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Principal Global Investors

Economic Insights: Recovery broadens
Update for the month of September 2020
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist
The August drop in new COVID-19 cases in the United Statesallowed the recovery to broaden. The rise in new cases inEurope and a second wave in Japan is dampening their nascentrebounds. China’s upturn marches on.
It was a risk-on month for financial markets, but long-termyields edged higher, handing losses to holders of safe-havengovernment bonds. Stock markets may have more upside as
economic activity resumes. Long-term equity returns will likely
be limited given current valuations.

World recovery continues apace
August can be a dull, placid month north of the equator. A timefor vacations, listless markets, football, kids back to school.
How we wish for those typical dog days of summer this year.
Even so, the strong rebound from the horrendous recessionsparked by the impact of this pandemic remains on track.
Traditional U.S. economic reports for July were well above
expectations again. Upward revisions to earlier better-thanexpected data added to the bounce. Housing activity booms.
Sales of existing and new homes soars, with the latter the best
since late 2006. Homebuilder confidence was the highest sine
1998. Mortgage applications are well above last year. Lumber
futures, which hit a price low in March at $251 per thousandboard-feet, now trade above $900, suggesting home prices will
stay on the rise. Housing starts were the best since February andnew building permits rose in every part of the country.
Business orders for durable goods jumped 11.2% in July, farabove expectations—this after a 7.7% surge in June. Orders
and shipments for non-defense capital goods ex aircraft areboth essentially flat with July last year. Retail sales are back to
new highs. July household income and spending kept rising.
Steel production is up for the 11th straight week (but still
well below last year). Regional business surveys from FederalReserve (Fed) District Banks all show expansion. Initial claims forjobless compensation on a non-seasonally adjusted basis keep
falling, now down to a still- very-high 821,600, but the fourth
month below a million. We expect August job gains to exceed
one million.
The July surge in daily new U.S. COVID-19 cases dampened therise in high-frequency data. But cases appear to have peaked
July 23; the latest seven-day moving average fell to 41,240,down 38.3% (here). So, daily and weekly August data resumed
the uptrend. Restaurant seatings by OpenTable are rising.
After a stall around 665,000 in July, daily traveler counts by theTransportation Security Administration crept higher in August
and could average near 700,000. Motor gasoline demand growth
flattened in July but has picked back up. Consumer spending as
measured by J.P. Morgan Chase credit/debit card data leveled inJuly but hit a post-recession weekly high mid-August.
Absent another virus outbreak activity, the U.S. economic
revival should stay on track. The third quarter rebound in real
U.S. gross domestic product (GDP) could be mammoth, near
25% annual rate.
We look for fourth quarter GDP to be up 5% or more as
reopenings spread and more people return to work. The reboundmay slow in 2021 if many temporary furloughs and businessclosures turn permanent. Growth would stay a more trendlike 2.5% or so in that case. Conversely, any prospect of a safe,
available vaccine in the first quarter could foster a two-quarterbounce in growth and bring the U.S. back to new highs in GDPand employment more quickly.
Japan’s economy has endured a series of setbacks. The twopercentage point hike in their value-added tax last October put
the economy in a tailspin. Shortly thereafter, powerful typhoon
Hagibis brought evacuation notices to tens of millions andcaused widespread flooding with dozens of fatalities. COVID-19
lockdowns began in April. After two months of respite, a second
wave of infections struck. Now, Japan’s Prime Minister Shinzo Abe
will resign from chronic health issues.
Still, a mild recovery from the economic lockdowns is underway.
Business surveys by Market News have turned higher. Exports
are rising. While low, household and business confidence istrending up. Consumer spending has improved. July industrial
production rose sharply and is well off its low. Mobility indices
are holding well above the level during the late spring respitefrom the coronavirus. Support for the ruling party is strong andan election doesn’t have to be held until October 2021, so policy
will likely not change much after Abe’s resignation. With thesecond wave of infections diminishing, we expect Japan’s revival
to gradually strengthen.
As in the U.S., the rash of new cases in several countries in Europe(here) in August may have dampened the recovery. Market News
surveys of purchasing managers fell significantly, the index forservice companies from a robust 54.7 to 50.1, just above breakeven. The index for manufacturing edged lower to 51.7. But, atthe same time, Apple mobility data continued to push a bit higher
in all countries. The mild uptrend in national business confidence
surveys stayed intact in August for Germany, France, Italy, andBelgium. The European Commission’s measure of consumer
confidence also edged up. We expect the moderate Eurozone
rebound to persist.
China’s remarkable industrial revival extended in August. Reports
for July were robust, and industry seems mostly back to normal.
Industrial production was 4.8% above a year ago; industrial
profits were up 19.6% over last year versus up 11.5% in June.
Fixed investment was reported as only down 1.6% year overExpressions 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.

year. House prices are rising; housing starts are strong. Evercore
ISI research suggests that China’s domestic air travel is booming,that August will be 85% to 90% of year-ago levels. Households
still seem restrained; retail sales rose in July but remained 1.1%
below the prior year. China may be one of the few countries to haverecovered all its GDP loss during 2020.

the Phillips curve, has ended. That idea: to get a low jobless rate,
the Fed had to tolerate higher prices. Fed officials have observedthat inflation has been low for decades, through expansions andrecessions, tight labor markets and slack ones. Ergo, since inflation nolonger rises as joblessness falls, the U.S. economy will benefit by theFed promoting job growth.

