Principal Global Investors

Economic Insights: The third wave ofrevivalUpdate for the month of January 2020
By Robert F. Baur, Ph.D., chief global economist, and Robin Anderson, Ph.D., senior global economist

World growth hit three air pockets since the Great Recession and financial crisis of 2008. The first
slowdown followed the Euro-area debt debacle of 2011 and 2012. Then, in 2015, a soaring UnitedStates dollar and collapsing commodity prices created a severe manufacturing recession. After eachslump, the global economy perked up rapidly in a synchronized rebound led by an accelerating surge in
China. The latest downturn began in China in late 2017 as officials tightened credit to slow the growthrate of debt. World growth gradually wilted.
Now, a third wave of revival from this twenty-some month tumble has begun. Economic momentum
is clearly improving in the U.S. and China. A modest upturn is starting in the Eurozone, and Japan’s
economy is nearing an economic trough.

China

Recent data validate this anticipation of better growth, particularly in China. Business surveys there have bounced inboth manufacturing and service sectors. Credit growth has accelerated as the government made it easier for local
governments to initiate bond issuance. China’s leading economic indicator created by the Organization of Economic
Cooperation and Development troughed in February, and our own activity guide has been picking up since spring. Broadgauges like retail sales, industrial production, and fixed asset investment all improved significantly in November. Narrower
markers of railway traffic, electricity output and airway passengers have trended higher for several months. Robust realestate investment and rising house prices will help keep economic growth near target.
The partial détente in the U.S.-China trade conflict bodes well for better growth next year. Official statistics in China
should show stable growth near the 6% range in 2020. Over the next decade, though, secular headwinds of poor
demographics, rising debt burdens, and waning competitiveness will keep economic growth in a long, gradual decline.

UnitedStatesU.S. activity appears to be bouncing. The production cuts at Boeing may cut first quarter growth in gross domestic (GDP)by three or four tenths, but the strike at General Motors is no longer a drag on industrial output. Even beyond autos,
though, manufacturing picked up in November. Small business optimism has perked up and remains near all-time highs.
Job growth is extraordinarily strong for this late in an expansion. This boosted consumer confidence. Wage gains keep
accelerating for production and non-supervisory workers, now at a smoothed 3.4% rise over the prior year. Householdbalance sheets are in excellent shape and the savings rate stays high at 8%. Housing activity is surging as consumers takeadvantage of low mortgage rates. Housebuilder confidence jumped to the highest in 20 years.
Though capital spending has been weak in 2019, we expect investment to rebound in 2020. After all, CEO confidence
is rising off the lows, trade uncertainties have lessened, and growth is improving. Wage gains will remain stout, so
consumers will support the overall economy. The robust savings rate and balance sheets make a sturdy foundation forvigorous consumer spending. We expect the expansion to persist through 2020 with growth at or above trend in a 2% to2.5% range.

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.

Eurozone

The Eurozone economy has lagged the U.S. and China recently, avoiding recession as the weak link this year, Germany,
kept expanding in the third quarter. For the Eurozone as a whole, the trough was likely the fourth quarter of 2019. Service
sector surveys have picked up from the bottom, but canvasses of manufacturing companies may not be there yet. Thoselatter surveys showed activity ticked down in December after weak October activity. But overall business sentiment shows
signs of recovery. Robust household activity is keeping recession at bay, buoyed by a vigorous labor market.
The Eurozone is set for an upswing. With better vehicle sales and improving growth in China, German manufacturing
will pull out of its funk. Wage growth is accelerating, and job gains stay hardy as the labor market tightens. Householdspending will sustain economic growth and ward off recession. Capital spending will rise as confidence returns. We expect
Eurozone growth to rebound modestly in 2020 to near 1.5%.

