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Principal Global Investors

Economic Insights: The stirrings of expansion
Update for the month of July 2020
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist
After a record-short recession, a new United States economic
expansion may have begun.
Economic data suggests recovery may be under way in much ofthe world. Daily new cases of COVID-19 are rising in some areas,
though sources (via Worldometers) aren’t yet indicating signs of asecond wave. Equities made progress in June with the best returns
among emerging market and tech-heavy indices.
A modest stock market uptrend should persist through thesummer but may encounter selling near the prior highs and morevolatility before the U.S. election.

A record-short recession
The National Bureau of Economic Research (NBER), the arbiter ofU.S. business cycle dates, concluded that February was the peak of
the last expansion. That economic uptrend lasted 128 months fromthe recession low of June 2009, the longest in U.S. history.
The worst recession since the 1930s began in March, due tobusiness closures and shelter-in-place policies to check the spreadof the current pandemic. This recession has also been unique in
its length, the shortest in history, ending in April or May, after only
two or three months.
Whatever date the NBER puts on the recession’s end, a new
expansion may have begun.
That’s mostly true around the world: A recovery from the worst
global recession in decades is possibly underway. China was thefirst country to emerge from the COVID-19 lockdown and datafrom its government notes economic improvement in March fromthe collapse in January and February. Industrial output for thoseworst two months combined was down 13.5% below the prior year.
Production surged in March and surpassed the prior year in April, up
3.9%; further progress was made in May. Purchasing manager indices(PMIs) from manufacturing business surveys improved from Mayand showed faster expansion. According to the Chinese government,
industry is mostly back to normal and expecting output in June toexceed May’s annual gain.
Chinese consumers have been more restrained, likely fromlingering fear of infection and reports of a renewed outbreak inBeijing. Retail sales disintegrated in January and February, off acombined 23.7% from the same period in 2019. Sales recoveredin May but were still down 2.8% from the prior year. Still, demandseems to be improving. June PMIs from services companies wererobust and above expectations. The all-industry composite index
from the National Bureau of Statistics reached the highest since
mid-2018. China reports incredible progress in just a few months.
If that’s indeed the case, its sharp recovery would help lead theworld out of recession.
The Eurozone economy is also showing signs of life after
the devastating collapse in March and April. The PMI for
manufacturing companies was 47.4 in June, still below 50
breakeven. But it’s the second highest this year and up from adevastating April low of 33.4. The all-industry composite PMI
jumped nearly 35 points in two months to 48.5, with further
increases likely in July. Daily mobility statistics point to a healthy
pickup in activity. German retail sales in May surged 13.9% overApril to put them above the level in February as well as May
2019. May retail sales in France and Spain rose even more sharply.
Confidence is still low but seems to be rising.
The Eurozone is benefitting from strong action by the European
Central Bank (ECB) to increase its country bond purchases andexpand its bank lending program. The ECB hiked its Pandemic
Emergency Purchase Program (PEPP) to a massive €1.35 trillionof potential bond purchases. In addition, the latest auction of its
Targeted Longer-Term Lending Operation swelled to €1.3 trillion,
funds that are available to banks for specified lending activity at a
cost that could be as low as 1.0%.
Further, after years of Eurozone austerity, fiscal stimulus iscoming to the fore. The German government agreed to new
fiscal spending well over €100 billion; other countries’ deficits aresurging. With PEPP, ECB bond purchases can be large enoughcover the Eurozone’s anticipated deficits. Widespread work
subsidy programs have kept the Eurozone jobless rate fromroaring higher, only ticking up to 7.7% in May. The Eurozone
recovery will accelerate in the third quarter.
Japan’s economy was faltering ahead of the COVID-19 crisis
from the October hike in the value-added tax. Fourth quartergross domestic product (GDP) in 2019 plunged 7.1%, annualized
quarter-over-quarter, and another 2.2% in this year’s firstquarter. The economy in June was following two tracks: furtherweakness in industrial output, down another 8.8% in May aftera bigger 9.8% plunge in April. The other track shows clear gains
in consumer activity with May retail sales up 2.2%. The Apple
Mobility Index for Japan keeps mending, now, nearly back to
January’s level. The composite PMI, at 40.8 in June, is still very low,
but rising. Recovery appears to be underway, but it will likely be
gradual and protracted.
The U.S. economy rushed higher in May after the collapse andclosures of March and April. Regional manufacturing PMIs leapt
to near breakeven or more in New York, Philadelphia, Richmond,Kansas City and Dallas, most well above expectations. May
retail sales sky-rocketed 17.7% over April as consensus forecast
only an 8.4% gain. According to data from the Bureau of Laborand Statistics, May payrolls climbed a monster 2.5 million jobs
versus pre-report guesses of a 7.5 million job loss. June payrolls
continued the gusher with a record gain of 4.8 million new jobs,
1.6 million above average projections. The May Chicago Fed
National Activity Index rose to a record, implying U.S. GDP growthnear 8%. The up-wave in data for May came from businesses
reopening and people returning to work.
The revival from suspending business closures continued thefirst half of June. But gains seem to have stalled somewhat
as daily new COVID-19 cases reached new records recently in

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.

several southern states. Restaurant seating data from Open Table,
the online reservation system, fell off the last couple of weeks.
J.P. Morgan’s tracker of consumer spending data from its Chasecredit and debit card system fell back noticeably in late June after
increasing steadily since mid-April. The data doesn’t seem toindicate this is a second wave of the pandemic, but lingering fear offurther infection could prolong a return to normal.

with high yield and other diversified (but more risky) corporate
bonds had robust returns as credit spreads narrowed markedly inthe second quarter. Even owners of long-term safe-haven bonds had
a positive return as yields on government bonds were flat to only
slightly higher in June and the quarter.

