Principal Global Investors

Economic Insights: Was the bond market right?
May 2019
Commentary by Robert F. Baur, Ph.D., chief global economist, andRobin Anderson, Ph.D., senior global economist

For the first time since early 2016, astute colleagues are asking about the odds ofa U.S. recession this year. As the May stock market downdraft gathers steam, thisworry spreads.
But there are two markets sending signals, each transmitting different messages.
On the stock side, the S&P 500 Index soared 25.3% from late December to its peak at April’s end, whichsuggested the world economic slowdown was ending and growth would soon pick up. Similarly, in China,
prices of local stocks blew higher as tax cuts, lower required reserves for banks, rising infrastructure
spending, and more loans to small businesses were expected to boost China’s flagging growth. The
Shanghai Composite index shot up 32.7% on those hopes from early January to mid-April.
In contrast, yields on safe-haven government bonds in the United States, Germany, and Japan started
sinking in late fall last year and were still making new lows at the end of May. Yields on 10-year U.S.
treasury bonds plunged more than 1.0% from the November high of 3.24%. Yields on similar maturity
German bunds and Japanese government bonds are below zero—those are near-record lows. The
collapsing yields suggested bond investors feared the stock market optimism was unjustified, theeconomic setbacks weren’t over, and the worst perhaps was yet to come.

Two markets, two messages.
Stock market optimism carried through early May. First quarter growth in Europe, Japan, China, and the
U.S. was all better than expected. But with setbacks in recent U.S. and China economic data, and thebreakdown of U.S./China trade talks, the bond market prophecies have proven psychic so far.
Bond investors were right about the length and severity of the global economic stumble that began lastyear. A sizeable buildup of U.S. wholesale inventories led to a months-long stagger in industrial output andbrought the May plunge in business surveys to just above contraction levels. Those excess inventories will
impede any U.S. recovery from this mid-cycle slowdown. Business surveys in China fell back a bit in April
after a few months of gains. Tough U.S./China trade talk is adding to the gloom, casting a pall over futurebusiness investment.
We’d guess the current gloom is overdone. Excess inventories, absent other imbalances, aren’t usually thecause of recessions.
Further, U.S. and German stockpiles are already declining. Too much inventory leads to price discounting,which may be the reason inflation has been so quiescent this year.
We expect trade negotiations of some sort will resume after mid-year. If that happens, growth will pick up
and make this the third mid-cycle slowdown since the financial crisis.
We look for world growth to exit last year’s slowdown as 2019 progresses.
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.

Interest rates: Still waiting for better growth
Throughout May, major stock indices plunged as investors actively sold equities, opting for safe
government bonds. Yields on long-term U.S. treasuries fell the whole month. Minutes from the last
U.S. Federal Reserve (Fed) meeting signaled there was little reason to change the fed funds rate forsome time into the future. The yield curve inverted at the short end.

What’s ahead?
Since the holidays, the bond market fretted that global growth had downside risk. That fear turned
to fact, as it’s clear growth isn’t yet recovering from last year’s downward lurch. The new worry
seems to be that deadlocked U.S./China trade talks, with little chance of resumption before fall, will
create an even more meaningful slowdown.
In the short-term, all this suggests that long-maturity government bond yields have little upside risk
and stock markets have more downside risk.
Fed funds
The Fed is now “patient,” i.e., on hold, dependent on new data that may alter their plans. However,the Fed’s sharp about-face from super-hawkish, and a hike in December to January’s dovish
turnaround, was surely motivated by the stock market collapse late last year. So, the Fed is clearlysensitive to market downdrafts.
If the current equity stumble extends and economic growth keeps stalling, we’d guess the Fed will
cut rates in June or July—maybe both.
Long-term rates
There could be slightly more downside risk to government bond yields over the next month or
so. But structural forces should eventually push yields higher late this year, in 2020, and possibly
beyond. The disinflation brought about by two decades of globalization is fading. Central banks aretrying to create inflation. Price discounting from excess inventories will end by late fall. Tight labormarkets and accelerating wage gains will pressure companies to raise prices. The global savings
glut—described by former Fed Chair Ben Bernanke to explain lower-than-expected long-dated
yields—is over.
We think a mild inflation surprise will occur late this year or at least in 2020. Investors will demanda premium for potential inflation, so the eventual direction for long-maturity U.S. treasury bondyields is up.

