Principal Global Investors

Economic Insights: A powerful equity
rally
Monthly update: January 2019
Commentary by Bob Baur, Robin Anderson, and the Economic Committee

A powerful equity rally: Yes, but, will the postChristmas stock market surge continue? Let’s
consider the environment. The stock market
collapse in December was historic. From theDecember 3rd peak to the Christmas eve trough,the S&P 500 Index (the Index) plunged 16.0%. Even
with the yearend upswing, the Index lost 9.2% for
the month, the worst December performance since1931. Credit markets cratered too, with the yield on
Barclay’s US High Yield index rising nearly 1% toover 8%.
Most world markets outperformed those in the
United States during December. The MSCI AllCountry World ex US Index lost 4.7%; the MSCIEmerging Market Index fell only 2.9%. The tech
darlings that led US markets to many months ofoutperformance failed in December.
Markets led; the Fed followed: US markets
groaned when Federal Reserve (Fed) Chair Powell
implied the shift to normal monetary policy wason “autopilot.” Expectations for several 2019
rate hikes, in spite of a slowing world economy
and tighter financial conditions brought the final
collapse.
The Fed lags. Fed governors heard the message
in the market nosedive and suddenly were
promoting a pause in normalizing policy. Even themost hawkish governors got on board. It was themonetary ceasefire that brought the massive rally.
After such a devastating market collapse, the suddenchange of heart by the Fed made the huge upswing
since Christmas almost inescapable. Besides,
recession fears were overdone. The US economy isstill robust; retail sales stay strong; the job market is
excellent; and wage growth is picking up.

Interest rate outlook:
Markets like a dovish Fed
Markets reacted intensely to Fed Chair Powell’s press conference and policy
statement after the recent Fed meeting: stocks and gold soared; yields
on 10-year US treasury bonds and the US dollar fell. The policy statement
dropped language calling for “some further gradual increases” in the fed
funds rate and implied the next move could be either up or down. Also, in an
unusual separate statement, the Fed said it is “prepared to adjust any of thedetails for completing balance sheet normalization” dependent on future
economic and financial conditions. Clearly, with inflation quiescent, thecentral bank wants to let the economy blossom.
None and done
So, we see no chance of Fed rate hikes in the first half of 2019. And whether
the Fed even raises rates in the second half is highly questionable. Having
been chastened by the December market collapse for being too hawkish,
we’d guess the Fed will err on the side of patience, especially with only
modest inflation. If stock markets rally hard in the second half, another rate
hike late this year could happen. Still, the upper range of the funds rate
at 2.5% is near many estimates of neutral. And with some slack left in thelabor force and capacity use well below past business cycle peaks, there’s noreason for the Fed to try to restrain the economy.
Whither long rates?
Near-term caution is still advised as yields on 10-year US treasury bonds
could be weak over the next few months. If the stock market has another
downdraft, we could see 10-year US treasury bond yields fall below 2.5%
before mid-year. If that happens, borrowers should use the opportunity
to lock in interest rates on all one’s borrowing needs for some time. If
US nominal growth stays in its current 4% to 5% range, long-maturity
US treasury bond yields should eventually push toward that subdivision.
Deflation worries are over and modest inflation is ahead. Inflation and real
economic growth each at 2% suggests a 4% yield expectation on 10-year US
treasury bonds at some future point is not unreasonable.

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.

Is the bear market over? With the Fed on hold, can the rally persist? Possibly, but, maybe not. Two key drags. First, central banks areunwinding a decade of financial repression and suppressed interest rates. Acclimated to years of capital subsidization, markets had
to adjust to this new environment, which brought last year’s volatility. And while the road to tighter policy may be stymied for a bit,tougher financial conditions may require more adjustment. Debt costs are higher; credit spreads are wider; and stock markets have been
range-bound.
Second, robust earnings expectations may not pan out. After a year of 25% earnings growth, low double-digit forecasts became
common. Estimates have fallen dramatically, but are still over 8% by Standard and Poor’s forecasts of $169 for the 2019 S&P 500
Index. With world growth slowing, especially in China, we’d guess those projections are still too high. Several companies have alreadydowngraded guidance: Apple, Macys, and Cat among others.
Given the shellacking individual stock prices receive when guidance is lowered, there seems real potential for another downdraft. The
fact that long-term interest rates have not surged alongside stocks suggests the rally may be peaking. Further, if stocks do run higher,
rate hikes would come back into view, reversing the Fed’s shift to pause. Nevertheless, such a retest of the December lows or beyond
would likely be a significant buying opportunity.

