Principal Global Investors

Economic Insights:
What bond bear market?
Monthly update: March 2019
Commentary by Bob Baur and the Principal Economic Committee

There aren’t any signs of one yet. The consensus forboth interest rates and inflation is that both stay“lower for longer,” a view that’s been right on target
for years. That belief became ingrained in investors
from thirty years of disinflation as falling tariffbarriers allowed global companies to produce theirproducts at lower costs by employing hundreds ofmillions of low-wage workers from China and otheremerging countries. That disinflation was followed
by a near-decade of slow growth and intense fears
of deflation from the global financial crisis and its
aftermath. So, modest inflation and the low interest
rates that accompanied it still seem permanent.
But, the manufacturing cost advantage of many
emerging markets has been narrowed by yearsof fast wage growth, especially in China. One
consistent theme that echoes the shift is tight labormarkets and accelerating wage growth acrossmajor developed countries. Robust productivity
growth in the United States, though, is keeping
business’ unit labor costs tame, so there is lesscurrent need for raising prices to protect profits.
However, if wage gains persist and spare capacity
gets utilized, eventually, inflation will work its
way higher. At that point, long-term interest rates
will need to contain an inflation premium andyields will rise. That may not come until sometimein 2020.
Looking ahead
The current fed funds rate is near some estimatesof neutral, (i.e., the rate that neither boosts, nor
restricts, economic growth). With inflation so tame,
there is little need for more rate hikes from theFederal Reserve (Fed). As the dot plot indicates, theFed is done for 2019; and we’d concur. Super-low
yields on long-term government bonds suggestthat bond investors fear world growth will slow
even more. If that happens, or if stock markets

Powell at the Bat
December wasn’t pretty for the Powell team last year.
The rate hike brought a plunge in stocks. “Recession Next!” the fear.
The Powell presser made it worse; his hawkishness was plain.
Restrictive rates and more bond sales would propagate the pain.
But, global growth was slowing, and the stock dive shocked the Fed;And business saw recession near: investment cuts ahead.
Then retail sales in January shrank the most in years;
And European business surveys brought us all to tears.
So, just a month was all it took, and Powell changed his mind.
The Fed would pause its hiking rates, await a better time.
Its sales of bonds would also slow, let long-term yields contract;
With lower mortgage rates, there’d be more home sales to transact.
The market cheered; investors bet that Powell’s put had worked.
As long rates fell, the dollar dropped, emerging markets perked.
The tailwind blew through February, markets caught a bid;
As economic data bottomed, growth would stop its skid.
And then in March when pundits thought that no more could be done,
Committee doves came out in force; the dot plot hikes showed none.
Powell’s change-around had worked, and confidence is mending.
Market optimism’s strong; consumers keep on spending.
The problem’s where to go from here with valuations high,And earnings guides may falter soon when next reports are nigh.
With yields so low and spreads so tight, could bonds still be a buy?
Short-term only, up in ratings, might be worth a try.
But, stocks and bonds tell different tales about what lies ahead.
Stocks say optimism reigns, but bonds cry growth will shred.
If bonds are right and growth is poor, then stocks will start to fall.
If bonds are wrong, then yields will rise, and stock returns stay small.
Inflation’s not a problem now, consensus “low for long.”
But, wages sure are surging and could turn that view all wrong.
Powell won this game; but, if inflation starts to rear,
We may need more than Powell’s bat to finish out the year.

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.

have another downdraft, those yields could shrink further into
mid-year. Yields on ten-year U.S. treasury bonds are currently held
down by negative yields on German and Japanese government
bonds where growth had slowed the most. With our optimistic
forecast for global growth, though, we’d expect long-bond yields
to trough by mid-year and work higher into year-end. Besides theacceleration in wage growth, commodity prices are percolating;broad commodity indices are well off the lows of last year. So,
inflation is surely not dead, only dormant.
Yield curve inversion
There have been many headlines about the recent inverted
yield curve where the yield on 10-year U.S. treasury bonds fell
below the yields three-month treasury bills. That has been an
almost infallible harbinger of recession for decades. We’re not
too alarmed yet. In the past, the inversion had to continue for awhile—weeks, not days, and it should be significant (i.e., morethan just a few hundredths of a percentage point). It also needs
to infect the whole curve, i.e., two-year yields over 10-yearyields, and that hasn’t happened yet. There’s also some question
about whether it even means anything today, given the Fed’s
suppression of long-term yields over the last decade.
Further, the yield curve becomes inverted when an aggressive
Fed raises rates into restrictive territory and bond investors
believe a recession is coming. Investors would buy long-termbonds as a safe haven, lowering long-term yields. With current
yields so low, the Fed is not very restrictive now. In addition, an
inverted yield curve is just one of many recession indicators, andfew others are flashing warnings now.