Stock market: investment environment changing
Main Street still prospers while Wall Street struggles. Tight labor markets and robust wage gains
are great for households and businesses even as financial markets flounder. Few world stock indices
are higher than a year ago. Bond investors had good returns since the holidays but have been flat atbest since late 2017.
But the long investment cycle from 2009 through early 2017 is waning as the accommodating
economic backdrop changes. That near-decade of very slow growth, fear of relapse, and super-low
interest rates and inflation meant excellent returns for investments in safe-haven government
bonds and U.S. stocks, especially growth and tech.
As fundamentals shift, what propels the next investment cycle will change, too.

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.

Reversals happen
We believe the driver of the next cycle will be a modest inflation surprise and the upward pressure it
puts on long-term interest rates. Inflation that visibly approaches or surpasses central bank targets
would reverse the trends that provided such great returns over that last cycle. It would bring a bearmarket in government bonds and distress in credit markets.
Even mildly higher interest rates suggest that value stocks could outperform growth, and that
financials might offer better returns than the tech darlings of the last decade. Once last year’s
sluggish growth phase ends, better global growth and less fear of relapse could lead to a peak in the
U.S. dollar and the underperformance of U.S. stocks versus those in Europe or the United Kingdom,
as well as currencies like sterling, the euro, and the yen.
Transition
We’re likely in a transition period from the end of one cycle until the new one gathers intensity. Thissuggests markets could remain trendless with poor overall returns a while longer.
Such a dramatic change in market leadership or investment cycle doesn’t occur overnight. Inertia
and reluctance to sell past winners mean investors need time to recognize that the backdrop haschanged. That’s what happens in a transition. Past leaders fail. New ones gain momentum.
For example, in equity markets, central banks are likely protecting against massive downdrafts, but
April’s high valuations mean the upside is limited.
Trendless markets, indeed.
Investment implications—and a word of caution
We’ve been singing the same cautious tune for some time and it’s still the right song.
We like short- to medium-term, high-quality bonds, whether credit or government. In equities, we’dstick to defensive sectors for now, but, shorter-term investors might look for a moderate buying
opportunity this summer as last year’s slowdown fades. We like commercial real estate, as rents canstill rise with mild inflation even if property prices are capped by higher long-term yields. Real assets
in general, like farmland, commodities, or gold, may become more trendy than financial assets if thenext cycle materializes.
The risks, however, are real and significant. We’ll cover this more deeply in the next section, but theworld economic slowdown isn’t over yet and renewed tough trade talk creates new uncertainties
for business. Potentially extending new tariffs to Mexico was a real surprise. Even if it was merely
a negotiating tactic, it creates doubt about the permanence of other trade deals. In addition,
the existing tariffs, as well as ambiguity about future deals, could easily curtail profits and delay
business investment decisions and hiring, extending anew the current economic lethargy.

World economy: a rerun of 2015?
As the old saying goes, history doesn’t repeat itself, but it rhymes.
Today’s economic backdrop looks a lot like 2015. At that time, a decelerating China pulled down
global growth. Excess capacity sent commodity prices tumbling and the dollar soared. The U.S.
industrial sector fell into recession as the oil industry reeled from decade-low prices and weak global
trade weighed on manufacturing.
Fast forward to now, with global trade suffering aftershocks from China’s slowdown. U.S. industrial
production is waning and business surveys have plunged. This time around, global growth is slowing,
inventories are too high, and trade uncertainties are hurting business confidence.

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.

As in 2015, this latest pullback will end. Yes, Chinese activity has weakened anew, and elevated tradetensions may further derail whatever green shoots were visible. So a world growth pickup may be delayeda few months.
Still, the first quarter rebound in Chinese data, decent Eurozone economic growth, and improving consumer
confidence are tentative signs that a rebound is ahead. A growth pickup in the U.S., China, and Europe will
help propel the rest of the world economy.
Here’s a deeper look at each of those sectors:
United States

The weakness in manufacturing activity hasn’t yet fed through to consumers. The
labor market is fantastic. Consumer sentiment is at or near cycle highs reflecting thatstrength. Real consumer spending is up 2.1% (3-month annualized growth) in April,up from near 1.3% in the first quarter. Home builder sentiment has jumped; homemortgage applications are trending higher even though April home sales were a bit
weak. Inflation is non-existent, perhaps an impact of price discounting in inventories.
First quarter’s measure of core consumer expenditure inflation (ex food and energy)
was revised down to 1%.
Looking ahead
A pickup in U.S. growth may be delayed. Second quarter growth is nearly stagnant as
inventory accumulation falls. The weakness in capital goods orders suggest investment
will stay tepid. Consumer spending should bounce back from a first quarter hiccup.
Manufacturing will likely pick up later in the year as companies should’ve worked
through inventory overhangs. A rebound in global growth may provide an additional
tailwind. We still expect 2.0% to 2.5% real economic growth this year.