Market outlook
Earlier in the commentary we made the case for another stock market downdraft ahead based on tighter financial conditions andpotential earnings downgrades. So, financial markets could see a tough first half of 2019. As a result, we still suggest investors stay
cautious the first half. For bond investors, that means short maturity, high quality corporate bonds. Stock investors could stick to
defensive sectors like consumer staples, healthcare, and utilities.
If a stock market downdraft does happen, we would suggest using it as a buying opportunity. While earnings forecasts may be too
optimistic given modestly slowing growth, worries about a US recession later this year are overdone. Our proprietary recession
dashboard shows few signs of an impending slump.
The same is likely true for the Eurozone and Japan, indeed, most of the developed world. The global slowdown is centered in China
and the countries that depend on Chinese imports of goods and commodities. But, households in developed countries should not be
impacted much by the slowdown. Wage growth is picking up in the United States, the Eurozone, the United Kingdom, and Japan. Labor
markets in those countries are robust; US and Japanese jobless rates are the lowest in decades and by a decade in the Eurozone. So,
household incomes and consumer spending should stay healthy and prevent a broad-based recession.
Main Street prospers; Wall Street struggles: So, the divergence between the real economy and financial markets that shaped 2018 will
likely persist the first of this year. But, because the developed world should avoid a recession, any stabilization of growth in the second
half should bring a gradual rebound of stock markets.
That dichotomy between households and financial markets suggests that real estate, and maybe real assets in general, could avoid firsthalf financial struggles and provide decent returns for the year. With a little inflation and a decent economy, rental income from realestate may edge higher. Even commodity prices have not experienced as much downside volatility as financial markets. And with the US
dollar likely having peaked and the Fed on hold, commodities could offer some stability and opportunity as the global economy steadies
toward yearend.

Regional economic updates
The global growth slowdown from last year will continue in 2019. But, fears of a global recession are unconvincing. In fact, global
recessions are extraordinarily rare. Using the International Monetary Fund definition, there have been four since 1945: in 1975, 1982,
1991, and 2009. The growth divergence between the United States, Europe and Japan will hold, but with the US economy set todecelerate a bit, the growth differential will be less extreme. In China, weaker growth will persist; the question is whether stimulus keeps
a hard landing at bay.
United States: A long-lasting and robust US expansion will help keep the global economy out of recession. The imbalances thattypically bring a slump are just not evident. Consumer balance sheets have improved dramatically. Cyclical spending, i.e., durable goods

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.

