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Principal Global Investors

Economic Insights: Severe recession, unprecedented reboundUpdate for the month of October 2020
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist
The world recovery from the COVID-19 lockdown and recession
has turned uneven. China’s rebound continues apace. TheUnited States’ revival remains robust with solid momentum
going into the fourth quarter. A resurgence of virus activity
across Europe and Japan has nearly flattened economic growthsince July, delaying their recoveries. Equity markets havesuffered their familiar September volatility and setbacks, which
will likely continue through year end.
A mild uptrend should reemerge in the New Year if expectationsof strong profit growth are realized.

Patchy world recovery
The lockdown response to the surge in COVID-19 infections andfatalities brought unparalleled economic devastation and record
job losses in March and April. The rebound in the following few
months was just as incredible, but in reverse, in job gains andeconomic revival. That spectacular resurgence of growth hasturned into an ongoing expansion in some places, one with amore sustainable pace. However, the recent surge in COVID-19
infections in parts of Europe and Japan is impeding their return
to normalcy.
Recent U.S. data support an optimistic economic view for current
robust growth and its continuation into next year. Businesssurveys of purchasing managers by Market News for thecomposite and manufacturing indices are the highest since early2019. Most regional Federal Reserve (Fed) business surveys are
the highest since late 2018. Capital spending is returning witha vengeance; new orders of capital goods excluding aircraft in
August surpassed year-ago levels and shipments of those goods
were nearly flat with last year. Business confidence is still below
pre-COVID levels; but it’s rising and far above what prevailed
during the financial crisis.
Households are participating enthusiastically in the rebound.
Housing activity is spectacular with robust home sales, record
homebuilder confidence, super-low mortgage rates, risingaffordability, and home purchase mortgage applications way
above last year. JP Morgan Chase credit/debit card data on
non-recurring consumer spending was 5.8% below last year
for the week ending September 18; outside of a spending
surge around Labor Day, that’s the best since March. Data fromtracktherecovery.org (here) shows average spending for the
first two weeks of September down 2.7% from January versus
an August average of 5.0% and progressively worse for Julyand June. Consumer spending also showed little decline fromthe July 31 end of the $600 supplemental jobless benefit.
Confidence is still below pre-pandemic levels, but is resilient
and rising; the Bloomberg measure of the Consumer Comfort
Index is the highest since April 5.

The drop in daily new U.S. COVID-19 cases from the surge inJuly flattened out in September after falling by a third in August(here). Fortunately, the number of fatalities is still falling gradually,
with the latest seven-day moving average on September 29 of728. So, high-frequency data is slowly advancing. OpenTable
data on restaurant seatings and Transportation Security
Administration traveler counts are improving.
Third quarter U.S. real gross domestic product (GDP) should
show a mammoth rise of 25% to 30%. Unless there’s anothersurge in virus activity, the U.S. economic revival has several
reasons to stay on track in the fourth quarter and through 2021:• Consumer spending has been growing faster than output;
inventories are very lean, which bodes well for further gains in
hiring and output.
• Vigorous housing activity means healthy job growth inrelated areas: construction, lending, appraisal, sales,furniture and materials.
• Initial claims for jobless benefits stay high, but, continuing
claims are falling, suggesting new hiring is much greater than
new layoffs.
• The $300 weekly jobless benefit retroactive to August 1 is
helping sustain consumer spending.
• The household saving rate is a high 14%, giving consumers thewherewithal to spend.
• Auto production is still rising.
• Monetary stimulus works with a lag, so the economic boost will
persist through 2021.

With these lifts, fourth quarter U.S. GDP should be in the 6% to8% range. Without a safe, effective and available vaccine, growthin 2021 could slow to trend of 2.5%, as many of the temporary
business closures and furloughs become permanent.
China is the other driver of world growth as their astonishingrebound from the COVID-19 recession marches on. Industry
reports for August were healthy. The manufacturing businesssurvey by Market News, at 53.1, is almost a decade high.
Industrial output is now 5.6% over last August and has recoveredback to the prior uptrend line. Fixed investment is just a touch
below a year ago. Credit growth is surging. Exports accelerated
to a gain of 11.6% with solid demand from the rest of the world.
House prices are up 4.9% from last year and property sales
volume is surging. Retail sales were above year ago levels forthe first time this year as the recovery broadens out. We expect
steady growth well into 2021.
A second wave of virus infections in greater Europe and Japan
has already dampened their recoveries. Markit News indicesof Eurozone business surveys weakened fairly dramatically inExpressions 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.

September. The composite index lost nearly two points and at
50.1 just barely shows expansion. The details point to a hugedichotomy between services and manufacturing. The rise in newcases is hardest on the service sector as many Eurozone countries
rely heavily on tourism for growth. Manufacturing is in a solid
expansion with the index at 53.7%, well above breakeven. Still,even the rise in German business confidence has slowed. United
Kingdom business surveys and other data show a very strong
rebound through the summer that has been slowed recently byanother wave of virus activity.
A fading revival is a similar story for Japan. Market News indicesof Japanese purchasing manager surveys are stuck in contraction
territory. While there have been sizeable rebounds in consumer
spending, industrial output, and business and consumer confidence,
they all remain well below pre-COVID levels. The surge in daily
new cases in greater Europe and Japan may be due in part tomuch greater testing as it hasn’t been accompanied by a rash ofhospitalizations and fatalities. We expect their recoveries to resume
in the fourth quarter.