Stock market outlook: Can the equity
surge continue?
Probably not. World stock markets have had a terrific run in2019. Of all the 47 world stock market indices we track, only two
had a negative return during the first quarter. China indices leadthe bandwagon with gains of 22.9% and 33.7% in Shanghai and
Shenzhen, respectively, and 35.4% for China’s small cap index.
Interest rates collapsed during the quarter, so bond investors
had a bonanza, too. Barclay’s U.S. Corporate High Yields index
returned a fantastic 7.3% in the quarter. Expectations foran eventual pickup in world growth and the sudden dovish
fervor of central banks spurred the serendipity. Prices of realestate investment trusts soared on plunging interest rates andimproved rental income prospects.

Looking ahead
The worst problem for equities would be a significant recession
in a large part of the world economy. As we discuss below, that
doesn’t seem likely as world growth stabilizes and green shoots
spring up. So the kind of devastating bear market that often
accompanies a severe recession is surely not in the cards.
Another problem for equities would be a significant rise in longterm interest rates, whether from increased inflation or simply
better growth. With current and expected inflation subdued,
the prospects for new cycle highs in U.S. treasury bond yields
in 2019 is likely pretty low. With investors clinging stalwartly
to the “lower for longer” consensus, it will take evidence of
inflation that will stay at or above central bank targets before
interest rates would rise much above 3%.
Even with the massive post-holiday surge, stock markets
haven’t even recovered all the losses of 2018. So, it’s hard to
be enthusiastic about prospects for good stock market returns
from current levels in 2019. Stock and bond markets have twodifferent views of world growth. Super-low government bondyields suggest the outlook for growth is poor. Meanwhile, thepost-holiday stock market surge portrays optimism about asolid recovery and healthy profit growth. If the bond market
is correct, stock prices should fade as growth worries return.
If the bond market is wrong, then interest rates would surely
rise, causing stock prices to fall along with valuations. That’s
what brought the turmoil last year as valuations peaked in
January 2018.
One positive scenario for stock markets: if interest rates would
stay mellow even as the slowdown in world growth ended. Stockprices could then mildly advance along with rising earnings.
But, it’s hard to see 10-year U.S. treasury yields staying below
2.5% when nominal U.S. growth is 4% to 5%. We’d guess it’s atime for stock investors to be cautious as returns from thesevaluation levels will likely be limited.

World economic outlook: green shoots
Stock markets plunged in December as evidence began toaccumulate that a recession might be around the corner.
Growth in China slowed significantly throughout 2018 and thefourth quarter rebounds in Europe and Japan were modest at
best. The Fed added to the gloom by raising the fed funds rateand sticking to its prior hawkishness. US holiday sales weresmashing records, but, sentiment plummeted with stocks.

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.

Cooler heads prevailed in late December and stock markets
rallied as investors anticipated the end of the slowdown. Frontrunning a recovery can only push stocks so far and the lateMarch stall may be investors waiting until some actual green
shoots to validate the upsurge in stock prices. Those signs arestarting to appear. After stabilizing in the second quarter, world
growth should pick up mildly as 2019 progresses.

United States: chasing Australia

Even with a weak 2.2% annualized growth in the fourth quarter,
the U.S. economy expanded at a robust 3% pace from thefourth quarter of 2017. However, the government shutdown
that lasted into January will keep any rebound modest. Thatdrag, along with seasonal adjustment problems that the Bureau
of Economic Research can’t seem to eliminate, may keep U.S.
first quarter growth below 2%.
We expect U.S. growth to return to trend, about 2.5%, therest of the year. Regional Fed business surveys have alreadyrecouped some of their losses. Consumer confidence measures
have risen off earlier lows. Small business optimism ticked
up in March. And why wouldn’t household confidence stayrobust? Job openings keep hitting new records, wage growth isaccelerating, and joblessness among the hardest hit workers has
plumbed all-time lows. A proxy for total U.S. household income
rose 5.4% in March over the prior year, the best jump in morethan a decade.
Looking ahead
If this U.S. expansion lasts through July, it will become thelongest in U.S. history. While we doubt the next U.S. recession
will be 27 years away like Australia’s current record run,
whatever downturn comes will likely be mild and several
quarters away. The key is further wage gains and job growth—and both have been smokin’. The Household Survey by
the Census Bureau showed 2.88 million new jobs in 2018,
the third best in more than three decades. The labor force
participation rate for prime-age workers (aged 25-54) is rising
nicely, indicating businesses are pulling in new workers fromthe sidelines.
The old age of U.S. capital stock plus the incentives in the Tax
Cut and Jobs Act of late 2017 should keep investment growth
healthy, albeit not as fast as the spectacular 7% pace of 2018.
Solid capital spending suggests that the recent pickup in
productivity gains will continue. It’s those increases that raise
standards of living, boost confidence, and keep householdspending vigorous. We expect U.S. gross domestic product(GDP) to grow around 2.5%, driven by sturdy investment andstrong consumer spending gains.

