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Principal Global Investors

Economic Insights: The rebound turns muted
Update for the month of August 2020
Commentary by Robert F. Baur, Ph.D., executive director, chief global economist
The United States economy surged ahead in May and Junefrom the cavernous losses in March and April. But widespread
concern about the rise in new COVID-19 cases dampened therebound’s vigor in July.
Economic data is improving in Europe and Japan. China’s
recovery is proceeding rapidly. Most stock, bond, andcommodity price indices rose nicely in July. The economic
rebound should keep the equity uptrend intact over thenear-term.
But high valuations for both stocks and bonds suggest that
long-term returns on diversified portfolios of financial assets
will be less than impressive.

Recovery: Challenging and lengthy
U.S. economic data for May and June advanced in spectacular
fashion after a record collapse in March and April. Retail sales
for June surged almost back to their February level. Nationalbusiness surveys by the Institute for Supply Management show
a solid expansion underway. The average of regional businesssurveys from the Dallas, Kansas City, Richmond, New York, andPhiladelphia Federal Reserve (Fed) banks jumped from an April
low of -66.4 to 12.4 in July, the best since late 2018. Housing
activity is booming; July homebuilder confidence is back to its
March level and above any point of 2019. The pending homesales index is the highest since mid-2006. Small business
confidence from the National Federation of Independent
Business is nearly back to its average of 2019.
We’d been expecting a V-shaped bounce that would last perhaps
two to four months as U.S. businesses reopened and people
started back to work. But widespread concern about the pickup
in daily new U.S. COVID-19 cases since late June dampened therebound’s vigor, likely limiting the V to two months. Restaurant
seatings compiled by OpenTable flattened out in July after risingin May and June. Daily traveler counts from the Transportation
Security Administration had the same flat trend in July averaging
about 665,000, but up from about 44,000 in April. The May-Junerise in consumer spending evident in JP Morgan Chase credit/
debit card data also leveled off in July.
The good news is that daily new U.S. COVID-19 cases may havepeaked July 23 as the seven-day moving average has been fallingsince then, down to 61,964 on August 1 (here). If that does prove
to be the peak, the U.S. recovery will likely stay on track but at amore muted pace than in May and June. Even with the July lull inthe upturn, third quarter GDP should have quite a pop. Suppose
June data is 5% or so above the second quarter average, aplausible estimate. Then, even if third quarter data stayed flat, theway the math works means GDP would show an annualized gainof 21%. So our earlier forecast of an 11.4% GDP gain this quarter
could be too low.

Beyond the third quarter, though, full recovery from thepandemic recession may be challenging and lengthy. Millions ofworkers are still on furlough or permanent layoff. Many small
businesses won’t reopen, especially in leisure and hospitality,with even large chains facing huge losses. The COVID-19 virus isproving resilient and lasting and may require major changes as
we learn to live with it. We’re optimistic that the revival from thecavernous losses of March and April will last through 2021, but
it will likely be at a more measured pace than the bounce since
early May. As a result, the U.S. economy may not exceed its priorpeaks in either GDP or employment until sometime in 2022.

Dynamic revival in China
Industry in China has come full circle. Industrial output was backabove the prior year’s level in June. With production activity
mostly normalized, total June industrial profits showed a second
month of growth at 11.5% over the prior year, following a 6.0%
gain in May. Official purchasing manager indices (PMI) fromthe National Bureau of Statistics for manufacturing edged up
to 51.1 in July up from a February plunge to 35.7, the worst
on record. The non-manufacturing PMI slid 0.2 to a still-strong
54.2, which put the composite PMI at 54.1, the second best
since mid-2018.
Real estate investment is still a driving force in China’seconomy. Construction PMI was a robust 60.5 and year-todate property investment up 1.9% from the same period lastyear. The vigorous rebound has pushed investors into local
stocks. Chinese stock indices were world leaders in July with theShenzhen Composite Index up a healthy 14.2%.
Households in China stay more restrained, likely from alingering fear of COVID-19 activity. China is experiencing amild flareup of new cases in the last few days that may keep
consumer spending from normalizing for a while. June retailsales were still 1.3% below June 2019. Vehicle sales, though,have been very strong. China was the first economy to exit
the pandemic recession and its revival has been dynamic. We
expect it to continue.

Word from Europe
Recovery in greater Europe is getting underway. United
Kingdom retail sales soared 13.9% in June over May and thepreliminary composite PMI jumped to a burly 57.1, the highest
in years. The Eurozone composite PMI, at 54.8 in July was thebest since mid-2018. Eurozone consumer sentiment is still low
but rising. After a nearly incomprehensible 40.3% annualized
plunge in second quarter Eurozone GDP, the upsurge in thethird quarter should reach well into double digits.

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 things are helping in the Eurozone. New cases ofCOVID-19 are staying low and the end of the lockdown seems tohave gone fairly smoothly. The robust rebound in China has given
Eurozone businesses a lift in confidence given the area’s healthy
exports to China. Further, wage subsidization plans have kept
unemployment from rising very much.
Perhaps most importantly, the political leadership of theEuropean Union (EU) has created an economic recovery plan thatencompasses what may be the first step toward a fiscal union.
The Recovery and Resilience Fund is a €750 billion addition to theEU budget. The money will be borrowed in the name of the EU
and the funds will be available for loans and grants to member
countries. The purpose of the Fund is to finance investment
projects that will raise a country’s long-term growth potential. It’sa real step toward coordinated fiscal policy. This Fund establishes
the principle that the EU can borrow funds and repay the debt
with taxes it collects from member countries. Euro-area recovery
should continue.