EuropeActivity bounced in the first quarter. Even as manufacturing surveys signaled decline,
our own Euro area business indicator picked up from its December low. Germany grew
nicely after its economy stagnated late last year. Euro area wage growth accelerated
to a new cycle high, a strong positive sign for consumer spending. The German joblessrate did tick up a tenth, but a large share of that jump may be due to a reclassificationof workers.
Looking ahead
Europe should grow in the 1.0% to 1.5% range this year, at trend or slightly below.
The services sector has held up well, supported by the robust labor market and thatshould persist. The risk is that worsening sentiment from new trade tensions could start
to affect hiring decisions. On the upside, if global growth does pick up, exports andmanufacturing will rebound.

China

Growth weakened after the healthy rebound at the start of the year. The employment
index in a key manufacturing survey dropped to the lowest level since 2009. Someof the strength in the first quarter—particularly in industrial production—may havebeen overstated, a typical feature of Chinese data. Better-than-expected growth in thefirst quarter suggested China would slow its impressive fiscal stimulus. But lackluster
April and May data, plus more tariff tension, means broad-based stimulus will makea comeback.
Looking ahead
Growth in China has likely stabilized and will likely strengthen somewhat as the year
progresses. Renewed stimulus in the face of heightened U.S. tariffs will prevent a further
weakening in activity. The Chinese service sector is expanding and fairly robust, which
will keep overall growth near the official target.

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.

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.
Any representations, example, or data not specifically attributed to a third party herein, has been calculated by, and can be
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.
This document is issued in:Japan by Principal Global Investors (Japan) Ltd. (Kanto Local Finance Bureau (Kinsho) No. 462,
Japan Investment Advisers Association,
The Investment Trusts Association, Japan
This material is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such
distribution or use would be contrary to local law or regulation.
©2017 Principal Financial Services, Inc. Principal, Principal and the symbol design and Principal Financial Group are trademarks
and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group. Principal Global Investors is theasset management arm of the Principal Financial GroupDisclosures
本書は情報の提供のみを目的として作成されたものです。本書中の情報は、弊社及びプリンシパル・
ファイナンシャル・グループの関連会社において信頼できると考える情報源に基づいて作成していますが、適用法令にて規定されるものを除き、本書中の情報・意見等の公正性、正確性、妥当性、完全性等を保証するものではありません。本書中の分析、意見等はその前提が変更された場合には、変更が必要となる性質を含んでいます。本書中の情報は、弊社の文書による事前の同意が無い限り、その全部又は一部をコピーすることや配布することは出来ません。
また、本書中の情報はあくまでも投資に関する一般的なものであり、投資に関する完全な情報が記載されているものとして依拠されるべきではありません。 本書中の情報は貴社の投資目的、特定な
ニーズ、または財政状況を考慮したものではありません。投資判断をする前には、その投資がお客様の投資目的、特定なニーズ、および財政状態にとって適切であるかをご検討ください。
MSCI指数は、MSCIが開発した指数です。当指数に関する著作権、およびその他知的財産権はMSCIに帰属しており、書面による許諾なしにデータを複製・頒布・使用等することは禁じられております。MSCIおよびその関係会社は、データの独創性、正確性、完全性、商品性、使用目的への適合性について保証するものではなく、当指数の使用に伴ういかなる責任を負いません。
記載の内容は過去の実績値であり、将来を約束するものではありません。

プリンシパル・グローバル・インベスターズ株式会社
住所：〒100­0011 東京都千代田区内幸町1­1­1 帝国ホテルタワー１1階
電話：03­3519­7880（代表） ファックス：03­3519­6410
代表者：代表取締役社長 板垣 均
ホームページ：http://www.principalglobal.jp
金融商品取引業者登録番号：関東財務局長（金商）第462号
加入協会：一般社団法人 日本投資顧問業協会
一般社団法人 投資信託協会