential downturn in 2021.
More evidence is needed to say the slowdown is ending.
We think the proof is coming. Commodity prices seemto be trying to form a bottom, a positive signal. There isbetter momentum in the U.S. and China. Japan and theEurozone are struggling, but not desperate. Improving
business surveys in China, South Korea and Taiwan are
signals that an upturn is likely.

Central banks ask how low is low?
How ‘bout them negative rates? Official interest rates keep
falling and falling and falling. At the September meeting of
the European Central Bank (ECB), the Governing Council
lowered its official rate to ‑0.5% and announced new bondpurchases of €20 billion per month. The forward guidance
was essentially that rates would stay at the current level orlower for light years. New ECB President Christine Lagardewill maintain former President Drahgi’s “do whatever ittakes to preserve the euro” attitude.
The U.S. Federal Reserve (Fed) reduced the fed funds rate
0.25% for a third time this year, to a range of 1.5% - 1.75%.
Fed Chair Powell was emphatic: we’re “not thinking about
raising rates right now,” a “Read my lips; no new rate hikes”
throwback. We expect fed funds to stay on hold through2020 and certainly no rate hikes until pigs fly or after thenext recession, whichever comes first.
The recently weaker U.S. dollar helps emerging country
central banks drop their rates without fear of currency
weakness. At the Bank of Japan’s October meeting,officials refrained from pushing rates more negative, but
noted that if further action was needed, it would come.
Is anyone thinking about bringing interest rates backabove ground? The Riksbank of Sweden was the firstcentral bank to move into subterranean territory and likely
the first to slither out. Riksbank Governor Ingves said it
would be a “bonus” to return to zero, warning that interest
rates need sunlight eventually.
What’s going on? Today, some $16 trillion of bonds
currently yield less than zero. It’s bizarre. Owners of thosebonds are paying borrowers for the privilege of getting“most” of their money back. To understand it, think of acasino: A gambler patronizes a casino and bets $100 on aregular basis. Over enough time, that bettor will go homewith an average of maybe $95 for every $100 wagered.
That’s just the way casinos work; the House wins. Oh,

Expressions of opinions and predictions are accurate as of the date of this communication and are subject to change without notice.
There is no assurance that such events or prospections will occur and actual condition may be significantly different than that shown here.

the player will have had fun, seen lots of blinking lights,
heard bells and whistles, gotten some free drinks andencouraging pats on the back. That’s surely worth $5?

the investor $94.54. There would be no bells, flashinglights or whistles and certainly no free drinks. Are we
simpatico here?

As an alternative, one could put $100 into a ten-year
Swiss government bond with a current yield of ‑0.56%.
After ten years, the Swiss government would give

Why would anybody buy a bond with a negative yield?
There actually are a few reasons.
Regulation

Financial institutions or pension funds may be required to keep a portion of assets in risklessgovernment bonds regardless of yield.

Currency
hedgingEuro area investors may find that U.S. treasury bonds offer worse returns than negative yielding Germanbunds when hedging costs are included.

Deflation

If prices fall, investors might gain from such bonds if the negative yield is above the rate of deflation.

FearExpect evenlower yields

Investors may believe other assets will have worse outcomes.
Prices of negative yielding bonds will rise if yields become more negative, giving investors arobust return.

What’s the impact? Initially, there may be some positives. Negative rates may support the local economy, pushing downborrowing costs to induce investment and spending. Governments benefit through lower debt service costs. Negative rates
weaken a country’s currency and boost exports. But, the longer rates are suppressed, the more problems that may develop.
•Low returns on safe assets threaten pensions. Insurance companies and pension funds won’t get enoughreturn to pay liabilities. Workers must put more into the fund. Companies would raise fund payments,
hurting profits.

•Individuals saving for their own retirement would save more. Greater savings mean less money to spend,
slower economic growth.

•Negative rates create uncertainty by suggesting the economy is in terrible shape, if such an unusual
policy is necessary.

•Banks would raise borrowing rates and/or reduce lending.

•Capital would be misallocated by funding low-return ideas and keeping inefficient companies in business.
Productivity gains would fall.

•Banks would likely not charge customers for holding cash. So, bank costs would rise. Banks would raiseother charges to compensate.

•Low safe returns induce investors to take on more risk leading to potential asset bubbles and thenfinancial crises.

•Super-low interest rates raise asset prices, creating more income inequality by favoring people most likely
to own those assets.

Where does it end? We don’t know. But, a long period of negative interest rates will likely create plenty of unanticipatedconsequences. Below-zero yields are surely unsustainable.

Expressions of opinions and predictions are accurate as of the date of this communication and are subject to change without notice.
There is no assurance that such events or prospections will occur and actual condition may be significantly different than that shown here.

Investment ideas
The long stock market rally from March 2009 to January 2018 may be over. A new and different investment cycle is likely
coming, but it’s not here yet. As a result, we don’t see any enduring trends on which investors can jump and stick for long-term
profit. It’s a short-term, tactical environment over the next 18 months to two years.
In that period, our economic framework suggests mild upward pressure on long-term safe-haven government bond yields.
Ten-year U.S. Treasury bonds yielded 1.69% at the end of October. Those yields could hit 2% or more if global growth picks up.
If the upturn is indeed shorter and weaker than the last two, U.S. treasuries yielding 2% to 2.25% would be a good buy for 18
months ahead of a possible 2021 economic downturn.
For a one-year window at least, bond investors should stick to high quality corporate or municipal bonds at two to four-year
maturities. Investment grade, high-yield or emerging market debt would work, just stick to the highest-rated securities.
Equity markets should still have some modest upside if growth improves as we expect. But, at these tall valuations, the future
may be limited. If recessions’ ghosts are worrisome, investors might consider taking a few profits on a semi regular basis, ifor as the uptrend progresses. We’d maintain a portfolio balance, both by sectors and by major country. International may
outperform U.S. equities. Value indices are too cheap versus growth. Caution and balance rule. Trick or treat?

Expressions of opinions and predictions are accurate as of the date of this communication and are subject to change without notice.
There is no assurance that such events or prospections will occur and actual condition may be significantly different than that shown here.

Disclosures
Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of April 2017.
Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do
not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee offuture performance and should not be relied upon to make an investment decision.
The information in this document contains general information only on investment matters. It does not take account of any
investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice,an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events
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