and investment, usually peaks before a recession, but it’s still well below prior-cycle highs. Profit margins are still improving, opposite of
the usual tell-tale recession sign. US corporate debt is high relative to history, but low compared to Europe and Japan.
Economic growth likely decelerated to near 2% in the fourth quarter, but the strength in retail sales suggests consumer spending
growth steadied at a robust 3.5%. Less inventory accumulation and weak capital spending likely drove growth lower.
Looking ahead: Growth may decelerate from a strong 3% in 2018 to the mid-2% range this year. The shutdown could take a half
percentage point from growth in the first quarter, but will bring a nice rebound in the second quarter. Consumer spending should stayvery healthy this year, hovering near 3%. The labor market is showing remarkable strength despite the age of the expansion. Wage
growth is picking up and will surely accelerate more. Modest inflation pressures mean faster wage growth will bring higher real incomes,a solid base for household spending.
The investment outlook is mixed. Capital spending plans from business surveys, a leading indicator of spending, worsened with thenegative sentiment and market plunge in December. Credit spreads on corporate bonds, the yield difference between corporate andgovernment bonds, are still high versus last year’s low. So, corporate debt costs are higher even though US Treasury bond yields arelower. Other leading indicators for investment, profits and lending standards, are very supportive.
Housing should improve from last year’s soft patch because the fundamentals are strong. Mortgage rates are lower and mortgage
applications are rising over the prior year. Home builder sentiment improved a bit recently after hitting a three-year low. Household
formation is rising and the home ownership rate is well up off the lows.
With no recession in sight, this will surely be the longest US expansion in history. And with the labor market so strong, it has thepotential to be longer than most forecasters believe possible.
Europe: The industrial sector has still not found the bottom of the downturn. Manufacturing surveys for January were terrible.
November industrial production contracted month over month, with German output off nearly 2%. The problems in Germany seem
short and atypical, ranging from new auto emission standards to low Rhine river levels. And the yellow vest protests in France are likely
driving weaker numbers. But slowing global growth, particularly from China, is another culprit.
Looking ahead: Despite the weakness in manufacturing, the Eurozone should avoid recession. Growth will be modest, hopefullynear 1.5% for the year. France avoided a fourth-quarter contraction despite the protests. Labor markets are in good shape with the
unemployment rate falling below 8%, the first time in a decade. Wage growth is picking up; that will support consumer spending, which
has been the driver of growth. With downside risks to European growth, the European Central Bank will remain cautious. Any rate hikethis year has become less likely and another round of long-term bank refinancing is more likely.
Japan: The economy should grow around 1% or a bit more this year. Data have been somewhat mixed with the January business survey
slowing to 50.0, the breakeven between expansion and contraction. December exports fell more than expected. But, the labor market isthe best in decades. Despite a declining population, total employment is growing robustly, up 2.4% over 2017, as more women and older
workers find jobs. With an ultra-low jobless rate of a miniscule 2.5%, wage growth is accelerating.
China: Economic growth hit the slowest pace in 28 years last year as auto sales declined for the first time since records began.
December retail sales and industrial production did improve sequentially, suggesting some stabilization. Other data stays weak. The
Caixin survey of manufacturing companies dropped below 50.0, an indication of retrenchment. Imports declined 7.6%, the lowest pacesince summer 2016 signaling concerns about domestic demand. Producer price inflation weakened, implying potential deflation andfalling corporate profits. In fact, industrial profits declined for the first time since 2015. China has put a lot of stimulus into the system,
especially lower income taxes. But, if the money supply and loans don’t grow because of concerns about rapidly rising debt burdens,
China may not be able to do enough to stabilize growth.
Emerging markets: With the Fed on hold and the US dollar weakening, this may be a better year for emerging countries than 2018. In
fact, we expect emerging market assets to outperform those in the US for much of 2019. But a Chinese slowdown remains a key risk to
its closest trading partners and commodity exporting countries.

Baseline Economic Forecasts for 2018 - 2019
A. Growth in Real GDP - Qtr-Qtr (% Change, Annualized):

Real GDP

1st Quarter 18
2nd Quarter 18
3rd Quarter 18
4th Quarter 18
ActualActualActualForecast
18,324.0
2.2% 18,511.6
4.2% 18,665.0
3.4% 18,760.2
2.1%

2016 Actual2017 Actual
17,659.2
1.6% 18,050.7
2.2%

Personal Consumption Expenditures
Durable Goods
Non-Durables
Services
Gross Private Domestic Invest.
Bus. Fixed Invest.
Structures
Equipment
Intellectual Property Products
Residential Invest.
Change in Inventory
Net Exports
Exports
Imports
Gov't Purchases of Goods & Services
FederalNational Defense
Non-DefenseState & Local
Final Sales of Dom. Product
Final Sales to Dom. Purchasers