The huge May pop from the April economic collapse was like taking
the express elevator back to the ground floor from the sub-subbasement, a V-shaped upwelling after a record contraction. Fromhere, the U.S. recovery may become more a stair-step affair, with anactivity breather followed by another rush higher. Now is likely one ofthose pauses. The rebound from the April economic plunge will likely
resume with renewed vigor for another few weeks.

Holders of short- to intermediate-term bonds won’t have to worry
about the Federal Reserve (Fed) or other central banks hiking official
rates anytime soon. The Fed will keep the fed funds rate in the 0% to
0.25% range surely through 2021 as inflation won’t be a problem.

By September, though, the early reopening energy will have dissipated,
and the recovery turn more gradual. We expect vigorous third-quarter
GDP growth near 10% annualized but followed by a more prolonged
recovery. Continuing claims for jobless compensation remain
stubbornly high and reports of layoffs are still coming in. Some small
businesses in the service industry won’t reopen and it will likely take
until 2022 for GDP and employment to reach their prior peaks.
Nevertheless, consumer incomes are being sustained; job growthis mushrooming. A healthy recovery should persist with growth in
2021 near 2.5% or more and some slowing into year end.

Looking ahead
Worldwide mending from the COVID-19 economic plunge appears to
be underway. A few countries—India and Latin America in particular—
are still struggling with a late arrival of the virus. But in the data
covered in this piece, we see recovery in much of the rest of the world.
China was the first to grapple with the economic collapse and,according to Chinese government sources, is sharply rebounding.
The rest of the world may follow that pattern. Prices and economic
data are carrying the same message of upside surprise. Stockmarkets anticipated the revival with the best quarter in two decades.
Some commodity prices are reacting to better demand. West Texas
Intermediate crude oil hit $40/barrel. Copper is up 27% in price fromits March low. The CRB Index of raw industrial prices has worked a bit
higher since April. Bloomberg’s broad index of commodity futures
prices is up 10.3% since the trough in March. The Baltic Freight Index
has nearly quintupled since mid-May.
The outlook for a summer pickup in growth looks good. The real
uncertainty revolves around the odds for a second wave of virus
activity in the fall and winter flu season. One disconcerting fact isthat new cases haven’t fallen to zero in any of the countries that wefollow. Fortunately, fatality levels appear to have kept falling. Any
economic dislocation from a second wave of virus activity will likely
not be as severe as in 2020.

Focus on markets
June was a good month for most stock and bond markets. The S&P
500 index rose 1.8% in price but was outperformed by many foreign
equity indices. The MSCI Emerging Market Index jumped 7.0% andthe MSCI All Country World Index climbed 3%. While June returns
were good, the second quarter was stellar; the S&P 500 Index soared
19.95%, the best gain since the fourth quarter of 1998. Of the 47 markets
we follow, only the Mongolian Top 20 index lost ground for the quarter.
Bond investors were generally treated well, too, as markets were
supported by massive central bank backstops. People holding funds

Looking ahead

Large central bank bond purchases will keep yields on long-term
U.S., German, and Japanese government bonds under modest downpressure through early next year. But, with yields already very low ornegative, and unlikely to fall further in the next year or two, there’s little
scope to expect much return. In addition, as growth revives, there will
be significant countervailing upward pressure on yields. So, we’d surely
avoid investments in long-term, safe-haven government bonds.
Somewhat higher yields are available on diversified corporate,municipal, or emerging market bonds. Credit spreads have alreadycome in significantly on investment grade bonds, so the potential
return from further spread narrowing is limited. Credit spreads onhigh-yield or emerging market bonds could still narrow more so
I prefer those to investment grade. However, we’d stick to higher
quality bonds in those riskier sectors. We’d also prefer short- tointermediate-term maturities to avoid the risk of rising long-term
interest rates next year.
Stock markets did broaden out during June. The Russell 2000 small
cap index nearly kept up with the soaring Nasdaq Composite anddid outperform the S&P 500 Index for the month and quarter. Wider
participation is a real necessity if the rally is going to persist. With growth
possibly reviving, we expect a modest equity uptrend to continue. TheS&P 500 Index could challenge the February 2020 highs in the next
couple of months, but we’d expect markets to encounter sellingpressure then. Volatility may also return prior to the U.S. election.
We prefer stocks that do best as growth picks up, cyclical sectors
like materials, industrials, financials, consumer discretionary. We’dalso stick with small cap and emerging market stocks; both did
well in June, and that should continue. The U.S. dollar is weakening;
growth appears to be reviving; commodity prices are picking up; allare good reasons to prefer emerging market stocks. Fear around thepersistent rise of new U.S. COVID-19 cases may have been behind thehuge surge in tech and growth stocks last month. We still believe techstock momentum will wilt before long, but we were early with thatcall last month. It has already faded versus the Russell 2000 and theMSCI Emerging Market Index.
All these suggestions remain tactical in nature, with a time horizonof nine months or so. The revival of world growth should keep theequity uptrend intact at least for a while. There’s a lot of uncertainty
around the strength of the rebound into next year and the potential
for a second wave of virus activity.
Looking further ahead, stock valuations as well as bond prices arevery high, signs that long-term financial returns may be far less thanexciting. The best potential for robust long-term equity profits is arotation into value and cyclical stocks, a reverse of the investment
climate of the last decade.
For now, though, the recovery seems on track and we’d stay fully
invested commensurate with one’s tolerance for risk. Stay optimistic
for now.

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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