Principal Global Investors

Economic insights:
The long awaited pickup is here
December 2019
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist, andRobin Anderson , Ph.D., senior global economist

Recovery from the long economic
downturn? We think it’s almost here.
Economic data has improved. Stock markets
have anticipated the new mood as major
United States indices plumbed record highs.
This positive turn of events could lastthrough 2020. The rebound will likely not
be as strong (nor last as long) as those that
followed the two other mini-recessions after
the financial crisis.
Late next year might be a good time toturn more cautious, as problems could
surface in 2021.

A never-ending slowdown:some background
Never-ending was certainly how it seemed. This latest
economic slump began in China in late 2017 and world
growth has gradually lost steam ever since. It hit first in
developing countries that sold raw materials to China, thenin developed nations that exported manufactured goods.
Inventories built to excess and industrial production sank.
But this was a manufacturing recession—tight job markets
and rising wages kept household consumption resilient
and avoided a more severe and broader slump.
Now surveys of manufacturing companies around theworld are trending modestly higher and show improving
output and better activity. Business leader confidence
seems to have hit bottom. Inventories are shrinking.
Industrial output and world trade are picking up. The true
economic trough was likely in August, when long-term
interest rates were collapsing, fears of recession were
rampant, and headlines spouted dire forecasts.

A modest recovery from the long slump is taking shape.
It’s already begun in the U.S., camouflaged by the General
Motors strike and year-long problems at Boeing with its
737 Max airplane. Both subtracted significantly fromindustrial output, but the latest durable goods orders
show improving activity. If Boeing restarts delivery of
the grounded 737s, investment will snap back sharply.
Regional business surveys for November show better
growth on average. The national survey from Markit News
hit its trough in August and has risen to the best level sinceApril. Money growth has accelerated. Capital spending
should re-emerge after several months of losses.
Households are in good shape and confidence stays
healthy. Consumer spending remains robust, with strong
wage gains and an excellent job market. Jobless claims
have picked up slightly but remain extremely low. Most
categories of joblessness are at or near record lows. As
new workers stream back into the labor force, a very
positive feature, the number of workers on disability has
been falling after incessant climbing for nearly three
decades. Job growth and wage gains have been thefastest for the lowest tiers of wage-earners. Housing
activity is flourishing, with starts and building permits
in solid uptrends as consumers take advantage of low
mortgage rates.
The fly in this so-far sweet-smelling ointment is corporate
profits. Surprisingly, profits have been mostly flat since2014, according to July’s sizeable downward revisions in
the National Income and Product Accounts. Accelerating
employee compensation, up 28% due to fast wage andbenefit growth, has outstripped the 16.5% rise in revenue.
Even with super-low rates, interest costs rose 38% overthat period due to significant increases in debt.
This fall in profit margins better explains the plunge inbusiness leader confidence in 2019 than trade uncertainty.
It also bodes ill for the length and vigor of this nascent
recovery. In addition, other signs suggest this historicallylong business cycle will end at some point. Banks are
slowly tightening lending standards. Loan demand isn’t
robust. Job growth has slowed. The yield curve inverted.

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.

End-cycle is likely a story, not for 2020, but for 2021.
For next year, we expect the U.S. economy to grow in
the 2% to 2.5% range, with perhaps some fatigue earlyin 2021. Manufacturing will get a further lift as global
growth recovers.

Activity in China
There are similar signs of modest improvement in China,
where growth hit its nadir last spring. Our own economic
momentum gauge for China has been improving all year.
The leading indicator, published by the Organization for
Economic Cooperation and Development, had a February
trough. Retail sales, industrial production, and fixed asset
investment all incrementally declined in October, buthave trended higher in recent months. Railway freight
and airline traffic increased. Vehicle sales and output are
rebounding. Electricity production surged in October.
Business surveys have been volatile, but the Caixin canvassof manufacturing businesses rose to 51.7 in October froma January contraction low.
The tax cuts, higher borrowing limits, and spending on
infrastructure that stimulated China’s economy this year
have been rather timid compared to past slowdowns.
Growth isn’t surging up out of recent doldrums. Officials
recognize the growth headwinds: Debt is alreadyvery high; the labor force will soon start to shrink;competitiveness is flagging.
Warning signs are evident in rising debt defaults andtroubles with smaller lenders. China isn’t allowing a major
surge in credit growth. Economic growth should stabilize
near 6% this year but will likely slow further in 2020.

Eurozone growth
Though lagging behind the U.S. and China, the Eurozone
will avoid a recession. Activity there is stabilizing.
Germany eked out a bit of growth in third quarter andinventories are falling. Household and government
spending, plus exports, have added to growth. Passenger
car registrations are surging. Business sentimentbottomed then picked up a lot in Germany. Eurozone
industrial production rose for a second straight month.
Manufacturing surveys picked up too, but services surveys
weakened. Employment growth has been decelerating
but the unemployment rate remains near the lowest in
well over a decade. While down from an early 2018 high,consumer confidence has been stable this year despite theplunge in business sentiment.
A tight labor market and rising wages have allowed
consumers to help avoid recession spreading beyond
manufacturing. Consumer confidence in France is almost
back to the highs of 2017. Retail sales have been robust,up 3.1% over the prior year in October. We expect growth
to pick up somewhat during the next few months, as
better trade flows boost exports.
With less political uncertainty and improvement in China,
Eurozone growth could surprise somewhat on the upside.
Still, any rebound will pale in comparison to the nearboom in 2017.