12,722.8
1,628.2
2,858.6
8,267.9
3,321.0
2,654.0533.3
1,250.9
875.7
615.3
30.3
-902.42,517.8
3,420.1
3,152.2
1,213.1
722.8
489.5
1,937.7
18,274.4
19,141.3

0.5% 12,842.0-2.0%
1,662.3
0.1%
2,886.7
1.0%
8,329.8
9.6%
3,316.7
11.5%
2,710.1
13.9%
551.7
8.5%
1,264.9
14.1%
897.9
-3.4%
613.2
-36.8
-841.03.6%
2,574.2
3.0%
3,415.2
1.5%
3,171.8
2.6%
1,224.0
3.0%
733.3
2.1%
490.1
0.9%
1,946.6
1.9% 18,515.9
1.9% 19,330.8

3.8% 12,953.3
8.6% 1,677.4
4.0% 2,919.2
3.0% 8,394.9-0.5% 3,436.2
8.7% 2,727.0
14.5%
546.9
4.6% 1,275.6
10.5%
910.2
-1.3%
607.7
89.8
-949.7
9.3% 2,542.2-0.6% 3,491.9
2.5% 3,192.0
3.7% 1,234.7
6.0%
742.2
0.5%
492.0
1.8% 1,956.3
5.4% 18,562.1
4.0% 19,471.6

3.5% 13,063.9
3.7% 1,698.0
4.6% 2,944.4
3.2% 8,444.8
15.2% 3,428.6
2.5% 2,758.4
-3.4%
551.0
3.4% 1,288.2
5.6%
923.6
-3.6%
612.2
35.0
-956.1-4.9% 2,561.7
9.3% 3,517.8
2.6% 3,203.1
3.5% 1,237.9
4.9%
744.0
1.6%
493.2
2.0% 1,963.6
1.0% 18,706.5
2.9% 19,638.2

12,248.2
1,476.8
2,763.9
8,022.5
3,050.5
2,411.2
494.7
1,116.2
803.9
591.3
23.4
-786.2
2,378.1
3,164.4
3,132.5
1,187.8
709.2
478.0
1,942.8
17,617.5
18,387.2

2.6%

2.9%

3.0%

2.9%

year-over-year

2.7% 12,558.7
5.5% 1,577.9
2.7% 2,822.0
2.3% 8,184.5-1.3% 3,196.6
0.5% 2,538.1
-5.0%
517.5
-1.5% 1,183.7
7.5%
841.1
6.5%
611.1
22.5
-858.7-0.1% 2,450.1
1.9% 3,308.7
1.4% 3,130.4
0.4% 1,196.4
-0.6%
713.8
1.9%
481.9
2.0% 1,932.3
2.1% 17,769.1
2.3% 18,550.0

2.5%
6.8%
2.1%
2.0%
4.8%
5.3%
4.6%
6.1%
4.6%
3.3%
3.0%
4.6%
-0.1%
0.7%
0.7%
0.8%
-0.5%
0.9%
0.9%

Real GDP

1st Quarter 19
2nd Quarter 19
3rd Quarter 19
4th Quarter 19
Forecast
Forecast
Forecast
Forecast
18,869.1
2.3% 19,002.0
2.8% 19,119.7
2.5% 19,232.5
2.4%2018 Forecast
2019 Forecast
18,565.2
2.9% 19,055.8
2.6%

Personal Consumption Expenditures
Durable Goods
Non-Durables
Services
Gross Private Domestic Invest.
Bus. Fixed Invest.
Structures
Equipment
Intellectual Property Products
Residential Invest.
Change in Inventory
Net Exports
Exports
Imports
Gov't Purchases of Goods & Services
FederalNational Defense
Non-DefenseState & Local
Final Sales of Dom. Product
Final Sales to Dom. Purchasers

13,138.7
1,708.5
2,962.6
8,490.9
3,460.3
2,785.6
555.0
1,297.7
937.1
616.7
35.0
-961.52,580.7
3,542.2
3,210.8
1,240.7
746.8
493.2
1,968.5
18,815.3
19,752.4