Extended difficulties in Japan
The pandemic extended the difficulties the Japanese economy
was having trying to recover from an October hike in the valueadded tax. Now, however, just as data began to improve a bit, thenumber of daily new COVID-19 cases is spiking, reaching a newhigh of 1464 on August 1 by one source (here).
Industrial production did rise 2.7% in June over the prior month,
the first increase since January. Retail sales bounced sharply inJune, jumping 13.1% over May and bringing sales back near thelevel of early 2020. Consumer sentiment has picked up somewhat
from an historic April low but is staying depressed. Businesssurveys still show contracting activity. Third quarter data should
show a substantial leap higher, but the recovery will surely besluggish and prolonged.

Looking ahead
Recovery from the pandemic recession is in progress around theworld. It’s well underway in China and parts of Southeast Asia andgetting a good start in the Eurozone and the United States. Global
stock prices have anticipated the revival with the strongest fourmonth rally in years. Commodity prices are mostly carrying the same
upside message. The CRB Index of raw industrial prices reclaimed
nearly half the ground it lost from the January high. European Brent
crude oil prices more than doubled from the April trough. Copper
prices, an excellent indicator of economic activity, have been surging,up 35% since mid-March.
The fast, sharp economic recoil from the demoralizing pandemicplunge is likely over, although lagging data reports will continue
to look great for another month or so. Several countries are still
experiencing high or fast rising daily cases of COVID-19, especially
India, much of Latin America, Iran, Indonesia, and the Philippines.
Recovery in emerging markets will lag the rest of the world, but isbeing boosted by robust growth in China, super-low interest rates,
and a weaker U.S. dollar. We expect the global recovery to proceed
quickly during the rest of 2020. We’re also optimistic about 2021.
But, until a robust vaccine is developed or we learn to coexist with
COVID-19, the economic outlook will remain somewhat fluid.

Focus on markets
July was another strong month for stock and bond returns and forbroad commodity price indices. The S&P 500 Index rose 5.5% inprice. The MSCI Emerging Market Index outpaced U.S. equities rising
8.4% in the month, boosted by the factors noted above. Performing
just below the top returns of several Chinese equity indices, the Dow
Jones Transports racked up an unusually hefty 9.0% price gain forthe month.
Two factors contributed to healthy bond returns across the risk andlong-duration spectrum. Yields on long-term U.S. treasury bonds
plunged to new multi-century lows and the Fed soothed bondinvestors’ fears of an insolvency-driven credit crisis with super-easy
policy. Barclay’s U.S. Corporate High Yield Index and U.S. Long
Treasury index gave investors a 4.7% and 4.2% return, respectively.
Euro area and emerging market bond indices had generally good
returns, too.

OutlookWith short and long-term interest rates near record lows or below
zero, and little reason to expect much change this year, bondinvestors will have difficulty finding robust returns. The Fed will keep
the fed funds rate near zero likely through 2022.
The results of the Fed’s long study of changing it's 2% inflation target
may be unveiled at the September meeting. We expect the change
to be a target of 2% inflation averaged over a period of time. So, adecade of inflation under 2% could be offset by a period over 2%.
This could extend the near zero fed funds rate indefinitely.
Yields on long-term government bonds should begin to have someupward pressure late this year or next, absent lasting pandemic
issues. Bond investors could position for that eventuality by owning
short-to intermediate-term corporate bonds, expecting a little morecompression in the yield spread between corporate and government
yields. But there isn’t much juice left in that tank as spreads havealready narrowed dramatically.
For long-term equity investors, we’ve suggested there would begood odds of an internal rotation in stock markets from secure
growth stocks to cyclical companies at some point. The latter stocks
benefit from strong growth. Stocks of the former type thrive in anenvironment of slow growth, super-low interest rates, and little
inflation, just like the decade since the financial crisis. Growth andtech stocks outperformed mightily over that period.
We have long felt the decade of the 2020s would be a much different
environment from the 2010s. It would be characterized by a bitof inflation surprise driven by fading globalization, massive fiscal
spending in response to the pandemic lockdown, and central banksupport of that policy with large purchases of government bonds.
The rotation we suggested would outperform in that environment
and we expected it to begin over the next year.
There are tentative signs of it already. The price momentum of verylarge tech stocks and even the Nasdaq Composite could be startingto fade. The July returns of the Dow Transports and Emerging
Markets are examples of cyclical company success. Further, themarket has been broadening: The Russell 2000 small cap index
nearly kept pace with the Nasdaq 100 Index since the March equity

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.

trough. The S&P 500 Index outperformed the Nasdaq Composite
after July 9. The materials sector did better than the S&P 500 Index
since March and the Industrials sector is no longer underperforming.
Whatever rotation is underway, if indeed it is, will be sporadic andirregular. This analyst still thinks positioning one’s portfolio for thatrotation is the best way to acceptable long-term returns if we arethrough the worst of the pandemic. The long-term upside for broad
indices may be limited by very high existing valuations, whether using
the ratio of price to sale or to earnings. There is a very large valuationdifference between value and growth stocks. At some point, rotating
into long underperforming sectors may provide decent returns even
if major indices make little progress.

We’d no longer overweight growth and tech stocks but prefer cyclicalsectors, such as materials, and industrials, consumer discretionary.
Financial stocks will do well when long-term bond yields see someupward pressure. That should happen at some point, more a questionof when, not if. With the U.S. dollar weakening and interest rates
still super-low, stocks in emerging countries will likely continue tooutperform, so don’t discount them.
For the short-term, recovery from the recession should offer further
modest upside to world stock markets. The S&P 500 Index could
reach new highs in the 3400 to 3500 area. We expect more volatility
leading up to the U.S. presidential election and perhaps after, given
possible problems around voting during a pandemic.

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