Some forecasters see harbingers of recession lurking in the
background. An early-first quarter poll of U.S. chief financial
officers by Duke University noted a near-majority believed a U.S.
recession would develop yet in 2019. That doesn’t seem likely.
The Fed isn’t aggressive. Inflation is tame. Household debt isn’ta problem currently. Inventories aren’t too big. Payrolls are trim.
Corporate profits are still growing. The imbalances that typicallypresage a recession just aren’t evident.

Europe: tighter labor markets,
rising wages
Eurozone data has been thoroughly disappointing. Slowing
manufacturing activity, softening Chinese import demand, andpolitical tensions have kept a lid on Euro area growth into 2019.
Italy fell into a technical recession and China’s slowdown almost
pushed Germany into one. The latest business surveys for Marchare still edging lower. But job growth has been stout, with thejobless rate the lowest in a decade. That puts upward pressure
on wage growth, which in turn boosts household consumption.
Looking ahead
Europe’s immediate growth prospects, while negative, will
likely pick up in the second half. Many of last year’s negative
growth pressures have moved into reverse and a stabilizationin China’s import demand should provide a meaningful boost
to European exports. Business and household confidence didn’t
fall nearly as much as the business surveys indicated. Business
confidence has already ticked higher in Germany and France.
The European Central Bank (ECB) responded to the downshift
in growth by extending its no-hike guidance through the fullyear and announcing new liquidity provisions, a strong banking
system support. It also appears that fiscal policy will become
more expansionary after Euro area elections. We expect growth
to be positive but uninspiring in the 1% to 1.5% range this year
and into next.

Japan: robust job market
After GDP contracted in last year’s third quarter, the rebound
was barely modest. Manufacturing activity is weak, given theslowdown in global growth and international trade. Profits
are falling after several years of robust growth, but businesses
don’t seem to be retrenching. Office vacancy rates in Japan’smajor cities are the lowest since the mid-1990s and rent growthis rising.

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.

Household consumption will continue to be the economic
driver supported by good income gains from the job market.
Japan’s job market is incredibly tight, with an ultra-low joblessrate on only 2.5%, the second lowest since 1993. There are
1.63 job openings for every job applicant, the most since a
short spike in 1973, so anyone who wants a job should find one.
Total employment is rising even as the population declines. We
expect growth to be 1% or so this year with some downside risk
if the hike in the value-added tax if enacted.

China: a billion here, a billion there …
Pretty soon you’re talking about real stimulus. Last year’s
slowdown in China’s growth was somewhat self-imposed froman official attempt to slow the growth of debt. The idea likely
was to prevent excess debt from creating a financial crisis in the
future. That drag coincided with another obstacle to growth,
reducing the pollution in China’s major cities. Add the tradedispute with the U.S. and the global growth downshift andChina’s slump became worrisome.

Emerging markets: a favorable tailwind
For several quarters, India has been the fastest growing majorcountry in the world. Since taking office, the Modi government
enacted several changes that were initially economic drags butwith long-term positive effects. Those changes have shown up
in India’s recent 7% pace of growth. Growth did tick down inlate 2018, but we think a rebound of sorts is occurring. Businesssurveys are edging higher and new manufacturing orders arestrong. The SENSEX Index is pressing up against new highs andinflation seems under control, at least for the moment. The
central bank will likely cut rates another 0.25%. GDP growth
could remain in the 6.5% to 7% range.
A China growth pick-up later this year would help lots ofdeveloping countries, especially in Asia. In addition, U.S.
interest rates have fallen substantially. The U.S. dollar isn’t
making new highs. These events, plus a gradual pickup in world
growth, will provide a decent tailwind for emerging markets as
2019 progresses.

Starting last year, officials began to energize the economy withseveral rounds of stimulus:•

cuts in income taxes and the value-added tax,•

lower bank reserve requirements to improve liquidity,•

less enforcement of pollution regulations, and•easier lending standards.

The improvement in the latest business surveys suggest thatgrowth has stabilized already. Fixed investment has ticked up
and retail sales growth has quit falling. Private reports indicate asurge in lending. Using official figures, growth will likely remainaround 6% for 2019, although we would expect any uptick to
fade into 2020 as the stimulus wanes.

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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