12,895.5
1,666.5
2,902.2
8,359.4
3,375.6
2,712.4
545.7
1,269.9
901.8
612.1
29.6
-912.32,549.0
3,461.3
3,179.8
1,227.4
735.6
491.2
1,951.1
18,514.7
19,395.5

2.3% 13,243.0
2.5%
1,725.3
2.5%
2,995.4
2.2%
8,545.6
3.8%
3,484.2
4.0%
2,809.9
3.0%
559.2
3.0%
1,304.2
6.0%
950.9
3.0%
621.3
30.0
-966.93.0%
2,599.8
2.8%
3,566.7
1.0%
3,220.9
0.9%
1,245.9
1.5%
749.6
0.0%
495.7
1.0%
1,973.4
2.3% 18,953.2
2.3% 19,895.7

3.2% 13,330.4
4.0% 1,740.2
4.5% 3,021.3
2.6% 8,592.2
2.8% 3,509.9
3.5% 2,831.0
3.0%
563.3
2.0% 1,310.6
6.0%
961.4
3.0%
625.9
30.0
-971.2
3.0% 2,618.5
2.8% 3,589.7
1.3% 3,229.9
1.7% 1,250.0
1.5%
752.4
2.0%
496.9
1.0% 1,978.3
3.0% 19,071.0
2.9% 20,017.8

year-over-year
3.0%
2.6%
Source: U.S. Dept. of Commerce, Bureau of Economic Analysis; Principal Global Investors

#

3.5%
5.0%
3.5%
2.4%
-0.9%
4.7%
3.0%
4.0%
6.0%
3.0%
3.1%
3.0%
1.4%
1.0%
1.0%
1.0%
1.5%
3.1%
3.5%

Classification: Company Confidential

2.4%

2.7% 13,412.6
3.5% 1,753.1
3.5% 3,043.7
2.2% 8,639.0
3.0% 3,534.1
3.0% 2,855.6
3.0%
567.5
2.0% 1,320.4
4.5%
972.0
3.0%
630.6
25.0
-972.8
2.9% 2,634.7
2.6% 3,607.5
1.1% 3,237.9
1.3% 1,253.1
1.5%
754.3
1.0%
498.1
1.0% 1,983.2
2.5% 19,188.8
2.5% 20,137.2
2.5%

2.5%
3.0%
3.0%
2.2%
2.8%
3.5%
3.0%
3.0%
4.5%
3.0%
2.5%
2.0%
1.0%
1.0%
1.0%
1.0%
1.0%
2.5%
2.4%

2.7% 13,281.2
5.6% 1,731.8
2.8% 3,005.8
2.1% 8,566.9
5.6% 3,497.1
6.9% 2,820.5
5.4%
561.2
7.3% 1,308.2
7.2%
955.3
0.2%
623.6
30.0
-968.1
4.0% 2,608.4
4.6% 3,576.5
1.6% 3,224.9
2.6% 1,247.4
3.1%
750.8
1.9%
496.0
1.0% 1,975.9
4.2% 19,007.1
4.6% 19,950.8

3.0%
3.9%
3.6%
2.5%
3.6%
4.0%
2.8%
3.0%
5.9%
1.9%
2.3%
3.3%
1.4%
1.6%
2.1%
1.0%
1.3%
2.7%
2.9%

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 of
future 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
regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are
subject to change without notice. Any reference to a specific investment or security does not constitute a recommendation tobuy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a
specific security for any client account.
Principal Financial Group, Inc., Its affiliates, and its officers, directors, employees, agents, disclaim any express or implied
warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document orin the information or data provided in this document.
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attributed to Principal Global Investors. Principal Global Investors disclaims any and all express or implied warranties of reliabilityor accuracy arising out of any for error or omission attributable to any third party representation, example, or data provided
herein.
All figures shown in this document are in U.S. dollars unless otherwise noted.
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