Looking ahead

The view that the tradeoff no longer exists was spawned by whatis thought to be a structural change in the U.S. economy. New
technologies and globalization have interacted to keep the supply of
goods and services well above demand, thus keeping inflation underwraps and the Phillips curve passé.

The world recovery from the recession is underway. China was thefirst to succumb and leads the way out. Giant fiscal and monetary
relief packages are supporting a monster U.S. rebound. Super-low
interest rates, a weakening U.S. dollar, and emerging demand from
China provide an excellent backdrop for developing countries tobounce back. The rush of new COVID-19 cases in greater Europe
and Japan has moderated their revitalization, but we expect only alull in the upturn.
Rising commodity prices validate robust economic prospects.
Record-low U.S. mortgage rates are creating a booming U.S. housing
cycle. Surging U.S. house prices and record stock indices enhancehousehold net worth, add to spending power and confidence andprolong the nascent expansion. With inflation quiescent for now,
central banks will keep policy accommodative for a long time. A
widespread second wave of COVID-19 infection would surely stop
the advance and could bring a double-dip recession.
Absent that, we expect the economic mending to persist.

The Fed massages its targets
At the virtual Jackson Hole conference, Fed Chair Powell described
what is an historic change in Fed policy. Two of the Fed’s goals arestable prices and maximum sustainable employment. Years ago, theFed translated the first into a flat 2% inflation target, a maximum.
The new target is described as flexible inflation averaging, i.e.,
inflation should average 2% over time. So, if inflation stays below
target for, like, a decade, the Fed would let inflation exceed 2% for along time, so long as it didn’t get out of control.
The change to the employment goal was more subtle. The Fed will
now focus only on shortfalls below the goal rather than deviations
above it. The Fed will strive to maximize employment and worry lessabout whether job growth is too strong or the jobless rate too low.
These two changes mean the Fed will shift from restraining inflation
to promoting robust job growth. Here’s the reasoning:
The jobless rate for Hispanics and African Americans hit record lows
the last year or two and overall unemployment was the lowest in
50 years, even as fast wage growth was pulling more people into
the labor force. Fed officials recognized the benefits of super-low
joblessness in reducing income inequality and enticing people into
the job market who had previously been on the sidelines. To this end,
the Fed will let employment and the economy run hot and not worry
if inflation exceeds 2% for a while.
Bottom line: The Fed funds rate will stay at its current record-low
level for the foreseeable future. Second, wage growth will pick up
at some point and the Fed will still not raise the Fed funds rate
preemptively to stop whatever inflation may result.
Inherent in the Fed’s change in policy is a belief that the longassumed tradeoff between inflation and unemployment, called

There’s a natural human tendency to believe that the future will belike the recent past. That what has happened will continue to happen.
Further, the longer those trends have persisted, the more firmly webelieve they’ll continue—we extrapolate the past into the future. It’s
possible that the new Fed policy is based more on extrapolation of
the last couple of decades than true structural economic change.
If the Phillips tradeoff is still alive but just resting, then the Fed may
get more inflation than it bargained for. We’ll find out after a fewyears of the Fed’s new policy.

Focus on markets
Financial markets were Risk-On in August. It was a great month forequity investors with only a few emerging market indices in the red.
The Dow Jones Transportation Index led the derby, up more than
12% for the month after hitting a record high on August 28. Safe
haven and government bond indices performed poorly as longterm yields rose for the month. More risky indices with high-yieldand emerging market bonds at least had positive returns as credit
spreads mostly narrowed just a bit.

OutlookThe new Fed policy framework will keep yields on short-term U.S.
treasury bonds very low, probably for years. This will also keep
meaningful down pressure on 10-year U.S. treasury bond yields for along time. Further, credit spreads (the difference between yields on
U.S. government bonds and those on similar maturity corporate or
emerging market bonds), have narrowed markedly from their Marchpeaks. Super-low yields and dwindling credit spreads make it difficult
for bond investors to find decent returns the next few years.
With the change in policy, the Fed clearly wants more inflation andwill tolerate it at moderate levels. They will eventually achieve at least
what they want. Long-term U.S. treasury yields keep trying to rise
and, at some point, they’ll succeed. As a result, we’d stick to shortishbond maturities, say, two to four years. That offers an opportunity totake advantage of rising long-term yields if that occurs.
We’d avoid government bonds because of basement-level yields andprefer corporate or emerging market bonds that pay a bit more. But
we’d stick to the higher quality bonds in the risk bucket with which aninvestor is comfortable. With credit spreads already low, there’s little
bonus left from spread narrowing.
With tech and growth stocks wildly outperforming the rest of
the market, it’s clear the internal rotation to cyclical stocks we’vesuggested in the past isn’t yet ready for prime time. The switch fromgrowth and tech to stocks that benefit from faster growth began at

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.

least twice since March but failed. August ended with another surge
in the Nasdaq Composite. We still think that reversal will occur, but it
will take firm evidence of more inflation and a steeper yield curve toentrench it. That may take a while.
In the short-term, there may be more upside to broad stock indicesas the world economy reopens and more people go back to work.
But we’d be cautious. There will be fewer positive economic surprises.

Stocks making new highs are priced for perfection. There will likely bevolatility around the U.S. election. We may soon learn that many of
those temporary furloughs were permanent.
In the longer-term, today’s high valuations suggest any equity upside
will be difficult and limited. We’re still optimistic into 2021 but expect
consolidation or potential correction before then.

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