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Principal Global Investors

Economic Insights: Roaring into recession
April 2020 commentary
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist

The world economy began a pandemic recession inFebruary. It arrived in the United States in March. Equity
and credit market pain was intense because the range ofcredible downside outcomes was so wide.
There were no safe havens.
A temporary equity trough may have been reached on
March 18, but market turmoil will persist until the count of
new virus cases peaks.
Unprecedented fiscal and monetary measures should keep
the virus recession from morphing into an insolvency crisis
with prolonged financial upheaval.

Recession likely began in March
It will be impossible to avoid a contraction of world economic
output with production and consumption being
drastically curtailed• Growth in China in January and February fell, and savagely, forthe first time since records began.
• Industrial production plunged 13.5%.
• Vehicle sales shrank 41.9% and retail sales collapsed 20.5%, allfrom the prior year period.
• Surveys of purchasing managers plummeted in Europe, Japan,and the U.S., some below the level of the financial crisis.
• Regional Federal Reserve (Fed) surveys of manufacturers
in New York, Kansas City, and Philadelphia nose-dived into
retrenchment territory.
• High-frequency U.S. data on restaurant visits, airline travel, andbox office receipts have fallen 90% or more.
• Initial claims for U.S. jobless compensation surged to 3.28million more than four times the prior week record from 1982.
The growth hits are staggered, based on the onset of virus
infections. China, where the virus originated in December, had
its worst shutdown in February. Businesses have since restarted
and will be mostly back in production soon. Rush-hour trafficmonitors show many Chinese cities fully back to normal.
Weekend traffic has been mostly nonexistent until last weekend.
Economic activity in Japan and South Korea likely troughed whilemost of Europe and the U.S. is still closed.
Our U.S. Recession Dashboard tells us recession risk is high, butsimple observation suggests it started in March. Our forecasts
convey a first quarter contraction of gross domestic product(GDP) near 3%, followed by an historic slump over 10% and athird quarter tumble around 2%.
Growth should revive in the fourth quarter. Here’s why.

RecoveryHow do we get out of this? Not gonna happen until new cases
peak and businesses restart.
China’s major outbreak began January 15, new virus cases
peaked mid-February, and businesses began to reopen in thefollowing two weeks. By the end of February, new cases had
fallen more than 90%. In February, virus problems in Europe
appeared first in Italy. Italy’s new cases seem to be stabilizing
with a peak so far on March 21. The crest may be near in Spain as
well. If the U.S. faces a similar cycle, new cases should max out in
1-2 weeks. Perhaps, some light at the end of a very long tunnel.
Further, consider a recession: the period between the peak of an
expansion and trough of the downturn. It’s a decline in economic
activity lasting a few months, impacting real income, wholesaleretail sales, employment, industrial production, and GDP.
Typically, recessions begin from imbalances that build toward
the end of an economic expansion. Debt gets too high, defaults
surge, bad loans cause banks to fail; the Fed hikes rates markedly;
oil prices spike; inflation rages; fast wage gains turn profits intolosses; a profit plunge brings layoffs and joblessness; consumers
lose confidence and cut spending. None of that has yet
happened. This time, recession was a deliberate policy choice toslow the spread of an infectious virus.
This is a far different type of contraction—its origin a shock—so it may unfold in an atypical fashion. It’s already triggered
massive fiscal and monetary responses by governments andcentral banks. Nothing in history is remotely comparable: a$2.2 trillion U.S. rescue package on top of more than $100
billion in prior relief, plus trillions of debt purchases by the Fed.
The European Central Bank (ECB) authorized €750 billion in
new bond purchases with fewer country limits. Official interestrates are near-zero most everywhere. Big relief measures in theUnited Kingdom, Australia, Japan, New Zealand, Norway, Canada,
Switzerland, India, Sweden, Taiwan, and Singapore, to name a few.
With this huge support effort, U.S. households may not suffer
the collapse in confidence that comes with a typical recession.
Yes, unemployment will surge from business closures. But if theExpressions 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.

downturn is unrelated to economic imbalances and possibly
short, businesses and consumers may look beyond the shutdown
shock to a growth revival and come back online more quickly.
At least, that’s the hope. Right now, forecasts are only guesses.

The equity risk is a full 50% decline in the S&P 500 Index to the1700 level, another 20% or so down from the March low. Whileplausible, the colossal relief packages suggest this isn’t the most
likely outcome.

