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Principal Global Investors

Economic Insights: About those future returns ...
where might you find them?
July 2019
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist

Intensified trade tensions and disappointment with interest rate cuts by the UnitedStates Federal Reserve (Fed) could provoke a summer relapse in equity markets.
But if world growth picks up as we expect, investments in stocks and corporate
bonds should be reasonably rewarding on a nine to 15-month basis.
Still, on a longer-term horizon, good financial returns might be very hard to find.

The backdrop for financial returns
Where to find good financial returns depends on the economic environment within which markets will function.
The growth slowdown that began in China and migrated around the world continues today. It was exacerbated byuncertainties caused by the Trump administration’s tariffs and trade tensions, which have intensified lately.
Two points on this topic:
There are signals of a pickup. Last month, we noted that the world economy appeared at a crossroads. The
global slump had lasted about 20 months, comparable to others since the financial crisis. It turned out to belonger and more severe than we earlier thought. Pessimism was rampant in June, and a further slide wassurely possible. Our bias then was that growth would pick up late this quarter and into next year. But
evidence of a clear turnaround was meager. Now, a few signs of improvement have arrived, suggesting thatthe end of the downturn might be ahead.
Leading indicators compiled by the Organization of Economic Cooperation and Development (OECD) for
China and a group of five other major non-OECD countries have both moved higher for four months. The
OECD leading indicator for all member countries is nearly flat and likely to turn up shortly. Broad commodity
price indices seem to be nearer consolidation than further collapse. The Baltic Dry Index of shipping costs
surged this year. Recent economic data and business surveys were better than expected in Taiwan, as wasJune industrial production in South Korea. This suggests the end of the Asian downturn is at hand.
Further, in both Europe and Japan, households and service sectors remain resilient with healthy labormarkets and good wage gains. June retail sales in Germany jumped at the fastest pace in twelve years.
The solid U.S. payroll report for July showed that the mighty American jobs machine is purring right alongwith improving wage gains. The huge upward revision to U.S. worker compensation in the National Incomeand Product Accounts (NIPA) showed that households are healthy, happy, and confident with great savingsand surging real income. Eurozone composite business surveys likely reached a trough early in the secondquarter; service sector surveys stay resilient. We don’t think this downturn will become a recession andexpect growth to return to near trend later this year.
It’s a late cycle thing. Some have wondered why U.S. business leaders lack confidence and convey pessimism,
why capital spending has been so lifeless recently. Part of it was uncertainty about trade issues, but, themore likely reason became clear with the sizeable revisions to U.S. NIPA data. That big upsurge in worker
income noted above came out of U.S. corporate profits, meaning total earnings have been broadly flat since2016, rather than rising. A surge in interest costs, rising wage pressures, and a failure of revenue to match
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.

For Public Distribution in the U.S. For Institutional, Professional, Qualified and/or Wholesale Investor Use Only in other Permitted Jurisdictions asdefined by local laws and regulations.

the pace of expenses caused a dearth of profit growth. Higher interest expense is the delayed effectof Fed rate hikes. The lack of revenue gains is due to drooping world growth. Wage pressure comesfrom a tightening labor market. It’s no wonder CEOs are so glum: no profits, no spending, no way.
The bigger picture is that the lack of profit growth suggests the U.S. may be later in its business cycle
than some have thought. Flat or contracting profits is one of three typical long-leading signs that arecession, however mild, may be out there somewhere in the future; now, likely still a ways ahead.
An inverted yield curve (i.e., yields on long-term treasury bonds below those on short-term bonds)
is a nearly infallible recession omen and is already sending that message. Recent U.S. payroll reportsthat point to slowing job growth over the last several months is a third precursor. We don’t thinkrecession is a worry for this year, nor is it likely next, as these harbingers have a long lead time. But
they do herald that the end-cycle is coming.

We don’t thinkrecession is a worry
for this year, nor isit likely next, asthese harbingers
have a long leadtime. But they doherald that the endcycle is coming.

A market return roadmap
The framework above suggests a market roadmap for investors over the next two or three years. But it’s a sketch with nostraight lines, no long-term trends, no passive index for investors to jump aboard and ride robotically into robust returns
for years. Note a few interesting potential turns and twists in financial markets:

Stock market returns. Pushed up by central banks’ dovishmonetary accommodation and decent second quarter
earnings, world stock markets had robust returns in Juneand mostly held together until late July. Frustration withFed action at the July meeting, worries about President
Trump’s new tariffs, and delayed evidence of better world
growth may provoke a summer relapse in world equity
markets. If that occurs, the widespread pessimism would
likely create a nine- to 15-month buying opportunity,
assuming economic gains do eventually appear toward
fall. Even without a correction, broad equity indices will
likely offer a modest reward into late spring next year andperhaps somewhat beyond.
As worries about global growth intensified over the last
few months, investors favored sectors that were thought
to have secure earnings growth, like large cap tech stocks,
or that were income proxies for bonds, like real estate
investment trusts and utilities. Those defensive sectors
have reached very high relative valuations. For thismedium-term horizon, we’d advise a balanced portfoliowith a typical weight of cyclical stocks that will benefit
from a gradual return to world growth. U.S. stocks should
outperform those in other developed countries. Emerging
market equities might be a better bet, if the economic
setting improves as we expect.
A major escalation of the U.S./China trade disputes
beyond the newly announced 10% tariffs on the rest ofU.S. imports from China would surely limit these positive
prospects. However, President Trump can’t unilaterally
ratchet up trade tensions too far without hurting hisreelection prospects. China will likely retaliate against thenew tariffs, but monetary accommodation and a gradual
pickup in world growth later this year will help mitigate
the damage from trade.