Looking ahead ... the third wave
This has been the third mid-cycle slowdown since theworld expansion began following the financial crisis.
Like 2015, it was a manufacturing recession. This third
upturn is bringing better activity in China and the U.S.,and stabilization to Japan and the Eurozone. Octoberindustrial output jumped in Singapore and Taiwan, often
a leading indicator of world growth. More broadly, there’s
no widespread economic or financial crisis. Central bankers
are hugely accommodative, with more rate cuts to comein high interest economies such as India. There’s little
stress in credit markets. The typical imbalances that makeeconomies vulnerable to recession are absent. Stockindices are on the uptick. Labor markets are tight andwages rising nicely in developed countries.
This recovery, though, will likely be neither lengthy nor
especially vibrant. Some end-cycle trends are alreadyevident and U.S. profit margins are suffering. Superlow interest rates created an explosion in corporate
debt issuance and investors searching for some sort ofacceptable yield lapped it up. Falling margins and highdebt levels hint at problems by 2021. The rebound in
China will be lackluster, too, compared to others since thefinancial crisis.
For now, enjoy the upturn as it materializes. Other signs ofa downturn may not be apparent until early 2021.

Does an inverted yield curve
predict recessions?
Well, it’s been almost infallible. In the past, whenevershort-term rates moved above long-term rates, a recession
followed within six months to two years. The curve did
invert this year: yields on both three-month U.S. treasury
bills and two-year bonds topped yields on 10-year U.S.
treasury bonds for several weeks. That makes a recession
certain, right?
Probably at some point, although this time was different(famous last words). In the past, when short rates rose
above long, inflation was rising and the Federal Reserve(the Fed) was hiking the fed funds rate to slow economic
growth and control inflation. Eventually, a recession
ensued as monetary policy tightened. Industry jargon
calls that a “bear flattening,” as short-term bond prices fell

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.

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.

when their yields rose. This time, the inversion occurred
not from surging short rates, but because long-rates
plummeted. Investors were buying long-term treasury
bonds as a flight to safety amid recession fears.
So have the three Fed rate cuts engineered a softlanding and prevented a recession even after the curve
inverted? Time will tell. It’s clear the August recession
panic was overdone. The yield curve steepened, which
ended the dreaded inversion. Because of the long lagtime for that signal, the coast isn’t necessarily clear.
U.S. job gains have slowed. Profit growth is nil. Both are
long-leading indicators of an economic tumble. Pastdue payments are rising on auto loans and credit card
debt. Companies are borrowing without offering many
covenants to protect repayments.
These signs aren’t at worrisome levels yet, but this trend
is not a friend.

Investment ideas
The economic backdrop always sets the stage for what
investors will experience in stock and bond markets.
Positive underlying fundamentals would generally
provide some upward impetus for both equities andinterest rates.
Monetary policy, however, is the biggest downward
influence on interest rates today. As a result, yields will
struggle to rise much from here. With U.S. inflation
expectations so low and inflation stable, the Fed won’t
be raising the fed funds rate anytime soon. In addition,
the Fed’s summer review of its inflation-fighting
framework will likely institute a “make-up” policy, suchthat the Fed will allow inflation to run above target fora while.
The mild boost in world growth, if it materializes, should
push up yields on long-term U.S. treasury bonds to 2%
or beyond, but any uptrend will be slow and tedious.
Negative yields on long-term Japanese and European
government bonds will limit any upward move in the U.S.
as money flows into the U.S. to take advantage of higher
yields. Yields on 10-year U.S. treasury bonds of 2.25%
might be worth accepting, as yields would likely fall andbond prices rise if economic troubles develop in 2021.
For bond investors, short-term bond yields aren’t much
lower than those on longer maturities. So investors
with a one-year perspective should stick to corporate ormunicipal bonds with two- to four-year maturities. Given
that the potential cyclical upturn could weaken into
2021, we’d also stick to highly rated securities.
That would apply to any risk class—investment grade,high-yield, or emerging market debt. Just stay with thehighest quality.

Stock investors enjoyed the enormous equity rally
from March 2009 through early 2018; it was hugely
profitable. Almost nine years of more than 17% annualcompound gains with dividends reinvested in the
S&P500 Index, it was one of the best rallies of all time.
It created a love affair with passive management. Just
jump on the trend and stick with it for wonderful gains,that was the thinking.
That long trend, though, is likely over. Except for the last
couple months, stock markets have struggled. Valuations
peaked in January 2018. The big tech stocks led the longrally, but that leadership peaked in June last year. Even
the outperformance of U.S. stocks over the last decade
has weakened.
From here, the outlook is for a modest upside. In thelast two months, stock markets have anticipated thecoming growth pickup. Major U.S. indices have maderecord highs and robust uptrends are evident in otherworld indices. With improving growth, the equity rally
should last a while longer, but the reward-to-risk ratio isshrinking. Trying to get the last 5% out of a rally can be
hazardous. It’s a time to be cautious.
For now, keep equity portfolios balanced, both among
sectors and U.S. versus international. As the growth
upturn materializes, cyclical sectors should continue tooutperform more defensive ones. And U.S. indices may
weaken versus international, both compared to otherdeveloped markets as well as emerging.
A pickup in world growth usually means the U.S. dollar
weakens, as money flows out of the U.S. into countries
with faster growth. That trend may have already started
with the U.S. dollar peak in September.

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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