An economic future

Investment ideas

Second quarter growth outside Asia will be horrific. A decent
rebound should be evident in the U.S. sometime in the thirdquarter; the income supplements will make up for a lot of lostwages. If problems last longer, more money will be sent fromWashington; Congress is already talking a Phase 4 bill. The
gradual restart to the U.S. economy will prevent any V-shapedsurge. Still, the U.S. could revert to trend growth in the fourth
quarter and 2021. The rebound will be slower in greater Europe
and Japan and start later in the year.
We’d caution against getting too wrapped up with spreading
horror forecasts of U.S. growth. Besides, a therapy may soon beavailable: Warmer weather could hinder the virus’ spread andcooped-up families will want to see the sun.
The outbreak of Covid-19 will have long-lasting but unknown
consequences. Globalization had been fading anyway, but is thisits death-knell? Will this stint of massive working-from-home be
the doom of centrally located office space? Will home delivery
from online sources crimp retailers and malls even further? Whatwill be the relationship between the U.S. and China as China
stresses the advantages of an authoritarian state and builds
alliances in Europe? Can schools and universities ever be thesame after a few months of forced online classes?
So many questions, so little clarity.

Focus on markets
March was ugly. A few U.S. treasury bond indices did show
positive returns; wheat and gold prices rose, but few investors
were so positioned. Not one of the 47 world stock indices wefollow rose. The equity market collapse was so brutal because therange of credible downside outcomes was so large.
Stock markets in China were leading performers as the country
was the first to recover from the virus. The Shanghai Composite
Index only fell 4.0% and 9.4% for the quarter. The S&P 500 Index
plunged 11.0% and 18.6% for the quarter. Even with a ferocious
three-day rally, that index is still down 25.1% from its peakthrough March 27. It’s still one of the better performing world
equity indices.
The speed and severity of the month-long waterfall suggest it
was driven partly by panic. It was exacerbated by forced sellingfrom quantitative funds that must maintain certain risk levels, i.e.,
the further markets fall, the more you have to sell. That’s akin to
the selling generated by “Portfolio Insurance,” which accelerated
the massive drop on October 19, 1987, Black Monday. Forced
selling seems mostly over.
The risk for markets is that this sudden economic downdraft
turns into another financial crisis, as it could if the cash crunchfor small businesses from widespread closures results in defaults.

In short, it’s likely too early yet to buy. The assumption behind
our investment strategy is that the virus contagion in the U.S.
and Europe will follow a path similar to China. The economic
disruption should begin to fade late in the second quarter. Thismeans growth should return through the summer. The net result
is that stock markets could recover a good share of their recent
losses in the second half of this year.
If growth returns, the plummet has run its course. We expect
markets to thrash in a wide range until new cases peak andEurope and the U.S. start back to work. Even so, disaster worries
may return and prompt a relapse that retests or exceeds theMarch low. Since growth should come back later in the year, that
retest, perhaps in May or June, would be a good time to moveequities to overweight in individual portfolios.
On a six- to nine-month outlook, we prefer cyclical sectors todefensive, i.e., financials, consumer discretionary, materials, andtechnology rather than recent outperformers such as healthcare, utilities, or consumer staples. With super-low interest rates
and the U.S. dollar likely to weaken further, we’d prefer emerging
market stocks to those in developed countries outside the U.S.
Interest rates are likely to stay very low. The Fed and other central
banks aren’t likely to raise official rates until well into 2021. The
revival of growth, though, should put modest upward pressure on
long-term interest rates. That would steepen the yield curve andbe good for financial stocks. That’s already begun. Yields on safehaven government bonds are so low as to be unattractive forlong-term investors. We’d avoid long-maturity safe-haven bonds:
U.S. treasuries, German bunds, and Japanese government bonds.
Credit spreads on high-yield bonds have widened dramatically,
but it’s the bonds of energy companies that have driven thewidening given the nose-dive in oil prices. Yields on non-energy
bonds may not yet be high enough to offset the risk of further
downgrades. We like bonds that the Fed is buying: high-quality
investment grade and municipal bonds over high-yield. Still,some high-quality, high-yield bonds may offer a bit more yield.
We’d stay with short-to medium-term corporates and municipals.
The Fed will be active in these markets, keeping prices
from collapsing.
All these suggestions are tactical in nature. Long-term investors
should consider whether the virus onset and massive fiscal andmonetary relief packages under way will alter the investment
climate of the 2020s. We think so; it may be vastly different thanwhat occurred post March 2009. As the underlying financialframework changes, significant market dislocations, i.e., bearmarkets, usually occur. Those bear downdrafts have often been
the line of demarcation between two dissimilar investment
environments. We’d guess this bear market is no different.

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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