Bond market returns. Bond investors have had a terrificyear, especially those owning high-yield and long-dated
U.S. treasury bonds. Barclay’s index of global high-yieldbonds had a 13.1% return this year through July. Barclay’s
index of long-term U.S. treasury bonds gained 11.1% overthe same period. Government bond prices surged fromthe collapse in yields and corporate bonds gained fromnarrower yield spreads to U.S. treasuries. It’s doubtful
those gains in bond prices can continue. It all depends onlong-term interest rates.
So, what’s that outlook? Both the Fed and European
Central Bank (ECB) will lower their official rates in
September and keep them super-low for an extendedperiod. Bond yields could fall further in the near term if
equity markets relapse on distress over trade or monetaryissues. Beyond that, it’s likely that government bond yields
are now tracing out a low through 2020.
Why? Inflation has trended broadly lower this year,
but perhaps not by as much as the depth of the world
slowdown might suggest. Several inflation measures
tracked by regional Fed banks remain near the Fed’s
target and showed little weakness this year. High U.S.
and Eurozone inventories pushed businesses to offer
discounts, keeping inflation low this year. Inventories arebeing liquidated, so price weakness should vanish. Rising
wages and tight labor markets will keep upward pressure
on inflation. Besides a bit more inflation as the year
progress, improved world growth should help mark thelow for bond yields.
Bond investors should definitely avoid government
bonds over the medium-term; they’re too expensive andoffer little return. We’d prefer corporate bonds offering
higher yields, as mending world growth prospects imply
manageable short-term risk in those riskier bonds.

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.

For Public Distribution in the U.S. For Institutional, Professional, Qualified and/or Wholesale Investor Use Only in other Permitted Jurisdictions as
defined by local laws and regulations.

A good long-term return may be hard to findBeyond that nine- to 15-month timeframe, investors should stay cautious and liquid.
The threat of recession over the next 12 to 18 months seems small, but the danger
could mount in 2021. The hidden danger is more inflation and higher than expectedlong-term yields. Yes, the widespread consensus is that inflation and long-term
interest rates will stay lower for longer, if not forever. The consensus believes thatthree decades of falling yields, followed by a near-decade of super-low rates and noinflation, is plenty of justification to extrapolate the same well into the future.
Is that reasoning valid? Not over the long-term. The disinflation of the last 25 years
was most likely from globalization: outsourcing production to low-wage emerging
countries which kept goods’ costs and prices from rising. Those low costs also put
downward pressure on developed country wages, which kept prices from risingmore generally. But the cost advantage from far-flung supply chains is surely
waning. Labor costs have risen dramatically in China, making U.S. manufacturingcosts much more competitive when productivity is considered.

This framework suggests
a market roadmap forinvestors over the next
two or three years. But it’sa sketch with no straightlines, no long-term trends,
no passive index forinvestors to jump aboard
and ride robotically intorobust returns for years.

Further, recent U.S., U.K., and European elections implied a recognition that outsourcing has negative local consequences. So
trade barriers are rising. Both forces are pushing global supply chains to be revised and production to move closer to the sourcesof demand: higher costs, rising prices, and more inflation.
In addition, the severity of the financial crisis created an extreme amount of slack in labor markets and production facilities. It
has taken years for those excesses to begin to be absorbed. Historically low jobless rates and rising wages in the U.S., greater
Europe, and Japan suggest labor market slack is shrinking. The result will surely be more upward pressure on wages and prices.
Central banks may ultimately find themselves behind the curve. The causes of the long disinflation are fading.

The real danger
The risk of a bit more inflation and higher long-term interest rates may create a challenging environment for investors after2020. Higher interest rates could bring significant distress in the corporate bond market with prospects of rising defaults. Thesuper-low cost of debt over the last decade has likely kept inefficient companies in business by allowing them to roll over theirloans. Higher rates will put the hurt on whatever zombie companies are still operating. Higher mortgage rates will dent housing
activity around the world.
If this milieu comes to pass, good financial returns will be very hard to find. Most financial assets, especially safe-havengovernment bonds, have very high valuations today, and they are unlikely to become much cheaper into mid-2020. Neitherstocks nor corporate bonds will like the environment that could coalesce in 2021, if a bit of inflation returns with higher longterm interest rates. If the worst comes to pass in 2021, cash and safe-haven U.S. or Japanese government bonds would be
the place to ride out the lurch. Eventually, this could bring a big rotation to value stocks and real assets (i.e., banks, financials,industrials, materials, real estate, commodities, emerging markets).
But, that’s a story for later. After we learn whether this fairly glum roadmap comes to pass.
For now, keep a balanced portfolio of stocks and bonds, according to your risk tolerance.

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.

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