Japan

The hike in the value-added tax (VAT) in Japan on October 1 had the same negative impact as prior ones: heightened sales
before the hike and a collapse afterwards. It may cause growth to contract in the fourth quarter and has surely delayed
any rebound in Japan. Manufacturing remains weak from global headwinds. Although the job market is incredibly tightand job openings plentiful, the unemployment rate remains remarkably tiny at 2.2%. The labor force participation rate forprime-age workers, 25 to 54 years, keeps rising, now at 88%, a record by a huge margin.
Nevertheless, Japanese industry is in recession as machine tool orders and industrial production keep falling. We do lookfor growth to pick up modestly in 2020 as the tax impact fades. The government has proposed a large stimulus package
to offset the VAT and the 2020 Olympics will provide a temporary lift. Industrial output in Taiwan and South Korea hastrended somewhat higher, a harbinger of a broader pickup in Southeast Asia from which Japan will benefit.

Global overview
We believe the foundation is being set for a mild but sustained
pickup in world growth for 2020. Central banks are very
accommodative. Interest rates stay extremely low. The lagged
impact of rate cuts will stay beneficial all next year. Stimulus
in China, while timid, is supporting growth. Trade uncertainty
has lessened. The U.S. dollar has weakened. Credit stress is
negligible. Inflation stays moderate. Commodity prices arerising, sniffing the aroma of better growth. The third wave ofrevival has begun.
But there are some notes of caution. The January 3 killing of
Iranian General Qassem Soleimani by U.S. forces brings thepotential for a spike in oil prices. The initial bounce in prices
was subdued, less than the immediate spike after the Iranianattack on Saudi oil facilities. A big spike in oil prices would beoverall negative for the U.S. economy. Still, the vast increase in
fracking oil production has muted negative fallout. Consumers
will be hit from higher gas prices, but the fracking industry
will be buoyed. The region is unstable, and uncertainty willcontinue. Significant escalation would curtail the upturn andcould bring economic problems forward.
While upbeat activity is coming, the recovery will likely be
shorter and less dynamic than the two since the financial crisis.
This time, China’s stimulus has been more timid than its creditfueled binges of the past. The fiscal impetus has been throughtax cuts, lower reserve requirements, increased infrastructure
spending, lower interest rates, and select provincial bondissuance. Officials have tried to rein in excess debt growth andkeep leverage under control. Bond defaults, unheard of in thepast, have been rising, validating Beijing’s need for caution on
debt. Growth has stabilized in 2019 but won’t be running away
to the upside.
China’s uninspiring recovery can’t be the engine of a dramatic
global synchronized rebound as in 2017. With China’s
import machine failing to gear up as before, its boost to theworld economy will stay subdued. Any growth revival in theEurozone, Japan, and emerging markets will likely be restrained
as well. Further, with a Phase 1 agreement between the U.S.
and China, it’s possible the Trump Administration could makethe Eurozone its next tariff target.
Can the U.S. alone be the driver of a dynamic world revival?
Likely not. There are several typical signs of the end-cycle thatare apparent, which suggest that the current U.S. rebound will
be not as strong nor as long as past bounces.
The world uptrend currently unfolding will likely have enoughmomentum to carry at least into early 2021. However, thepotential dullness of this upturn could create the setting
for another slump of sorts in mid-to-late 2021. Accelerating
U.S. wage gains could set the stage for the recently dreary
profit growth to become losses. This would shut down job

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.

growth and capital spending and potentially usher in a mild U.S.
recession. If that were to happen, other signs would arise before
the recession’s onset that could give more clarity about its timing
and severity.
For now, though, let the growth pickup to run its course and enjoy
the ride while it lasts.