Looking ahead
The world recovery from the devastating recession continues apace,but has turned uneven, given the eruption of virus cases in greater
Europe and Japan. Revivals in the U.S. and China are driving world
growth. Commodity price rises have stalled a bit in September but
are holding most of the gains since March. This validates the global
economic renewal as well as prospects for its continuation.
Monetary accommodation by central banks will keep short-termyields low for years.
Did the COVID-19 recession reset the world economy to begin
another long expansion? Or is this rebound just a nice lull after
which the ills that built up during the prior long upturn will reassert
themselves? The jury is still out on that question just yet. But
whatever broad profit snags that existed in early 2020 are being fixed
as businesses use this opportunity to cut costs, raise productivity, andextend debt maturities with interest rates at multi-century lows.
A safe, effective, and widely available vaccine would surelyupgrade the prospects for a new, long-lasting uptrend. Absent aserious second virus wave this fall and winter, the world rebirthwill march ahead.

Will interest rates, inflation stay low?
The change in Fed policy and the comments after the September

Fed meeting practically guarantee that the fed funds rate will stay in
its 0% to 0.25% range until 2023. With negative official rates in theEurozone and Japan, the Bank of England is thinking about joining
the NIRP (negative interest rate policy) posse of central bankers.
Promises of substantial bond purchases by most developed country
central banks, coupled with short rates anchored near zero for years,
keeps significant down pressure on yields of long-term government
bonds. It will be hard for yields on 10-year U.S. Treasury bonds to riseeven to 1% much before early 2021.
What about after that? The dramatic change in Fed policy to“average inflation targeting” was designed to convince investors
it was serious about more inflation. The Fed has wanted togenerate a little inflation ever since the financial crisis but has been

unsuccessful. The change to a target of average inflation mostly had
the effect of pointing out that monetary policy may be, or is already,losing its effectiveness.
Because of that failure, the most important policy change isn’t thenew monetary accommodation. It’s the combination of determinedmonetary ease, mammoth fiscal stimulus, and the lack of muchbudgetary restraint, especially in the U.S.
In addition to this significant change in policy, the COVID-19 crisis has
accelerated the reshoring of some supply chains back to their homecountries. For over two decades, globalization has lowered inflationby companies employing low-wage workers in China and otheremerging countries to keep production costs low.
As globalization fades, the low inflation it fostered may dwindle with
it. Merging the impact of fiscal and monetary policy shifts with thequickened trend to reshoring, it’s difficult to imagine that the decadeof the 2020s will not see a little more inflation than the consensus
believes possible.

Financial market outlook
In late August, the stock market seemed primed for a correction.
September and October have historically been volatile and subject
to sharp downdrafts. Markets had a huge run since March andthe leaders were priced for perfection. Investors were very bullish;
downside protection was extremely cheap since few thought it wasneeded. It happened as September was not a pretty month for mostfinancial markets. Japan was one of the few countries where broad
market indices ended ahead. With government bond yields staying
flat for the month and credit spreads widening a bit, few bond indiceshad good returns.
Even so, underlying equity fundamentals seem mostly okay. The
world recovery is continuing. Profit growth will be picking up. Absent
a serious second wave, it’s hard to see the catalyst for a severe
downside move. Nevertheless, the volatility and moderate weakness
of September could easily persist through the end of the year. TheU.S. election season will stay uncertain and the outcome may not
be known for a while. Equity weakness could be triggered no matter
who wins. At some point, economic reports will come in below
expectations.
While caution is warranted in the near-term, the odds favor moderate
equity upside over the next year. The Fed and other central banks
will stay aggressively easy. More fiscal spending will surely be coming.
It appears a vaccine will be on the horizon early next year helping
households and businesses return to some normalcy. Profit growth
will resume as companies are firmly cutting costs. Further stock
market weakness in the fourth quarter could create investment
opportunities for next year.
The momentum of the favorite tech stocks faded in September. Andwith reflation likely coming, we’d move to sectors that do well whengrowth picks up, like materials and industrials. Financial stocks should
do well in that environment, too, as the yield curve should steepen,
but aggressive monetary policy has prevented that. Overall, we’d
prefer U.S. stocks but believe that reflation will help push emerging
market equities higher in the next year too.
On a one-year horizon, we’d prefer stocks to bonds as bond investors
will have a hard time finding good returns. Yields on safe haven

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.

government bonds are so low, we’d avoid them. Within the bonduniverse, corporate or emerging market bonds with their slightly
higher yields should be favored. That’s with a couple of caveats. To
prevent losses from higher long-term interest rates, one could stick
to shorter maturities, like two to four years. And while credit spreads

could narrow a little further next year, we’d prefer staying with higher
quality bonds in whatever risk bucket fits one’s risk tolerance.

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