Investment Implications
The economic backdrop always sets the stage for what investors
will experience in stock and bond markets, because it’s thoseunderlying fundamentals that drive future financial trends. A
stronger world economy in 2020, followed by potential problems
in 2021, suggest there will be no multi-year trends that investors
can simply ride to easy profits. The New Year will be a time forshorter-term, tactical decisions.
Whether thinking short- or long-term, most diversified equity
investors had a fabulous 2019. The S&P 500 Index soared 28.9%
in price during the year, while the broad MSCI All-Country World
Index surged 20.8%, not including dividends. Long-term, buy-andhold investors didn’t fare quite as well after adjusting for the 20%
or more plunge in stocks from early October 2018 through late
December 2018. Still, multi-year holders of the S&P 500 Index
gained 10.4% from that 2018 peak through yearend 2019. That’s
a nice return.
Bond investors also had a great year. All the 22 bond aggregates
we follow had positive returns. The best reward came fromowning long-dated U.S. treasury bonds as interest rates fell to
low levels raising the price of those bonds. Barclay’s index of long
U.S. treasury bonds returned a terrific 18.1% during the year. As
August worries about an imminent recession faded, owners ofinvestment grade, high-yield, and emerging market debt enjoyedreturns of 11% to near 15%.
What’s ahead for interest rates? The Federal Reserve (Fed) has
made it clear that the bar for raising the fed funds rate is high.
That means the Fed won’t hike rates until there are definite signs
that inflation is picking up in a sustained fashion. In addition, theFed will likely change its inflation-fighting framework away froma simple fixed 2% target. The new target may be 2% “average
inflation” over time. So, if inflation stayed below 2% for several
years, the Fed would allow inflation to exceed 2% for a while to“make up for” the undershoot. All this implies the Fed will stay on
hold throughout 2020 and perhaps much longer.
Improving world growth would suggest that long-term interest
rates will see mild upward pressure in 2020. We wouldn’t be
surprised to see yields on 10-year U.S. treasury bonds hit 2.25% ormore at some point. Similarly, yields on 10-year German bunds willturn positive, up from ‑0.4% or so in early December. With yields
at the short end fixed by the Fed, modestly rising long-term yields
imply the yield curve will steepen. That would please members of
the Fed Board.

Today, short-term bond yields aren’t much lower than thoseon longer maturities. Bond investors with a six- to nine-month(or perhaps 12-month) perspective should stick to corporate ormunicipal bonds with two- to four-year maturities. Given thatthe potential cyclical upturn could weaken into 2021, we’d buy
only highly rated securities. That would apply to any risk class:investment grade, high-yield, or emerging market sovereign or
corporate debt. Just stay with the highest quality. If the upturn
is more dynamic than expected, long-term yields will likely risefurther, so that short-maturity stance would still be appropriate.
Can stocks keep moving higher? With better global growth andabsent a significant escalation of Middle East conflicts, there
should be some modest upside for world stock markets in 2020.
Rising yields would imply it’s better to overweight stocks versus
bonds in 2020 at least for a while. For U.S. equities, valuations
are high and profit expectations are likely too robust, so, it may
be a grudging uptrend. The price-earnings ratio of the S&P 500
Index using trailing 12-month operating earnings is 20.4, not far
from the peak P/E of 21.5 at yearend 2017. Standard and Poor’s
average analyst estimates of 2020 earnings growth were 11.1%
at yearend 2019. That estimate has been gradually falling and will
likely continue to fade.
An equity portfolio that’s balanced between U.S. andinternational, as well as between sectors, may have the best
opportunity for decent returns. Faster world growth is often adrag on the U.S. dollar. Foreign equities are generally starting theyear with lower valuations. Big U.S. tech companies have beenleading the long uptrend from March 2009, but that leadershipis waning. We wouldn’t underweight value stocks or the financial
sector as growth picks up.
However long this upturn in stocks persists, it will likely be the last
rally before the end of the historic U.S. expansion. It’s now midway
in its eleventh year, the longest ever. It’s also the first time the U.S.
economy has traversed an entire decade without a recession.
Beyond whatever economic problems may develop in 2021, goodfinancial returns over the next decade may be very hard to find.
Several broad measures of sentiment point to low decade-longaverage U.S. stock returns:• the price-earnings ratio;• Tobin’s Q, or the ratio of market capitalization to
replacement value;• Warren Buffet’s favorite indicator, the ratio of total U.S.
market capitalization to the size of the U.S. economy;• and the portion of equities in total household financial assets.
Each is a sign of widespread public enthusiasm for stocks, which
has historically been a broad contrary indication for future returns.
While we expect the six to 12-month outlook to be rewarding,investors may want to be cautious about the long-term.

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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